Xinyuan: A Largely Under-Appreciated Company for the Strong-Stomached
Xinyuan is a Cayman Islands holding company that conducts most of their businesses through operating subsidiaries in China. It focuses mainly on Tier II to Tier III cities in China that are quickly developing, thus catering to home buyers moving in from rural villages to urban cities. Xinyuan has also expanded its home building into the U.S. to cater to home buyers in China looking to buy properties in the U.S.
Face-Value Valuation and Risks:
Xinyuan's stock is currently valued at 2.4 ttm P/E, 0.44 P/B and 45% FCF yield. This means that the stock is currently very cheap compared to the S&P 500's 9.28 P/E, 1.18 P/B and 4.39% FCF yield. When compared with the industrial average of 22.5 P/E and 1.9 P/B, Xinyuan looks like a bargain.
However, there are certain risks that are holding the stock back, making investors nervous about Xinyuan's prospects. But these risks are currently priced into the stock, and even with the 84% run-up of the stock, there is still significant upside to capture. But first of all, some of the concerns for Xinyuan:
Firstly, the current housing bubble in China. Investors are afraid that they are at the peak of the cycle. Investors have the right to be concerned as due to the Chinese government's selling of private land since the late 1990s, real estate prices have shot up by several hundred percent. The real estate market is exposed to certain cycles, and there is a risk the whole bubble would burst if there was some new government regulation aimed at cooling the market which would cause a great sell-off, creating much volatility in the process.
Secondly, recent news of numerous frauds from China that have occurred still spooks investors. There have been fraudulent cases recently and generally, the Chinese government disallows the companies to provide the SEC with enough information to verify the audits, including Xinyuan as stated in its 2012 annual report, page 37:
"Our auditor, like other independent registered public accounting firms operating in China, is not permitted to be subject to inspection by Public Company Accounting Oversight Board, and as such, investors may be deprived of the benefits of such inspection."
Thirdly, in first quarter 2013, there were a number of investors concerned about the 13.25% bond issuance that XIN has taken up, questioning management's decision in taking up the bond. They are worried that XIN has taken up more than it can chew, and that the debt is not healthy for the balance sheet, especially if they have as much cash as they claim.
Basically, what is holding investors back is a question of shareholder trust of Xinyuan's management especially with the backdrop of numerous frauds and a concern that the real estate market in China is too over-valuated.
With some of the risks identified, I will explain why these risks are priced in and what can investors like myself can do to reduce them:
Firstly, the housing bubble. Indeed, the bubble may pop anytime, but consider the business model of Xinyuan: Xinyuan follows a strict set of rules while identifying opportunities for development. It ensures that the Tier II or III cities' land that they are targeting has strong economic strength, population, clear government intention of sustainable development and lower levels of competition as compared to Beijing or Shanghai. This hence limits its speculation, indicating that management has a clear strategy in mind.
In addition, since 2012, it has entered into a direct negotiation model with the local government. It does this by first making a down-payment of 20% to 50% for the auction of the land. If they get the land, it will be included in the total payment. Even if it doesn't get the land, it will be refunded with interest of 10% to 12% from the advanced down payment.
Furthermore, it plans its projects conservatively. It ensures that 60% of a project's funding comes from customers via pre-sales. Most of the time customers pay 40% in cash when they purchase their home which is above the mandatory 30%, as most first-time home buyers are not speculators.
In short, Xinyuan's management knows where to pick its fights cleverly and conservatively.
It also helps if we take a long-term general view of China's market. Indeed, China has slowed over the past few years and there seems to be a real estate bubble. However, in the long run, millions of Chinese still have to have a home as they rise from lower to middle class, and this means that there will be loads of opportunities for Xinyuan to capture in the future, during the rebound if there is a bubble burst.
Quoting David Gardner: "Make your portfolio reflect your best vision for our future." I believe that the future will be bright for Xinyuan despite these short-term pressures.
Indeed there would also be much volatility in the stock especially when the bubble bursts. However, Ben Graham said that volatility also creates opportunity. During these down prices, these are the best times to allocate more capital toward undervalued companies like XIN.
Xinyuan has also diversified into the U.S., which is experiencing an early recovery in housing. So it also has opportunities back in the U.S., cushioning the impact of the bubble outside of China.
Secondly, is Xinyuan a trusted company? In its first quarter 2013 earnings call, when asked whether it was cooking its books, Mr. Gurnee, CFO for XIN, explained: "Actually we are not and then I tell them that we have been audited for about eight years by Ernst & Young."
Furthermore in second quarter 2013, Gurnee received a question on increasing shareholder confidence and cash audits, he replied:
"We do, do cash audits. We do spot surprise cash audits here on a monthly basis but also Ernst & Young our auditors for many years now has really stepped up well... they went through an in-depth cash flow audit... we believe we’ve taken all the measures that we can to establish our cash is real and we don’t have VIEs, you can go kick our assets they are not going anywhere. You can find them. You can see them. You can kick them...There is, we’re conducting regular audits...where we’re doing surprise audits on our largest bank balances done by our internal audit department on surprise visits. So, I think between that and E&Y...we’re pretty covered in investor. It takes a lot to convince investors to have confidence and we’re doing the best we can."
In addition, Mr. Yong Zhang, founder and CEO of XIN, together with his wife, Ms. Yuyan Yang, the co-founder, holds 37.1% of the company. This shows management eats its own cooking, and that is a positive point for investors in XIN.
I believe this shows a lot of about the commitment of the management to serve their shareholders, and especially with a 4% dividend at 12% payout ratio of 2013 guidance, and 60 million share buybacks, it shows how shareholder-friendly this management team is in the backdrop of numerous frauds. Quoting Buffett: “When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.”
Thirdly, why did XIN issue bonds at 13.25%, especially when its balance sheet is as strong as it claims? Tom Gurnee explained the usage of those bonds very clearly and well in the first quarter earnings call 2013:
Firstly, the company used it to pay down the Forum notes (15.6% coupon rate) that they borrowed in 2010, which was due on April 2013. The total cost of that note including warrants was about 20%. So they borrowed 13.25% to settle and fully pay 20% existing notes, increasing their financial strength.
Secondly, in order to finance its operations in the U.S., it had to transfer/remit its money from China to the U.S.
However, "the remittance of U.S. dollars by Chinese entities via inter-company dividends is subject to a 10% withholding tax."
Hence in order to avoid that hefty tax, the company decided to initiate "back-to-back loan arrangements," whereby, "Under back-to-back loan arrangements, our PRC subsidiaries make deposits denominated in RMB into banks in China as collateral to request the banks in China to issue standby letters denominated in U.S. dollars in the same amount as the RMB collateral to their outbound branches, and our U.S. project companies enter into loans denominated in U.S. dollars with such outbound branches in the same amount specified in such standby letters."(2012 Form 20-F)
Basically, it is avoiding that 10% tax.
So what is it going to do with those bonds? Well, using those 13.25% bonds, it is using it to pay down these back-to-back loans. Again, it is paying down more debt and increasing financial strength.
In addition, the repayment of these back-to-back loans "will result in an equal value of RMB restricted cash being reclassified to unrestricted cash and that’s usable to pay for land acquisitions in China."
So basically, it finances both the U.S. and China at the same time. It is nice to see management allocating their resources properly.
And that comes up to about $60 million used to pay the back-to-backs.
Thirdly, the company is using it to repay a seller (insurer) note on the Williamsburg property in New York, costing about $30 million (after interest, due September 2013) which it is going to settle before that.
So, $40 million + $60 million + $30 million = $130 million, leaving them about $70 million to use for its general corporate purposes to do more expansion.
Last, the main reason why it did this issuance was summarized by Gurnee in its first quarter earnings:
"Our managed auction process was going very well and the size of it was expanding, and we decided that we should be doing a bond to raise money to expand" and "we have big plans for land acquisitions in 2013, over US$650 million expected to be spend for new projects in China alone."
This is signalling that management is going to be aggressive in pumping back money to the business as they see good signs. And as seen from above, they are using it pay down existing debt with $70 million + $60 million (the freed unrestricted cash) left to do that expansion, together with equity and cash on their sheets, and that debt is used for the direct negotiation model that they are aggressively pursuing since 2012.
So why can't it be cheaper than 13.25%? It is the first time XIN, as a smaller developer, is doing a bond issuance, and the banks and bondholders definitely must get more coupon to compensate for that risk.
Furthermore, their bonds are trading at less than 11% yield. If they issue a bond next time they would enjoy lower interest rates. So it is a good step towards their creditworthiness (which is at B+ now, rated by S&P).
On the issue of if it is cooking its books, I do not believe it is, as Ernst and Young have been auditing its books for eight years. And, seeing that it is using the debt wisely by paying down old debts, expanding and increasing creditworthiness, management is making good use of its capital with a conservative business model.
Valuation and Market Expectations:
As we have established that we can trust the management and its numbers, we can use these reported numbers to valuate XIN.
Under the reverse discounted cash flow model of earnings, the market values it at -16% growth for the next 10 years and 3% terminal growth for the next 10 years at a 20% discount rate.
Even if we value XIN at 0% growth for the next 20 years, 10 years growth and 10 years terminal, at current earnings of 2.23 per share, and a 20% discount rate, its intrinsic value is $12.87, a 55% margin of safety.
If XIN is able to produce even 5% of earnings growth, which is lower than ROIC of 10% and ROA of 8%, for the next 10 years, XIN is worth more than $20, a 70% margin of safety.
The floor for the stock is net cash minus net debt of $374 million. With about 72 million shares, its cash per share is $5.05 and that is floor for the company.
Furthermore, much of XIN's book value consists of cash and property. Property are tangible assets that have the potential to increase in value as well, unlike clothes or computer equipment.
Book value of $11.94 is a good proxy too. And XIN has raised its book value by 15.9% CAGR over the last five years. Using $11.94 as a start, and 15% growth with 20% discount for 10 years, XIN is worth about $7.80 at such a high discount rate of 20%. Highlighting even more how much XIN is underestimated.
At current prices and with the run-up of XIN, volatility is the final risk that stands in the way of the investor. Practically, investors can dollar-cost average to counteract this.
Moreover, with much of the risks already priced in as discussed above, and with XIN at such low valuations and with committed management, I believe the risk/reward is appropriate and investors will be rewarded accordingly for believing in its future.