E-House China: Not All Housing Is Weak

While the real estate market languishes in the United States and new home sales decline to anemic levels, China housing statistics show a very different picture. As the population streams into urban areas to take advantage of modernization trends, real estate developers can hardly keep up with the demand for new housing. E-House China (EJ) enters this market as a property agent that contracts with developers to sell their housing units. The business is extremely profitable as there are few fixed costs associated with building its franchise, and a thriving market generates rapid revenue growth.

The new property market in China is characterized as highly fragmented and immature. While the largest developers typically have their own salesforce, mid-tier and smaller developers usually hire an outside agent to show and market the new properties. The standard practice is to offer agents a base rate commission plus a higher commission rate if the average sales price for a development exceeds a target level. While the base rate usually comes in around 1-1.3% of the sales price, EJ has managed to average around 2.2% due to the higher sales price it has received from purchasers. While this rate is likely to subside a bit as competition and information flow pick up, the rates should still be very attractive and mix nicely with increasing numbers of units sold.

In 2006, the company sold an estimated 2.9 million square meters of inventory. That number is expected to come in at 3.6m in 2007 and CSFB estimates ‘08 and ‘09 levels to hit 5.5m and 7.9m square meters. At the same time, inflation in property prices will compound the growth resulting in higher commission dollars per square meter. Agreements have already been inked with developers with units coming online in 2008. It is estimated that the company has already contracted to sell 70% of their expected volume for 2008 taking much of the guess work out of next year’s growth assumptions.

While the new property sales have been the primary driver of growth up to this point, management is diversifying its revenue stream by entering the secondary market whereby it serves as an agent for owners selling used properties. While this business is less active than the new property industry, the historical trend is for the market for existing products to eclipse the market for new properties within the growth curve for an expanding economy. While the new division is not cash flow positive yet (it was only begun in 2006), it is expected to turn a profit next year and will begin to build its level of contribution as the market picks up.

Currently, regulations in China allow for agents to represent both the buyer and the seller of properties which opens the door for higher revenues with the same amount of work necessary to close the deal. The maximum an agent can charge on each side is 1% but EJ should be able to turn in some hefty margins for properties where it represents both the buyer and the seller. The traditional arrangement with individual agents (personnel) is to allow the agent to keep 30% of the commission and the company (EJ) to receive the remainder. This allows the company to enjoy much better margins than its counterparts in more developed nations.

After pricing its IPO at $13.80 in early August, the stock has traded very well, topping out at $36 last month. The offering raised approximately $169 million which the company is able to use at its discretion. There is no debt to speak of which leaves the company in great shape financially with $2.38 in cash per ADR. Analysts expect management to make acquisitions of competitors or complimentary businesses. Since organic growth is working so well right now, it is unlikely management will spend the cash unless it has a significantly accretive place to employ it. However, the opportunity in the market may allow for such an acquisition in 2008.

There are two main concerns that investors should be aware of when investing in EJ. The first revolves around government regulations. The Chinese has been very expressive about its concern with housing inflation and the inefficient use of land. Recent enactments have made it more difficult for consumers to purchase second homes and have raised the minimum down payment for certain acquisitions. While this makes for a more challenging environment, CSFB points to similar regulations in 2005 and notes that EJ was able to land some impressive contracts during this time because the developers needed expertise in selling the new properties.

Finally, the company has had an increase in DSO or days it takes to collect commissions from sellers. It typically takes some time as developers wait for projects to be completed and then pay out commissions on the bundle in the quarter after sales are complete. However, if the overall market becomes more strained, those commissions could become difficult for the developers to pay which would be a significant problem. The trend seems to have peaked and the DSO level is slowly coming back to a more manageable level the last 2 quarters.

In summary, the personal real estate market in China continues to grow at a robust rate, and E-House China is taking advantage of the trends. The growth rate is attractive, the valuation is indicative of high growth and a stable balance sheet, and management has options at its disposal for making attractive strategic decision. I think this represents an opportunity for any investor wishing to take part in this emerging sector of the global economy.

Full Disclosure: Author does not have a position in EJ

Comments

[sf123]

I happen to invest in real estate in China. In the last 6-12 months, the goverment is raising mortgage lending rates trying to curve the bubble in both real estate and the economy. As a result, even though the prices have gone up, the sales volumn is way down and lot of property agents are going out of business. EJ may be posting good numbers right now but I do not think that will continue. So be cautious about the stock!

[rzld36]

Thanks

[calvino]

I am not paying 47 multiples for a real estate agency if they are in Florida, China, the Moon or selling funeral plots in Heaven. When dudes like you destroyed the wealth of millions of investors in the 2000 Delusion, you should have learned your lesson. Yet here you are again, just too smart to be measured. Technicals? Ok, China says no more lending to developers as of two weeks ago. Yesterday China said more interest raises coming. What the heck would prompt you to recommend a real estate agency into this environment - a notoriously cyclical business with zero barriers to entry. I know, you are just smart like that.

[ZacharyScheidt]

whoah there little buddy! sorry if I stepped on your toes.

I think there is potential for the stock to trade higher. I could be wrong (wouldn't be the first time) but there are strong growth trends in place in the market that EJ operates in, and management has done a good job of capturing the growth. They may stumble - China real-estate may decline.

But hey - try to give me a little more detail on your analysis. What growth are you expecting? Will smaller fragmented agencies take market share from EJ in selling major development projects? Usually these large developers want to sign an exclusive selling agreement with a large reputable agency.

Thats my take - but its only my opinion.