Xinyuan's Q3 2017 Results: Another Good Quarter But Questions Remain

Summary

• The company reported impressive Q3 2017 operating results, but there were three items that negatively impacted earnings.
• Xinyuan's capital return story keeps getting better.
• Xinyuan is a long-term buy at today's price.

Xinyuan Real Estate (NYSE:XIN) is a hidden gem that has outperformed the broader market so far in 2017.

(Source: Nasdaq)

The outperformance over the last 10 plus months has been great but, in my opinion, the stock still has a lot of room to run. I have been impressed with this Chinese real estate company since I started following it years ago and the management team just gave me another reason to stay long -- the company reported strong Q3 2017 operating results and management again showed that they are running a shareholder-friendly company.

Q3 2017 Results, Another Good Quarter But Questions Remain

On November 9, 2017, Xinyuan reported what I would consider strong Q3 2017 financial results, especially when you consider the backdrop (i.e. government restrictions in China). The Q3 2017 highlights were:

• For the quarter, contracts sales increased 15.1% YoY (from US$525.4M to US$604.5M) and total revenue increased 8.6% YoY (from US$444.3M to US$482.4M).
• SG&A expenses as a percentage of total revenue was 10.6% for Q3 2017, which was down from the 12.1% reported in the same period of the prior year.
• Net income declined 41% YoY (from US$28.0M to US$16.5M) and net earnings per diluted ADSs ("American Depositary Shares") was US$0.22 for Q3 2017 (down from US$0.41 for Q3 2016).

The top-line growth was impressive, but the declines in net income and net earnings per ADSs are somewhat concerning. When widening the lens, Xinyuan reported a 19% YoY increase in total revenue (from US$1.05B to $US1.25B) but a 29% YoY decline in net income (from US$62.7M to US$44.7M) for the nine months ended September 30, 2017.

(Source: Q3 2017 Earnings Release)

The company had a charge related to extinguishing some high-interest debt in Q3 2017, but, as shown, there were two other items that also negatively impacting earnings: (1) an increase in interest expense and (2) an increase in income taxes.

Let's take a moment to review how these two items have recently been trending:

Xinyuan's interest expense has been really volatile over the last year but it is encouraging that the current period expense came in lower than the Q2 2017 amount. During the Q2 2017 conference call, management noted that interest expense came in high for the quarter for the following reasons:

interest expense increased partly because our new bond issuance of $300 million U.S. was completed in February, yet our $2 million bond was redeemed in July which caused lower debt amount in this quarter. Another reason is some of our own financings in this quarter haven’t been capitalized yet.

For income taxes, the Q3 2017 balance is comparable to prior periods but that does not make it reasonable. The balance continues to rise without management being able to provide much color:

Unidentified Analyst

Hi, what is your reason for such a high tax rate? It used to be I remember is like 30%, 40% tax, and now it is always 60%?

Helen Zhang

Our effective tax rate for the second quarter of this year is around 55% and if we compare the effective tax rate of last quarter it was 56%, so this quarter was lower than the previous one.

Unidentified Analyst

I see, but a few years ago, I remember that the tax rate was lower, you know just this year somehow the tax rate is higher, just can you clarify on that?

Helen Zhang

I don’t think the tax rate is much higher compared to previous years, but I guess two reasons, one is this year 45% of our sales are coming from commercial projects. So, commercial projects has higher LVAT tax rate compared to residential. And second one is we issued about $600 million bond and some of the interest expense hasn’t been capitalized in our projects which is not tax deductible.

When responding to an analyst's question on the higher-than-average income taxes, management also did not help their case during Q3 2017 conference call. These analysts brought up a great point in that Xinyuan used to have a materially lower tax rate but it has trended significantly higher over the past few years. I can understand the volatility in interest expense and taxes, especially with the company focusing on rolling its debt into low-interest bonds, but I believe that Xinyuan will need to get a handle on the income tax line item if the company wants to report strong earnings growth. Or, at the very least management will have to be able to effectively communicate to shareholders: (1) why the rate is so high and/or (2) when the rate will begin to normalize, if ever.

A Capital Return Story That Keeps Getting Better

Xinyuan's capital return story that keeps getting better. To this point, the company announced that it would be paying a quarterly dividend of US$0.10 per ADS, which marks the 23rd consecutive quarter that Xinyuan has paid a dividend.

Additionally, the company repurchased ~421k ADSs at a total cost of US$2.2M during the most recent quarter. Over the last two quarters, Xinyuan has repurchased ~US$6.9M worth of ADSs. This may not sound like much, but it represents ~2% of the company's total market capitalization.

Risks

There are risks that come along with investing in a small-cap Chinese real estate company like Xinyuan, so it would be wise for investors to first familiarize yourself with the company (and its history) before deciding to purchase shares. To learn more about the company, a good starting point would be to review Xinyuan's website.

Another risk factor is its high debt balance, which has been substantially increased in the last few years. I consider debt as a necessary evil for real estate companies, including Xinyuan, but at some point this company will need to improve its balance sheet by getting a handle on its financial leverage. As such, an increasing debt balance is a risk but not [yet] a significant risk, in my opinion.

Bottom Line

There is a lot to like about Xinyuan because I believe that the company has great long-term business prospects in place. The U.S. properties and the company's construction management service (discussed in detail during the Q3 2017 conference call) will be catalysts for the stock over the long haul and, in my opinion, the company's management team appears to be effectively navigating the challenging operating environment in China.

The Q3 2017 results show that the company is still growing its business but, more importantly, management will now need to focus on communicating Xinyuan's long-term story to the market. There are questions related to the company's income taxes that remain open but, as I described in this article, the tide may be turning for this Chinese real estate company. As such, long-term investors should seriously consider adding Xinyuan to their watch lists.

Author's Note: I hold XIN in my R.I.P. portfolio, and I have no plans to reduce my position in the near future. For full disclosure, I purchased additional XIN shares earlier this week.

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Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

Disclosure: I am/we are long XIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.