- Xinyuan has all the traits of a healthy company: solid income, growth, dividends and institutional investors.
- Xinyuan is incredibly cheap, with a P/E of 2.7 and at 31% of book value.
- There is zero indication that Xinyuan is a fraud. It is guilt by association concerning a class-wide fear of Chinese fraudulence.
- Fraud concern was raised when a newly appointed CFO left Xinyuan after only two months in 2013. But it appears he got a better offer elsewhere.
Xinyuan Real Estate (NYSE:XIN) is a Chinese residential real estate developer listed (and IPOed) on the NYSE. It is also a mystery, because it is mind-bogglingly cheap:
- It trades at a P/E of 2.7 and 31% of book value.
- It earns a healthy income and is growing quickly in a fast-growth market.
- It pays a 5.15% dividend.
- It has a strong balance sheet and can withstand quite a bit of market turbulence.
- It made the Forbes Asia "Best Under $1 Billion" list in October 2013.
Given the reasonably valued American homebuilders such as KB Home (NYSE:KBH) and Toll Brothers (NYSE:TOL), XIN's stock price should be around 7x higher at $28 -- not $3.88. That is the difference between a $300M and a $2B company.
So Why Doesn't the Market Correct?
For two reasons: One, institutional investors generally will not touch anything below $5.00 on principle. So until the small, private investors carry it above that price point, the stock will not have access to those owners. And two, the small private investors are afraid that XIN is a fraud. It is a catch-22: Without the confidence that institutional investors inspire, the small investors don't dare to bid it above the threshold where institutional investors can join in.
The Fraud-Belief History of Xinyuan Real Estate
Xinyuan IPOed on the New York Stock Exchange in December 2007 at a decent $15.40, only to be steamrolled by the global financial crisis and stumbled down to below the $2 mark in late 2008. It then started to climb back up as investors eyed potential bargains in REITs and homebuilders that seemed strong enough to survive the financial crisis. It had reached a high of $7.37 in mid-2009 when the Chinese fraud scandals started to appear (as capital was no longer around to sustain the frauds), and then took another dive to below $4.00 where it then plodded along until the $59B private equity fund TPG gave the company its stamp of approval, investing $109M in mid-2013. This kicked the stock into gear and it rose past the $5 mark, and then up past $6 and even $7.
As long investors, we thought that the moment of "market correction" had finally arrived -- and then the newly appointed CFO quit after only two months on the job. Private investors still made up the majority holdings in Xinyuan and they fled in droves after this news, sending the stock back to below the $4 mark -- where it is today.
So, Is It a Fraud or Not?
I believe Xinyuan is not only a legitimate business but actually a very conscientiously run business. The arguments that it is a fraud (in what I believe to be the order or importance) are as follows:
1. Xinyuan is a small-cap Chinese stock. As several spectacular frauds came to light, many will simply avoid Chinese stocks overall on the assumption that there is some kind of structural flaw in either 1) Chinese business morals, or 2) U.S. accounting of Chinese businesses.
The statement that "All small-cap Chinese businesses are frauds" is false even if the two points above are true. Some Chinese companies will be run by hardworking and honest people, willing to admit failure and genuinely concerned with their stockholders. The trick, then, becomes to tell one from the other and be extra wary of any irregularities.
But as a value investor, it should also count as a big "for sale -- heavily discounted" sign on the overall class of Chinese stocks. If you think that discerning fraudulent overseas companies from legitimate ones is within your circle of competence, this should be a market for you.
2. Shaky CFO history. The former CFO, Tom Guernee was the chair of the audit committee of Longtop Financial Technologies, which turned out to be a billion-dollar fraud involving complicit Chinese banks helping to sneak a false cash balance past Deloitte.
Guernee immediately resigned his post, testified to the SEC under immunity and was never charged. Does it look good? No -- but it implies incompetence far more than it implies complicity.
2b. More CFO trouble. When Guernee left his post at Xinyuan in 2013, his replacement, Mr. Kevin Wei, who came from a position in IFM Investments Limited (NYSE:CTC) resigned his post after only two months with this explanation (excerpt taken from the XIN press release):
Kevin Weihas advised the Company that, effective November 15, 2013, he is stepping down as Chief Financial Officer due to personal reasons relating to the roles and responsibility of his position. Mr. Wei will stay as an advisor to the Company through April 2014 and continue to contribute his expertise to the Company's development.
The market immediately assumed that Wei left after discovering Xinyuan to be a fraud. This was the news that killed Xinyuans market correction in late 2013. I'd argue, however, that Kevin Wei simply quit because he got offered a managing partner position at Fontainburg Associates in Hong Kong:
- His LinkedIn profile states the shift happened immediately.
- His LinkedIn profile still carries Xinyuan as a reference -- if he found out it was a fraud, he could have easily left those two months off of his CV.
- He stayed on as an advisor. If he had just arrived surely it would be far better to just expose the scam or, at least, threaten to do so if he was in any way associated with the company any further.
- Xinyuan also had a newly appointed CEO, Mr. Xinqi Wang, who had assumed his position 45 days prior to the announcement that Wei left. If Wei had discovered fraudulent accounting, why would Wang not also leave at this point?
- Furthermore, TPG had just invested $109M and had an appointee on the board, so the "Wei fraud thesis" has to assume that management managed to keep Wei from reporting to the board prior to his resignation, which I consider unlikely to the extreme.
3. Expensive bond issuances. These were $40M in April 2010 at 19% and $200M in May 2013 at 13.25%, despite what appeared to be very strong liquidity positions. Xinyuan operates as a Cayman Island holding company with Chinese subsidiaries. The holding company had $25M worth of bonds maturing in 2010 and would have to pay a withholding tax of 20% to channel funds from the PRC to its holding company to pay the principal. A previous bond holder offered the issuance of a $40M bond with minimal due diligence and Xinyuan jumped on it.
In essence, the withholding tax is again the reason that Xin chose to take on seemingly expensive bond debt in 2013, likely to fund its Brooklyn, N.Y. development (which is there for anyone to see).
4. "Didn't you see that 60-minutes show about Chinese ghost towns?" Lesley Stahl interviewed Wang Shi, the CEO of China's largest home developer Vanke (OTC:CVKEF), and visited ghost towns. The argument is made that China is overdeveloping and a real estate bubble is in progress.
While a bubble is a large risk for investment in Xinyuan or any other Chinese developer, it is not an argument for fraud. Furthermore:
- Ghost towns are failed speculations on the case of investors, not developers. All the apartments got sold to Chinese middle class investors looking for a vehicle to invest in.
- Just because it is a ghost town now does not mean it will continue to be; Shanghai's Pudong was an empty construction site with no residents in the late 1990s. Today it has over 5M residents and is a fully occupied modern city.
- Eyewitness reports have confirmed that Xinyuan's developments are, in fact, inhabited.
- However, vivid the images of ghost towns are not in themselves arguments for a nation wide bubble -- just as the overconstruction in Texas in the 1980s didn't affect San Francisco or New York.
So what we have here is a well-run home developer with a 20%+ five-year average growth rate, a strong balance sheet, and a rather large pipeline of projects. It trades at a P/E of 2.72 vs. the S&P average P/E of 19.11 (ratio of 7.0) and a book value of 31% vs. the S&P average of 2.69 (ratio of 8.7). Mr. Market has decided that this business is on sale for $300M. I'd say that it could be $3B before 2018.