Peter's Perspective
16th January 2015 by Peter Churchouse

The Curious Case of Kaisa

How does a well-regarded company with a seemingly strong balance sheet, a solid asset base, and plenty of cash slide into default in a matter of weeks?

In October rumours swirled that the Chairman of Chinese property developer Kaisa Group (1638 HK), Kwok Ying Shing, had been detained by Chinese authorities and was now ‘unreachable’.

Vice Chairman L.L. Tam flatly denied the allegations and said operations were continuing as normal.

So far, so China…

The market capitalization of the company at the end of November was roughly US$2 billion.

Analysts remained bullish on the stock.

At the time 15 out of 16 recommendations labelled the stock a “Buy” with just a single “Hold”.

And then in December things started to fall apart. The stock started to crater.

The company admitted that some of its unsold residential units in Shenzhen were blocked from sale by Shenzhen’s Urban Planning and Resources Commission.

On the 10th of December, the Chairman announced his resignation… for “health reasons” effective 31st December, in a filing to the H.K. stock exchange.

The stock continued to collapse along with the bonds. The price of the 2018 U.S. dollar bond went from par, i.e. US$100 in early December to less than US$40 today.

By the end of December, share trading was halted. The management exodus worsened with the resignations of both the Vice Chairman and the CFO.

Analysts covering the company have simply run out of people at Kaisa to speak to…

Then earlier this month the company defaulted on a loan repayment, payback of which was triggered by a clause of early payment upon resignation of the Chairman.

But there are lessons and reminders as the dust continues to settle.

As you can imagine, the first high profile default in a sizable listed sector is causing considerable nervousness in the China real estate space. Especially given the overseas U.S. dollar debt that Kaisa has raised.

Lesson Number 1: China’s Anti-Corruption Drive can hurt investors anywhere at any time.

I’ve just spent a couple days in Beijing with some extraordinarily well connected individuals. I made some enquiries about the Kaisa situation.

The responses I received can be summed up as follows:

“It’s corruption for sure….. But nobody knows what the hell is going on.”

Published reports say that President Xi Jinping’s two year old anti-corruption drive has rounded up between 70-100,000 suspects from all over the country. The real number is likely higher.

The higher profile cases like Kaisa, where you have a Hong Kong listed company with U.S. dollar offshore debt are bound to attract more attention. But the lower profile private cases? Suspects just disappear.

No one knows just how many people have been rounded up, but sources I have heard from in China suggest the scale of this purge is largely unreported in the press. The accused are being held in all sorts of government facilities. I was told that one located in Inner Mongolia houses over 10,000 suspects.

As far as I can tell, nobody knows where the Chairman is*, or why the sale of Kaisa development properties has been banned by the Shenzhen authorities (or at least those who know are certainly not making the information public).
*My source in China suggests that he’s currently in Hong Kong.

There is suggestion that the Chairman was “close” to the head of one of the Shenzhen suburbs which where a lot of the company’s projects are located. This official is known to be under investigation.

One more thing: this ‘purge’ is FAR from over. My connections in Beijing tell me this will run through to the end of 2016. And it’s hugely popular with the public. More public companies are bound to get into trouble.

Lesson Number 2: Offshore Investors get little protection.

Kaisa is a mainland company with an onshore asset base.

Offshore creditors (i.e. the holders of Kaisa’s offshore U.S. dollar bonds) get paid long after domestic investors.

Foreign entities cannot get legal security over mainland real estate assets.

Domestic creditors have the ability to freeze assets very quickly. As such, they are incentivised to move fast. And nearly 20 banks and trust firms have already requested a freeze on Kaisa’s assets from a court in Shenzhen.

As an offshore investor, get used to being at the back of the repayment queue. Your bond yields therefore need to provide adequate compensation for that.

Lesson Number 3: The small players are expendable. Even listed ones.

I’ve said this before and I’ll say it again: you HAVE to stick with the larger players when it comes to buying real estate companies in China.

The small players are NOT too big to fail.

Last year I recommended China Overseas Land & Investment Ltd (688 HK) and China Resources Land Ltd (1109 HK).

These are the largest property H-Shares (Mainland companies listed in Hong Kong), and subsidiaries of large State Owned Enterprises (SOE’s).

They have low gearing, a strong balance sheet, good access to capital, and high and consistent returns on equity.

I said at the time… “I know this will raise a few eyebrows, but I believe there is a distinct possibility of a 30% to 50% bounce in these larger China property stocks…

People said I was nuts.

As of today you’re up 35 percent and 47 percent respectively…

The government won’t let these companies go under. They’re too large and systemically important.

That is NOT to say that this is the only reason why I like the larger players. It’s just one of many.

That’s an important distinction.

Investing in a state-owned company just because it’s state-owned is idiotic. Go talk to owners of Brazil oil company Petrobras or Russia’s Gazprom if you want more details!

Lesson Number 4: DEBT!!!!!

Regular readers will know I pay a lot of attention to developer debt loads.

In my mind, the riskiest type of property company is one that borrows heavily, buys land, develops properties and relies on ‘churning’ these properties to keep its cashflow and balance sheet alive.

That’s all good when there’s lots of liquidity, you can borrow cheaply, and real estate prices are going up double digits annually… but when prices start to fall and volumes decline you can get into trouble very quickly.

I prefer companies that have lower debt loads and that keep rental properties on their balance sheet… it helps them withstand the inevitable down cycles in the property market.

Some Chinese developers are simply carrying too much debt.

On the table below you’ll see my two picks at the top. They have substantially lower debt to equity ratios than the smaller comparables, along with debt to asset ratios. As you look further down the list, you’ll notice a general trend of higher debt ratios.

In the table you’ll see that debt becomes a much larger multiple relative to earnings (here shown as EBITDA)… i.e. less credit-worthy.

Hong Kong-Listed Mainland Real Estate Developers including market capitalisation in US$, Net Debt to Equity Ratio and Net Debt to EBITDA. List includes: China Overseas Land & Investment Ltd, China Resources Land, Country Garden Holdings Co Ltd, Shimao Property Holdings Ltd, Longfor Properties Co Ltd, Evergrande Real Estate Group Ltd, Guangzhoue R&F Properties Co Ltd, SOHO China Ltd, Agile Property Holdings, KWG Property Holding Ltd, Greentown China Holdings Ltd, and Kaisa Group Holdings Ltd.

The dust has certainly not settled yet. Another Shenzhen developer Fantasia Holdings Group Co’s (1777 HK) stock and bonds are plunging on news that authorities have stopped processing transaction agreements for just four apartments.

Political and regulatory risks are now back in the spotlight. Investors are jittery to say the least.

There will be diamonds in the rough, but for the meantime we recommend sticking with the big boys. It’s a trade that has paid off handsomely thus far….

Good investing,

Peter

P.S. In the interests of full disclosure, I am an independent non-executive Director of mainland property developer, Longfor Properties (960 HK).


Peter Churchouse Peter Churchouse is a widely respected analyst and commentator on financial markets with well over 3 decades residing in Asia. He spent over 15 years as Asia Strategist and Head of Research for Morgan Stanley as well as running a hedge fund. He shares his knowledge, insight and investment recommendations through his subscription publication The Churchouse Letter, along with his free newsletter Peter’s Perspective.
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