By: Jared Sleeper
Xinyuan Real Estate (XIN) may well qualify as the world's cheapest stock. Xinyuan is a real estate developer in China that builds massive housing developments in China's tier 2 and 3 cities (not Beijing, Shanghai or Guangzhou, which are considered tier 1), selling units to China's burgeoning middle class. The company was founded in 1997, and launched an initial public offering on the New York Stock Exchange in December of 2007, becoming the first Chinese real estate company to do so.
Xinyuan originally appeared on our radar because the stock appears cheap. Very, very cheap. The company's market capitalization of roughly $200 million is backed up by $100 million in net income last year (and $100 million projected for next year as well), $487 million in cash and cash equivalents and $768 million in tangible assets (in this case, primarily housing inventories). This is offset by $285 million of outstanding debt (short- and long-term), and additional considerations such as accounts payable totaling (all together) roughly $500 million. The undervalued nature of Xinyuan's stock doesn't take complicated ratios to see, it is a matter of arithmetic. The $487 (cash in millions) + $786 (assets in millions) - $750 million (total liabilities) = $523 million, more than two and a half times the company's current market cap. In terms of valuing the company's income, a conservative valuation of 5X earnings (trailing or forward projected) yields a valuation of $500 million, again roughly 250% higher than current valuations.
With this in mind, we set out to determine why a real estate developer in one of the fastest growing regions on earth might be selling at a forward P/E of 2 with a substantial cash position. We found two primary reasons that we believe explain the disparity. The first is that the market perceives a risk of fraud. This has been a huge concern for all Chinese small cap companies traded in the U.S. Many investors, both large and small, have been burned by Chinese companies that were completely fraudulent, often companies listed on U.S. exchanges through the reverse merger process. As we will explain below, we feel very confident that Xinyuan is not a fraud.
The second reason is that there are substantial fears about the housing bubble in China, and an expectation that dark days are ahead for Xinyuan and similar companies as the government takes action to eliminate the widely perceived housing bubble. We make macro-agnostic calls as we don't feel we have the time or resources to make market-beating macro calls. But we do feel that there are significant faults in the way the market seems to be implicitly pricing Xinyuan's shares given the consensus views about the future of the Chinese housing market, and that the company is well positioned to prosper in all but catastrophic conditions.
First, on the matter of Xinyuan being a fraud. Here is what our research revealed:
Xinyuan IPOed on the NYSE in 2007. This is important because the IPO process is very rigorous (investment banks selling shares to clients do extensive due diligence), and most of the fraudulent Chinese small-caps used reverse-mergers to become listed on U.S. exchanges. Examples of reverse merger stocks crushed by fraud allegations include China Valves Technology (GM:CVVT) and Deer Consumer Products (GM:DEER). Xinyuan appears to be unfairly lumped in with this group despite its far less shady means of being listed on the NYSE.
Xinyuan lacks many of the traditional signs of a Chinese-small cap style fraud. The company buys back shares and pays a dividend, and it also reported two consecutive quarters below its own projections, which is something atypical of fraudulent companies who usually exceed expectations since they are, after all, cooking their books.
Importantly, the company is audited by Ernst & Young, a very reputable American firm that has pledged its reputation that Xinyuan's books are accurate. Most Chinese frauds were audited by less prestigious firms, often based in China, and Ernst & Young has modified its practices significantly to ensure even greater accuracy in the wake of the recent scandals.
Xinyuan's CFO, Tom Gurnee, is a Stanford Grad with whom we have exchanged a few emails. He comes across as friendly and intelligent, and had a strong track record in the U.S. before moving to China, where he was CFO of Sohu.com (SOHU), a major search engine there. His presence is reassuring as Chinese frauds are known for having management with difficult-to-research backgrounds. Moreover, through conference calls and other communications, he seems to have very strong business instincts and knowledge.
The company has a low short interest (230,000 shares) which implies that no major investor has committed to the idea that the company is a fraud.
According to the CFO (no independent confirmation of this is available) the company's chairman and founder owns roughly 40% of the company's shares. This substantial insider ownership should be reassuring to investors, as is the fact that we could find no evidence of related party transactions, another prominent feature of Chinese small cap frauds.
The company has both paid a dividend and bought back shares recently, and has announced that it will declare a new dividend very soon, with a target in the 5% annual range. This is a very powerful sign to shareholders that the company's books are solid, as fraudulent companies generally look to conserve their cash given that they frequently overstate their cash positions. We look to this dividend announcement as a major near-term catalyst.
All told, we feel fairly confident (though certainty is difficult when dealing with all but the largest corporations) that Xinyuan's books are accurate, although we will continue to vigilantly look for any signs to the contrary.
Next, we'll address the much discussed Chinese housing bubble. There is a great deal of merit in this claim, and most reports we looked at concurred that a substantial decrease in prices is on the way. However, this appears to be already priced in to the stock, and we believe the market may be overestimating the potential for harm to the company for the following reasons:
- Management continues to guide for net income in the $100 million dollar range next year, saying that while they have seen softening conditions, things are improving as of February.
Xinyuan abstained from purchasing property for the past three years, building up cash to wait for prices to cool off. As land prices have fallen recently given the expectations for trouble, the company has begun using this cash in limited ways while maintaining huge liquidity ($200 million cash net of debt). Nonetheless, Xinyuan holds no assets purchased at the bubble's peak, insulating it significantly from a downturn.
Xinyuan develops land in tier 2 and 3 cities, which did not see prices increase as dramatically as areas like Beijing and Shanghai, meaning the bubble is likely to be less pronounced for them. Recent data, which did show declines in new construction pricing, showed only tiny decreases in prices throughout China, including cities in which Xinyuan builds.
The company has the flexibility and resources to weather periods of downturn well, include substantial margin space (gross margins of 28%; net margins of 15%) should they need to discount property, which they have done in extremely limited ways so far in response to falling prices at auction. They also have the means and will to buy into weakness to secure attractive asset prices.
Outright collapse of property prices in China is unlikely, as the country has very, very little private leverage (most of Xinyuan's condos/apartments are purchased without mortgages), and the government is already heavily restricting home buying. Should prices seem set to fall in a way that would be overly damaging, the government can simply loosen its controls and dramatically increase demand. The fall in prices currently being experienced was deliberately caused by the government, a far cry from the situation in the U.S. With strong underlying fundamentals (read: massive economic growth and urbanization), low leverage and a powerful government that very willfully stepped in to avoid a damaging bubble (leading to the recent declines in prices), pure research suggests that an uncontrolled collapse of the sort that might seriously weaken Xinyuan's financials going forward is unlikely.
All told, we think the market is severely undervaluing Xinyuan. We believe the company is legitimate and that, even factoring in the current housing bubble, the company is stunningly undervalued. It is difficult to predict exactly what the company will look like going forward since it is so dependent on macro factors which are beyond our expertise, but considering some potential scenarios provides an idea of the extent to which Xinyuan is undervalued.
Should the housing bubble shrink the value of Xinyuan's inventory by 30% (such a figure implies economic catastrophe in China and likely the world) and reduce earnings next year 80% below the company's projections, Xinyuan would still have a $287.2 million net asset value and $20 million in earnings for FY 2012, leaving it undervalued at current levels.
On the upside, it is frankly difficult to value the company without appearing hyperbolic. Considering company's net income of $100 million and net assets of $523 million, we believe Xinyuan has the potential to be worth at least its net tangible assets (U.S. developers KB Homes (KBH) and Toll Brothers (TOL) both trade at P/B multiples much higher than 1, despite much slower growth), implying a valuation north of $500 million, or roughly $6.50/share. Again, this is more of an estimate than a price target as the macro situation on the ground in China will be a major determining factor. But the result remains: Barring economic calamity, shares of Xinyuan are extremely undervalued, likely due to the almost certainly incorrect market perception that the company is fraudulent. As our extensive due diligence points strongly toward the company being legitimate and we believe that the risks of the Chinese housing bubble are overblown in light of Xinyuan's depressed valuations, we recommend buying shares of Xinyuan at current levels, with a very conservative $4.25 price target (52% above yesterday's closing price), at which point we will carefully reevaluate our position.
Additional disclosure: All investors should do their own due diligence before buying any publicly traded stock. Although we present evidence that we believe shows Xinyuan to be a legitimate and undervalued company, minds greater than ours have been fooled by Chinese small cap stocks before, and investors should carefully consider all risks of ownership.