October 15, 2010 - 10:24am EST by
2010 2011
Price: 3.12 EPS $0.00 $0.00
Shares Out. (in M): 76 P/E 0.0x 0.0x
Market Cap (in $M): 236 P/FCF 0.0x 0.0x
Net Debt (in $M): 161 EBIT 0 0
TEV ($): 397 TEV/EBIT 0.0x 0.0x

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Xinyuan Real Estate ("the Company") is a Chinese residential real estate developer primarily focusing on Tier 2 and Tier 3 cities in China. The Company operates a balance sheet light model, only purchasing land for near-term development and building projects in phases.

To make the history part real simple...the company raised cash when things were good, got too far away from home and took on a couple of projects that were outside their area of expertise.  They did not recognize the implicit advantage they had as a local player.  The expectations for performance were not met, and now we are at a ~$3.00 stock price all the way from ~$15.00 on the IPO in December 2007.  The write-downs have been taken, the projects they are stuck with that are selling slowly are still selling but nowhere near the pace they want them to - before looking at the NAV of the company, if you were to throw out their two trouble projects (Kunshan and the Suzhou) assume that every NAV calculation below is lower by 0.80 cents, it is only 0.80 cents because we have already assumed a 25% price decline compared to current sales prices which are unchanged relative to previous two quarters. 

We took a look at "projects under planning" (5 projects to be developed from late 2009 land purchases) and factored in weighted average price declines of approximately 16% on project prices from Q2 2010. The NPV of the cash generated from these projects plus the existing balance sheet comes to about $5.50/share vs. a current price of $3.10. 

If you put together a scenario that has the world falling apart and assume a 30-50% price drop in existing projects, a sales rate that slows from 9.6%/month (trailing 4 quarters) to 3%/month and gross margins of 5% on the project pipeline vs. 21% in the latest quarter (the margin hit implies sell-through of the land they have acquired in the last 18 months ~40% of what they paid) and sit on the remaining capital of the company we come out to a price of about $2.60/share.  This is possible, but it is important to point out that the vast majority of the product (we already accounted for the trouble projects above) is NOT high end developments in the center of major cities with tons of investment buyers.  The buyers are greater than 80% owner occupied and the units are priced to be ~5x the annual income of the folks in the area, this is extremely manageable from an income perspective so it is likely to dampen any blow in a proverbial bubble-bursting scenario.

If things go well for property in general in China (yes this is an outcome with P>0) then the company could be worth ~$8-$9/share.  This (i) will take time (ii) assumes sales rates and price increases at levels similar to early/mid 2009 (not the craziness at the end of 2009).  It's an option.

It's China, so are you ever going to get your money returned to you as a shareholder or is management going to squander it with useless growth projects that have negative return on capital?  Not guaranteed (nothing is) but likely.  The company has contemplated buybacks and dividends (both have tax / earnings implications due to the repatriation of funds to the US) but structures have been evaluated.  When the Suzhou project ran into difficulty the company immediately began to pare project plans and preserve capital rather than finishing the project to save face.  After several attempts at finding a suitable CFO the company's finance department is operated by an American, Tom Gurnee who has been a board member since the IPO. He was installed by the largest shareholders giving us comfort that the board has appropriate influence over management. He has been given the resources to hire, train, and empower an independent planning, internal audit, and compliance staff that work for him and not the Chairman.  The Chairman and the formalized investment committee use Tom's plans in combination with feedback from local operating teams to analyze (not decide by gut) future capital deployments.

Awesome, that all sounds how does the company make money/stabilize/maintain its advantage going forward?  The company pays careful attention to project profitability and has refocused on developing where they have a distinct strategic advantage. This is evidenced by land purchases in 2009 primarily in Zhengzhou and Jinan, locations where the company has the longest history and greatest profitability.  Opportunities for co-develop projects with major instructional investors are beginning to come in and the company is focused on strategically positioning itself to be the premier construction management firm in its geographical region - they were quick to say that they get the benefit of scale, decent margins on the development and with co-investors at the project level they don't have to lay out capital. 

What's the story with the big holders (sellers?)?  There are some big holders in the stock.  Blue Ridge and Equity International are the largest and both have reps on the board.  They invested with locked up capital pre IPO.  Per Bloomberg, Equity International is selling. We don't know why exactly but would imagine it was not an accident that there was talk of a buyback in recent quarters given the dynamic. 

Overall, as we are fairly patient, we like the upside post the removal of any selling overhang, the continued cash generation from the projects being completed as we speak, and the opportunity to leverage company infrastructure with partnership projects. 

Diligence Disclaimer:

We have not yet been to the locations to see the properties however we have verified their existence with secondary sources, nor have we conducted a full legal diligence ensuring our rights as owners (as much as is possible in China).  Interviews with the management team are ongoing, and we hope to learn more as we further our conversations with the company, local government officials and property owners. 

Relevant Notes:

  • Land
    • Land is typically bought at auctions although the company would consider purchasing it from a competitor if the price is right.
    • The Company typically wins 30% of bids which he believes is indicative of its' conservative bidding.
    • Land accounts for between 35-45% of total project costs.
    • At auction, a bidder will have to put up significant amounts of deposits (10% in some cases).
  • Project costs
    • Land is 35-45% of a project's cost, typically.
    • Permits and engineering are ~10%.
    • Construction is generally the remainder.
  • Project timelines
    • Total timeline from land acquisition to final unit sale is approximately 18 months for a project of about 200,000 gross floor area (square meters).
    • Presales begin after about 8 months at which point approximately 20-25% of the construction costs have been incurred.
    • The Company can borrow up money up to 65% of the land purchase price after construction has begun. The bank has collateral over the full project, not just the land.
    • A typical project is split into 5 stages which are almost equal to one another in area.
    • The Company assumes 30% of construction costs are laid out before it can generate cash flow from sales.
    • An 18 month project will be cash flow negative for 12 months.
    • 85% of units are typically sold by the time construction is complete.
    • Presales start after about 50-55% of total costs have been incurred.
  • Strategy and execution
    • The Company attempts to achieve a minimum of 30% gross margin.
    • According to Tom, the Company has never missed a cost target.
    • They want at least a 25% unlevered IRR.


Continued sales of properties, converting asset values into cash.

Unclogging of mortgage financing at Chinese banks - assuming no loosening of government policies or rates.

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