The Long Case For China Housing & Land Development

China Housing & Land Development Inc (CHLN.OB) is the largest private residential real estate developer in Xian city, Shaanxi Provence, China. This is a city with a population of 8 million situated 600 miles from Beijing and is the gateway to China’s vast western resource-rich region. Xian is pivotal to the Beijing government’s ‘Go-West’ strategy, which specifically aims to diminish the wealth gap between people living in the rich eastern seaboard and those in the hinterland. Xian has been targeted to receive major infrastructure development, both by local government and non-government bodies. The Xian Bureau of Statistics calculates that the city will require approximately 78.7 million sq feet (~$3bn at Dec’06 pricing) of new accommodation annually until 2020 to meet its needs. With its well-established reputation and Level 1 status, which offers protection against new entrants, China Housing is ideally positioned to profit from this large infrastructure build-out and to participate in joint ventures with international players such as Hutchison-Whampoa in Shaanxi and other regions. CHNL plans to have a full listing of its shares on a US market on or before mid 2008. Currently CHLN is very much an undiscovered stock, trading recently at about $6.00, equating to a 2008 p/e of 5.0 on a fully diluted basis. This is unusually attractive considering its strong track record, its exciting project pipeline and the future prospects on offer.

Long-Term Outlook

The long-term macro-economic outlook for China is bright. China is predicted to be the world’s largest economy by 2030 and Goldman Sachs recently issued a report saying that Chinese middle class will reach 650 million by 2015. By all accounts many years of strong growth lie ahead with the housing market for the burgeoning middle classes a major beneficiary. In recent years much of China’s wealth has been generated along the eastern seaboard. A significant and worrying disparity between the mostly urban rich and the mostly rural poor has emerged. The Beijing government is increasingly aware of the importance of preserving national stability and has targeted several development initiatives towards improving the hinterland and the lives of those who live there. Development of the western region (dubbed ‘Go West’ strategy) is a top 5 priority of the national government in the 2006-2010 Plan for Economic Development. On the political front the Communist Party Chairman and country President, Hu Jintao, during the 5-yearly party congress meeting, which opened on October 15, 2007 reiterated his goal of adopting additional important moves to alleviate the income disparity gap. Whilst China has experienced some growing pains, it does appear on balance to be positioned to continue its march towards economic success for many years to come.

Xian City

Xian city has merits in its own right. It is the capital of Shaanxi Provence, population 36 million, and it is a popular tourist destination for attractions such as the Terra Cotta Warriors and the Old Walled City of Xian. It has a strong local economy with hi-tech, military, aeronautical and pharmaceutical industries and a number of universities. Xian has enjoyed economic growth of 15% per annum over the past several years and has annual population growth of 5% - this growth in part being driven by the central government’s ‘Go West’ strategy. Xian is a forward looking city and is taking positive steps towards preserving its clean air with a large roll-out of compressed natural gas filling stations for its motor vehicles - vehicles run on CNG cut fuel costs by 60%, reduce particulate emissions by 95% and reduce carbon monoxide emissions by 75% (refer to China Natural Gas (CHNG.OB)).

An important development instigated by the Xian governing body is the establishment of a satellite suburb in the Chan Ba district, with the government investing $7 billion by 2020 on infrastructure, including roads and a new subway to connect Chan Ba to Xian city center. According to the government Chan Ba will have a population of 900,000 by 2020, up from 300,000 today and it will have a 2,224 acre hi-tech zone – Baqiao – encompassing an aerospace research center, retail and commercial units, a logistical center and residential housing. In total there are central and local government drivers in place to create over 1.26 billion square feet of new housing between 2005 and 2020, representing about 80 million square feet annually. At the end 2006 the average selling price per sq ft in Xian was $38, implying an annual new-build requirement of $3 billion.

Despite the strong local demographic and economic trends Xian real estate prices are much lower than those of other metropolitan areas such as Beijing and Shanghai - Xian house prices are approximately 25% of those in Shanghai. Whilst property price appreciation in the eastern seaboard may be limited in the not too distant future, property prices in attractive cities such as Xian seem set to increase based on the large pricing discounts on offer, inward investment, quality living environment and demographics.

China Housing & Land Development Inc.

Established in 1992 as a state owned enterprise and privatized in 1998, China Housing has an established track record with local government and consumers based on its high quality developments. It is the largest private real estate developer in Xian and the third largest in the region, the two larger being state owned enterprises. CHNL has been ranked as the #1 private housing and land development company as recognized by the China Enterprise Confederation and China Directors Association. The company has obtained Level 1 status from the China Ministry of Construction, the highest level awarded by the government, allowing it to develop large as well as small projects. The significance of Level 1 status is that any new competitor can only begin at Level 5, allowing it to only do very small projects and a developer can only move up one notch in a single year regardless of whatever fine qualities it may have. In effect this affords incumbents such as China Housing a degree of competitive advantage over newcomers. With Xian’s attractive property market now receiving more attention from international developers the prospect of joint-venture arrangements with such new entrants has positive implications for China Housing’s future.

History and Pipeline

Residential project sizes for China Housing have historically averaged 1,000 to 2,000 units with adjacent commercial space. Residential units are mostly sold through on-site sales centers with the commercial space being sold or leased to major retailers. Following privatization in 1998 sales grew from $2.4 million in 1999 to $54 million in 2006. During this time the company completed 7 projects amounting to 4.2 million square feet. All projects have been profitable for the company with an average IRR to date of 140%. China Housing has 2 current projects and 4 new developments.

Current Projects:

• 24G, expected sales $36.2million and profit after tax $8.6 million.
• Junjing Garden 1, expected sales $73.4million, expected profit after tax $10 million.

In both cases the majority of sales revenue has been recorded in the P&L on or before Q2’07. The remaining sales balance, $45 million, is expected to be mostly included in H2 2007 with a smaller amount hitting the 2008 P&L.

New Developments:

• Junjing Garden 2. Over 2,000 apartments totaling 2.5 million sq ft of residential space with 130k sq ft retail/commercial. Construction started in July 2007 with planned completion by December 2009. Expected sales $125 million and after-tax profit of $24 million. Whilst pre-sales commence in 2007 it will be H2’08 before the project is sufficiently advanced to enable sales to be recorded in the P&L. On October 18 China Housing issued a progress update on pre-sales bookings for Junjing Garden 2. During a 2-week period the company pre-sold 250 apartments. Quote: ‘The scale of the first pre-sales was greater than our original expectations as the real estate market in Xian remains extremely strong with demand for housing far outstripping available supply’. (Refer below: Pre-Sales Update Junjing Garden 2).
• Yijing Garden. 1,500 apartments totaling 1.9 million sq ft residential space with 107k sq ft retail/commercial. Project expected to start October 2008, be completed in 2010 and generate $105 million sales and $23.8 million profit after tax. Assume the project not sufficiently complete to have sales hit the P&L until start of 2010.
• Kang Canyon. This is a luxury project comprising 150 single-family villas. Expected to start late 2008, be completed in 2010 and generate $32.4 million sales and $7.4 million after-tax profit. Again, assume sales to be recorded in P&L from beginning of 2010.

New Land Development Project:

Baqiao Hi-Tech Zone. This is a form-changing transaction for China Housing. In May 2007 the company acquired exclusive rights to develop 487 acres of land for residential purposes in one of the most attractive parts of Baqiao hi-tech zone. The company plans to invest the necessary capital expenditure for electricity and water to prepare the land to be sold off to other property developers starting in the last quarter of 2007. CHLN anticipates land sales will generate proceeds of over $500 million in the next 4 years and profits after tax of approximately $170 million. A total of 45 acres is to be sold in late 2007 and at least 100 acres in each of 2008 and 2009. In the Q2’07 earnings release (see reference below), Mr Pingji Lu, Chairman of China Housing confirmed; “Recently, several high profile developers have committed approximately $1 billion to new developments that are directly adjacent to ours at significantly higher land acquisition costs. This not only reinforces our expectations for future property prices but provides us with multiple opportunities to evaluate partnership opportunities with these developers that could potentially increase returns for our shareholders.” He went on to outline his expectations that the company would generate at least $35 million from Baqiao land sales in Q4 and advised; “we have initiated negotiations with several major international developers with positive indications and subsequent pricing above our internal expectations”. The Baqiao land project represents a very exciting opportunity for China Housing.

Share Placement: ‘Make-Good’ Obligation

In May 2007, to support the acquisition of the 487 acres of land at Baqiao, China Housing issued 9.3 million shares plus 2.8 million warrants to accredited investors. Included in the terms was a ‘Make-Good’ obligation whereby the company placed 510,000 shares of management owned stock into an escrow account. This provision stipulates that in the event that the after-tax income for the company during years 2007 and 2008 is less than $16.3 million and $35.8 million, management will forfeit the escrow shares and they will then be distributed pro-rata to the investors who participated in the share placement. Hence, there are clear minimum net income targets for China Housing for 2007 and 2008.

Financials

Based on the project information listed above the P&L summary is as follows.

All figures millions except EPS in $.

Included in the P&L projections:

The net income per project is on an after-tax basis. Allocation of SGA, interest and taxes is inherent within the figures. Also included is management’s anticipation that property prices will increase by about 10% per year. As for the assumed timing of project completions these are relatively conservative.

Not included in the P&L projections:

Within the next 4 years China Housing will generate over $200 million cash from projects currently in the pipeline. A large amount of this cash will be reinvested into new projects. A general rule of thumb is that the cost of land represents about 25-30% of the sales value of a typical project. As such $200 million of invested cash would generate additional sales of $700-800 million with a rolling time delay of 2-3 years. Sales of $700-$800 million would typically generate net income for CHLN of about 20% i.e. $140-$150 million, say $40-$50 million annually. To some extent, China Housing will make further pipeline investments in the next year or two which will flow into the company’s revenue stream a couple of years later. No recognition of this can, as yet, be incorporated into the latter stages of the P&L projections.

Additionally, it is very possible that China Housing may use some of its highly prized Baqiao land by way of contribution to an attractive development venture with an international partner, either in the Xian region or elsewhere. Recall that new arrivals, regardless of strong reputations, must commence as Level 5 entrants and they can only graduate to Level 1 after a 5 year step-up process. A solution for these companies is to align themselves with Level 1 developers such as China Housing.

Management

• Lu Pingji, Chairman & CEO. Has been with China Housing since its inception as a state owned enterprise and has over 30 years experience in housing development, management and construction.
• Feng Xiaohong, COO. Board Member. Vice President of Shaanxi Provence Real Estate Association. Member of China Architecture Association. Over 20 years experience in architectural design and development.
• Xiao Gengxiang. Board Member. Extensive experience in real estate acquisition, finance and restructuring.
• Wan Yulong, CFO. CPA.

On October 15, China Housing announced the appointment of four new independent Board Members who collectively have extensive high-level experience in real estate and other businesses. (Refer below; Appointment of 4 Independent Board Members).

Events to Watch

1. Sale of 45 acres of Baqiao land in Q4’07.

Considering that this sale of 45 acres of Baqiao land is required in order to enable China Housing to generate sufficient net income in 2007 such that management do not have to forfeit their 510,000 shares as a result of missing the ‘Make-Good’ target, it is likely that the sale should occur with at least a small degree of comfort before the end of the calendar year. November seems likely but it may conclude in December depending upon local sign-offs etc. This transaction should generate sales for CHLN of about $35 million and, more important, it is a watershed event in confirming the high value of the remaining 442 acres on CHLN’s books.

2. Full stock exchange listing.

On October 15, CHLN appointed 4 new independent board members. This is one of the important criteria to be satisfied prior to obtaining a full stock exchange quote on Nasdaq, Amex or NYSE. The company has publicly stated that it anticipates having a full listing on or before summer 2008. However, whilst summer 2008 is seen as a latest target date the full listing now seems likely to occur sooner.

3. Business deal with large developer.

China Housing is set to enjoy several years of business and profits growth. The current assumption is that sales of Baqiao land shall continue annually to 2011, and possibly some thereafter. This Baqiao land is viewed within the industry as a prized asset and it presents China Housing with the opportunity to enter into one or more development ventures with, for example, large international companies who may not have CHLN’s valuable Level 1 accreditation. No deals should be assumed until well after CHLN has already concluded some Baqiao land sales so that the value of the land is well established.

Summary & Valuation

China Housing is a company in a dynamic market in an excellent macro-economic environment. With its stock trading at $6.00 the market value of the company is only $180 million. Set this against the existing backdrop:

1. Strong record of growth in sales and net income every year since privatisation in 1998 and a lifetime IRR on all projects of 140%.
2. A business operating in an economic environment set to remain strong for years to come.
3. An existing pipeline of profitable projects.
4. Expected to generate over $200 million cash in the next 3-4 years (this is greater than the current market cap of the company).
5. Owns exclusive rights to develop 487 acres of highly prized land, which the company believes capable of generating over $500 million in sales by 2010.
6. Has a degree of protection from external competition via its Level 1 status.
7. A strong balance sheet with no need to raise funds via new share issuances.
8. A stock price on a 2008 p/e of 5 on a fully diluted basis.

Clearly the stock is considerably undervalued at the current time. However, China Housing is a small company, albeit undergoing a very positive transition, and its stock, being an illiquid OTC stock, does not warrant receiving a full valuation until at least some of the following road-marks have been passed;

• Sale of first plot of Baqioa land in Q4’07.
• Full stock exchange quote in 2008.
• Business deals with major development companies, possibly in 2008.
• Increased project pipeline from $200 million cash being generated.

Once some of the above benchmarks are achieved and the company obtains broker coverage with some exposure in the financial media, CHLN should trade on a forward p/e of 20-25. At this early stage I consider a 15 times multiple of 2008 EPS $1.22 to be reasonable, considering the strong economic environment and the multi-year sales and earnings visibility that already exists. A 15 times forward multiple gives a fairly comfortable target share price of just over $18.0. As we progress through 2008 I would anticipate that unfolding events will be positive and this should allow the target price to be raised, perhaps considerably. By then the stock will surely have a full market listing together with broker coverage and the company will be known in the financial community.

Warning

CHLN is a thinly traded stock with average daily traded share volume of just under 70,000. Small, illiquid stocks like CHLN can move sharply on little or no news and especially so when day-traders become involved. If investors are considering buying shares of CHLN they should be aware of temporary price spikes. I view CHLN as an excellent long-term hold - that is why the stock is and will remain in my portfolio. I tend to avoid buying shares that are spiking, preferring instead to buy them later when the price abates.

References:

• Company web site
• Roth Capital Partners Investor Conference September 2007
• Q2’07 results
• Appointment of 4 Independent Board Members
• Pre-Sales Update Junjing Garden 2
• Also refer CHLN’s recent 10k and 10Q SEC reports, available from Edgar.