Sunac China: High Gearing Remains A Concern Despite Efforts To Deleverage

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About: Sunac China Holdings Limited (SCCCF)
by: The Value Pendulum
Summary

Sunac China's net gearing increased from approximately 170% as at end-FY2018 to 224% as at end-1H2019.

Sunac China is in the process of deleveraging; it is slowing the pace of land acquisitions, and accelerating revenue recognition and cash collection.

Sunac China trades at a mid-single-digit forward P/E, which is justified by its high net gearing.

Elevator Pitch

Despite being among the top five property developers in Mainland China in terms of contracted sales, Hong Kong-listed property developer Sunac China Holdings Limited (OTC:SCCCF) (OTCPK:SNCHY) [1918:HK] trades at 5.4 times consensus forward FY2019 P/E and 4.2 times consensus forward FY2020 P/E. In contrast, another top five property developer China Vanke (OTCPK:CHVKF) (OTCPK:CHVKY) (OTCPK:CVKEY) [2202:HK] is valued by the market in the high single-digits P/E at 6.7 times consensus forward FY2019 P/E. This disparity in valuations is largely attributable to Sunac China's high gearing with a net debt-to-equity ratio of 224%. In contrast, China Vanke's net gearing was 35% as of end-1H2019.

Sunac China's valuation should continue to stay in the mid single-digits P/E range, as its gearing is likely to remain elevated above 100% in the near-term despite deleveraging efforts. I will avoid Sunac China for now, until its gearing comes down below 100%.

Company Description

Started in Tianjin in 2003, Sunac China is primarily a property developer, with the property development segment accounting for 91% and 97% of revenue and operating profit for 1H2019, respectively. Sunac China's other businesses include the Cultural and Tourism segment which is responsible for the management of hotels, shopping malls and theme parks in the cultural and tourism cities; and property management, office building rentals and fitting and decoration services. Sunac China was the fourth largest property developer in Mainland China in terms of contracted sales for 2018.

Highly Geared But In The Process Of Deleveraging

Sunac China's net debt-to-equity ratio or net gearing (including perpetual securities) increased from approximately 170% as at end-FY2018 to 224% as at end-1H2019. The increase in Sunac China's net gearing for 1H2019 was mainly due to land banking activities, the acquisition of property development projects leading to increase in borrowings being consolidated, the increase in area under construction of salable properties and construction costs associated with new projects for the Cultural and Tourism business.

The company's total land bank increased from 166 million sq. m. as at end-FY2018 to 204 million sq. m. as at end-June 2019. Based on Sunac China's average land cost of approximately RMB4,307 per sq. m. and assuming an effective interest of 65%, I estimate the company spent approximately RMB100 billion on land acquisitions in 1H2019. Between December 2018 and June 2019, Sunac China's borrowings increased by RMB73 billion, of which a significant portion is likely to have been used to fund the company's land acquisitions.

The risks associated with Sunac China's high net gearing are mitigated by a few factors.

Firstly, the company's cash and cash equivalents (including restricted cash) rose 14.8% from RMB120 billion as of end-FY2018 to RMB138 billion as of end-1H2019. Sunac China's cash-to-short-term debt (debt due within a year) ratio or cash coverage ratio is 1.14 times. If only debt due in 2H2019 is considered, Sunac China's cash coverage ratio rises to a comfortable 3.1 times.

Secondly, despite having a high net gearing of 170% as at end-2018, Sunac China managed to secure significant new financing in 1H2019. The company raised $2.95 billion in USD-denominated senior notes for the first six months of 2019. In August 2019, Sunac China secured a term loan facility amounting to $280 million from a consortium of banks. In April 2019, Sunac China's credit rating was revised upwards by credit rating agencies. Sunac China's long-term foreign currency issuer default rating was raised by Fitch from BB- to BB, while S&P (SPGI) raised Sunac China's long-term issuer credit rating from BB- to B+.

Thirdly, Sunac China has utilized its borrowings prudently with respect to land banking activities. Sunac China did not overpay for land acquisitions, with its average land cost of approximately RMB4,307 per sq. m. representing 29.6% of its average selling price of RMB14,550 per sq. m. for 1H2019. Sunac China also remained focused on high-quality projects, with more than 83% of its land bank located in Tier 1 and Tier 2 cities.

Sunac China is in the process of deleveraging, which it plans to achieve by slowing the pace of land acquisitions and accelerating revenue recognition and cash collection. These will be discussed in the subsequent sections of the article.

Slowing Down The Pace Of Land Banking

Since May 2019, Sunac China has not participated in public land auctions. This is partly due to the company's deleveraging efforts and partly due to its judgment of the property market. Sunac China acquired land in the first four months of 2019 in an opportunistic manner when it judged that land prices were reasonable in certain cities and locations. When land prices subsequently recovered, Sunac China made the decision to stop participating in land auctions since May 2019. Sunac China thinks that the bottom for land prices will come in either end-2019 or early-2020. As a result, Sunac China is not likely to do significant land acquisitions in 2H2019, which should help to lower the company's net gearing.

Moreover, Sunac China is not under pressure to replenish its land bank. It has an estimated salable resources of approximately RMB570 billion from more than 420 projects under sales in 2H2019. With contracted sales of RMB214.6 billion in 1H2019 and a full-year FY2019 target of RMB550 billion, Sunac China will only need to achieve a sell-through rate of 58.8% in 2H2019 to meet its full-year contracted sales target.

Looking beyond 2H2019, Sunac China's current land bank is equivalent to salable resources of approximately RMB2.82 trillion which is sufficient to support the company's contracted sales for the next three to four years.

Accelerating Revenue Recognition And Cash Collection

Sunac China's revenue and net profit attributable to shareholders grew by 64.9% YoY and 61.7% YoY to RMB76.84 billion and RMB10.29 billion for 1H2019, respectively. An increase in earnings (and as a result retained earnings) helps to bolster the company's equity base and lower net gearing.

Based on Sunac China's contracted sales of RMB214.6 billion for 1H2019 and its historical revenue recognition, I estimate that Sunac China has unbooked sales (contracted sales that have yet to be recognized as construction of the property projects has not been completed) of at least RMB500 billion as of end-June 2019, which is equivalent to approximately three years of revenue. Sunac China's equity base should be progressively strengthened, as the company recognizes revenue from contracted units as the property projects are completed and delivered to buyers. The market consensus expects Sunac China to record approximately RMB120 billion of revenue of 2H2019, vis-a-vis 1H2019's revenue of RMB76.84 billion.

Another key aspect of Sunac China's deleveraging strategy is to utilize cash collected from contracted sales to pay down debt. For the first eight months of 2019, Sunac China achieved contracted sales of RMB306.58 billion, representing a 15% YoY increase. In Mainland China, property developers can collect the full sales proceeds within three months of the signing of the sale and purchase agreement.

Sunac China has an estimated salable resources of approximately RMB570 billion from more than 420 projects under sales in 2H2019. The key regions for the company's property projects include the Southwestern China region (Chongqing, Chengdu and Kunming, etc.), the Shanghai region (Shanghai, Suzhou and Nanjing, etc.), the Southeastern China region (Hangzhou, Hefei and Ningbo, etc.) and the Guangzhou-Shenzhen region (Guangzhou, Shenzhen and Foshan, etc.) which accounted for salable resources of approximately RMB106 billion, RMB89 billion, RMB69 billion and RMB35 billion for the second half of the year, respectively.

As highlighted in the preceding section, Sunac China should be able to easily meet its FY2019 full-year contracted sales target of RMB550 billion with its salable resources on hand. This implies another RMB330 billion (higher than 1H2019's RM214 billion) of contracted sales for Sunac China in 2H2019, and a similar amount of sales proceeds to be received in due course.

Net Gearing To Remain Elevated With M&A Being A Risk Factor

Sunac China's net gearing as of end-December 2019 should be significantly lower than 224% as of end-June 2019. I estimate the company's net gearing to be in the 140%-150% range by the end of FY2019, taking into account the slower pace of land banking, and accelerated revenue recognition and cash collection from property sales. In other words, Sunac China's net gearing will remain elevated in the near-term. Among large-cap property developers, Sunac China and China Evergrande Group (OTCPK:EGRNF) (OTCPK:EGRNY) [3333:HK] are the only ones with net gearing in excess of 100%.

Also, M&A is another potential risk factor in Sunac China's deleveraging efforts. While Sunac China has stopped participating in land auctions, it remains on the lookout for M&A opportunities to acquire land bank. Approximately 60% of the company's land bank was sourced via M&A. With the Chinese economy slowing down and uncertainty in credit markets, there is likely to be an increasing number of small, poorly-capitalized property developers which are unable to repay their debts and have to resort to selling their companies or property projects.

Valuation

Sunac China trades at 5.4 times consensus forward FY2019 P/E and 4.2 times consensus forward FY2020 P/E based on its share price of HK$32.85 as of September 9, 2019. The stock's forward FY2019 P/E is at a slight premium to its historical 10-year average forward P/E of approximately 5 times.

The stock is valued by the market at 2.1 times P/B versus its historical 10-year average P/B of 1.0 times.

Sunac China offers a trailing 2.9% dividend yield and a forward FY2019 dividend yield of 4.1%.

Variant View

The key risk factors for Sunac China include slower-than-expected deleveraging, faster-than-expected pace of land banking and weaker-than-expected contracted sales growth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.