A few months ago, I wrote an article asking if Xinyuan Real Estate (XIN), a property developer in China, was the world's cheapest stock. I pointed out the company's absurdly low valuation and described two potential reasons for it: fear of fraud and fear of a Chinese housing market collapse. Since then, much has happened to Xinyuan, and it now appears clear that fears about the Chinese housing market are not the primary reason Xinyuan remains undervalued (for those unfamiliar, the stock currently boasts a forward P/E of 2.34 and a P/B ratio of .33, compared to P/B ratios well above one for reasonably valued American homebuilders such as KB Home (KBH) and Toll Brothers (TOL)).
The company beat its own estimates in the first quarter handily despite discounting some of its properties, and with a third of the year gone reiterated its guidance for net income in the range of $97-$107 million for the full year, against a market cap of roughly $223 million. Instead, the market is clearly pricing significant, even imminent, fraud risk into XIN shares. In the original article, I listed many reasons why I thought fraud was particularly unlikely in Xinyuan's case, including its status as an IPO rather than a reverse merger like many similar frauds, its credible big-4 auditor (Ernst and Young), and the company's history of returning value to shareholders through share buybacks and dividends.
This generated massive doses of healthy skepticism in the comments section, making it clear that XIN has a way to go at convincing investors that its books are clean. However, despite valid points raised by some commenters, I remain of the persuasion that the odds of fraud in XIN's case are lower than the market seems to be pricing in, making this a potentially lucrative opportunity for investors to buy a quality company at a truly ridiculous discount to any reasonable valuation.
Before I set in to the reasons I believe Xinyuan is unlikely to be a fraud, I'd like to explain why many investors might think it may be cooking its books. I can identify four primary reasons for this belief:
1. XIN's CFO, Tom Gurnee, was the chair of the audit committee at Longtop Financial Technologies, a company which ended up being a spectacular fraud, catching a prominent auditor (Deloitte) as well as many well-heeled hedge fund investors off guard. This case famously involved complicit Chinese banks who reported false cash balances to the auditors. Mr. Gurnee resigned his post at Longtop and was never charged in the incident, though it should rightly serve as a red flag for investors to take a closer look.
2. Xinyuan has a questionable transaction on record from April 2010, when the company raised $40 million using bonds at a very high interest rate (16%, 19% effective including attached warrants), despite what appeared to be a very strong liquidity position at the time. This was at the center of a laborious back and forth with the SEC discussing various components of the company's filings.
3. Xinyuan is a Chinese small-cap stock. This alone, given the past year of spectacular collapses, is enough to raise significant skepticism and even drive some investors away. It remains possible that virtually all Chinese companies trading only in the U.S. have some form of accounting discrepancies, or at least that accounting problems are very widespread.
4. Xinyuan remains very, very undervalued. For many, this alone raises the odds the company is fraudulent, as it seems logical that a reputable third party would have done its own due diligence and purchased the company or a significant portions of its float given the stunning undervaluation, or that the company's founder would have instigated a "going private" transaction like many wrongly undervalued Chinese small caps have. That this hasn't happened and the stock remains undervalued is, in and of itself, a red flag.
Standing on their own, these facts certainly lend credence to a degree of investor wariness about XIN's shares. When viewed holistically in context, however, the fraud case begins to look weaker.
(1) Though details of the Longtop fraud remain murky, Mr. Gurnee did time as CFO of Sohu (SOHU), which is as reputable as companies in China get right now, and is still chairman of the audit committee at eLong (LONG), a travel website in China that trades at a very healthy forward P/E of 20 and above its book value, strong signs that the market doesn't consider it a strong fraud contender. It is very possible that Mr. Gurnee was deceived at Longtop, especially given the depth of the fraud down to the bank level.
(2) Xinyuan's justification (see number 3) for its $40 million bond sale is that the company projected a financial shortfall for the year as it was planning massive land purchases (bank-borrowing to purchase land for development is illegal in China), but that the company ended up postponing said purchases due to the housing slowdown in China. In addition, the company was retiring $75million in bonds at the same time, so the result was still a substantial net outflow. Thus, the company has almost exclusively had negative cash flows from financing in recent years, making it look much less likely that the $40 million raise reflected a desperate need for additional capital to sustain operations despite an inflated balance sheet, as some likely suspect.
(3) Represents a classic case of guilt by association, and is precisely why the potential profit is so large as time passes by and investors learn of XIN's legitimacy.
(4) This remains a mystery to me. XIN's only major institutional holder, John Griffen's Blue Ridge Capital, continues to hold 20% of the float, and XIN's founder and chairman controls another 40%, leaving little room for other major holders without their buy-in dramatically moving the share price. Regardless, it seems like factors (1), (2) and (3) here are ruling the day, which the comments on my previous article seemed to prove.
Those aside, however, a series of events have occurred in the past few months that I believe make the case that XIN is legitimately much stronger than it was when the original article was published:
1. XIN announced a hefty quarterly dividend of $.04 per ADS (totaling .16 per year, or more than 5%). This represents a substantial outlay of roughly $12 million dollars, which is very atypical behavior for a company that is overstating its financial position as said companies usually hoard cash to stay afloat.
2. Perhaps most importantly, XIN's 20-F (an SEC filing for foreign companies with shares in the U.S.) for the full year 2011 came back cleanly audited by Ernst and Young. Many will point out (rightly so) that this comes after a prominent failure by E&Y in the collapse of Sino-Forest, but it is important to note that this event occurred before the validation of Sino-Forest's latest yearly results, and that it, paired with other prominent cases (including Longtop) likely made XIN's audit far more intensive than those in the past (for example, additional measures have been taken to avoid the bank complicity issue that arose during Longtop). In other words, though audit standards were clearly ineffective in the past, audits conducted after the recent blow-ups should carry higher weight as the auditors now have little room for error with their all-valuable reputations on the line, and are being extra-careful.
3. XIN announced a surprise, $20 million share buyback program, representing a substantial percentage of its current float. Together with its dividend, the company will return $32 million to shareholders this year, 14% of the company's current market cap. It is key to note that this was unexpected; though the dividend had been pre-announced, XIN took this pro-shareholder step without any prior indication it would do so.
Further evidence for XIN's legitimacy comes from the most unlikely of sources: a Citron Research report claiming that Evergrande Real Estate (3333.hk), one of China's largest developers, is a massive fraud. A report from a short-selling shop like Citron is typically a death knell for small cap Chinese companies trading on U.S. exchanges, with prominent examples such as LongTop Financial (LFT), China MediaExpress (CCME) and Duoyuan Global Water (DGW) leaving investors empty pocketed after published reports challenging their financial statements, often despite vicious push back from the companies and analysts who have generally been proven wrong. Evergrande, for its part, has done a good job refuting the most recent allegations so far, with the stock down only 10% and several up days recently as I-banks rushed to its aid. However, the Citron report nevertheless gives valuable insights into what a hypothetical takedown of XIN by short sellers (a worst case scenario for longs) would look like, and allows me to co-opt their analysis tools, apply them to XIN and gauge the results, which almost uniformly point to Xinyuan not being fraudulent, or at the very least highly dissimilar to Evergrande:
1. Growth Citron begins their report with a chart showing that Evergrande's asset growth has exceeded that of its peer companies by an almost unbelievable margin, up 721% total since 2007 versus roughly 150% for its peers. Citron doesn't describe exactly what it means by asset growth, but any reasonable measure of XIN's asset growth (real estate, total, etc.) is in the 70-90% range since 2007, well below the cited peers, making it less likely that the company is faking its growth.
2. Land Purchasing. Citron took issue with Evergrande's claim that its massive land purchases make sense given its size and market conditions. XIN has taken exactly the opposite approach, only recently restarting land purchases after more than two years of waiting for conditions to improve.
3. Off Balance Sheet Financing. A common tactic used by Chinese real estate companies is to finance land purchases using JV Equity partners, which helps get projects built without massive volumes of debt. Evergrande's balance sheet is rife with these arrangements, but Xinyuan's is quite clean in comparison: the company currently has no outstanding equity financing after buying the remaining 55% of its one such arrangement (Jiantou Xinyuan) in September of 2009. Since then, Xinyuan's projects have been funded with commercial construction loans and cash flow from operations.
4. Interest Rate Return. One of the most hard-hitting portions of Citron's report alleged that Evergrande's cash balance must be grossly overstated because the company was earning interest at a rate (.45%) anomalously low relative to peers (average of roughly 1.1%) and below the legal minimum limits established by the Chinese government (roughly .6%) for the relevant period. Xinyuan, for its part, earned interest of 1.3% of its substantial cash balance for the FY 2011, in line with peers, lending legitimacy to its roughly $500 million cash hoard.
5. Cash Deposit Trend. Another item called out by Citron are Evergrande's contract sales vs. deposits collected, which have diverged significantly as of late (aka deposits aren't keeping up with reported sales). Xinyuan has no such problem, in the past year its deposits have grown markedly, even as a percentage of revenue.
6. Debt Levels. Citron also focused on Evergrande's increasing debt levels, which it believes the company is using to hide financial weaknesses elsewhere. Though Xinyuan does carry long term debt (the $40 million deal discussed above) that represents a decrease over time, and the company has issued no new long term debt since 2010.
7. Cash Flows. Citron pointed to Evergrande's persistently weak or negative cash flows as indications that the underlying company is weak. Xinyuan, on the other hand, consistently has negative cash flows from financing as the company pays down debt and returns capital to shareholders through dividends and buybacks.
Taken together, I believe the three actions by Xinyuan described earlier combined with the seven points outlined above make the odds of the company being fraudulent quite low. Of course, such odds are never zero, and caution is crucial. Given the red flags listed above and the nature of the company, this is a speculative play with a largely binary outcome. In time, either this company is worth roughly $10 per share (that would be 8X FY2012 projected net income), or it is a shell game worth pennies on the dollar. All things considered, I think the odds of the company's legitimacy are high enough to make the net odds-adjusted value of the shares far higher than they are today.
For example, assuming a 50/50 chance of fraud with payouts of $10 and $0, XIN is worth roughly $5/share. Based on the statements from above, I think the odds of the company being legitimate are higher than that, so XIN resides in the "speculative" section of my portfolio, exactly where an late-stage biotech startup (the situations are quite similar on a risk/reward basis) would be. I strongly recommend that other investors do their own due diligence, reading both XIN's 20F in its entirety and the Citron report on Evergrande before making any investment decision.
In the meantime, if looking for a way to play Chinese real estate without the single-stock fraud risk of XIN, consider the Guggenheim Chinese Real Estate ETF (TAO) which is correlated to XIN but far less risky. Another interesting pick to check out in the space is E-House China (EJ), which specializes in providing various real estate services to both developers and consumers, and has prominent investors including Orbis Holdings, Soros Fund Management and Invesco. As always, please post comments below, especially if you have further evidence that increases or decreases the odds of XIN's fraudulence. Happy trading!
Disclosure: I am long XIN.
Additional disclosure: As mentioned above, XIN is a speculative investment and investors should know that this is not a recommendation to buy, merely a recommendation to consider buying, an action that should only be completed after thorough due diligence.