Description

Summary

• Baoye is a Chinese company that is vertically integrated with construction, residential real estate development and building materials. It is listed on Hong Kong stock exchange for 14 years and has been profitable for every year since

• Baoye is a free lottery ticket investment opportunity where one can buy a company, that has been profitable for 13 straight years, below a strong net cash position and almost no debt

• A lot of cash - There is RMB 3.76bn of net cash and the market cap is ~RMB 3bn. Note that this net cash position was accumulated over the last 4 years where they have been paying down debt and allow profit to sit on b/s as cash due to a lack of reinvestment opportunity (more about this later)

• Competent and shrewd management - The management owns over 50% of the company. The founder Pang Bao Gen (PBG) owns ~33% of the company. They are good operators and have proven themselves over the last 14 years. Unlike many Chinese companies who only cares about short term profit, Baoye’s management takes a refreshingly long-term perspective and avoid any kind of financial engineering. But they don’t necessarily think about adding shareholder value in the Western sense. On my interaction with them, they even considered share buybacks as financial engineering. Within the company, they debate a lot about whether they should just focus on core operations and avoid dabbling in the stock market. (More on this later)

• Profitable through the cycle - See chart. Baoye is trading around 5x P/E.

• Growth stock in a value stock? - For most companies that are trading this cheap, there is unlikely to have any growth or more likely to deteriorate. Baoye has been focused on housing industrialisation for the last 10 years or so. Due to a combination of rising labour cost and need to protect the environment, Chinese government has been aggressively introducing policies to encourage the formation of housing industrialisation. Baoye is very well positioned for this growth. While the timing of this growth is uncertain, the possibility of this growth materialising is very high

Why does this opportunity exist?

• Little-known and small market cap- No sell-side research coverage at all. Only 42.7% of shares are listed on Hong Kong Stock Exchange (HKSE) as free float and a quarter of free float is held by long term investors – Market cap of around USD 400m

• Limited liquidity - Daily trading volume is pretty low

• H - shares v.s. Domestic shares - The management owns domestics shares which have the same economic right and voting right as H-shares which are trading on HKSE. But domestic shares are essentially private shares in mainland China which means management cannot sell their shares on open-market nor can they use their shares to finance personal loans. Hence management does not benefit from higher share price trading on HKSE

• Little top line growth - Baoye does not display strong revenue growth since 2010 as a result of management conservatism (I would argue over-conservatism) and a conscious choice to invest in housing industrialisation

• Market assign zero value to the cash - given mgmt’s control of the company, market is assigning no value to the shares and value the company at 5x p/e given its lack of apparent growth. Investors have lost patience with Baoye over the last 4 years

• Management has been actively pushing down the reported operational performance to depress share price

Can this be a fraud?

You can find a more detailed research here: https://www.dropbox.com/s/gefcb5o8oxr99ij/Baoye%20Verification%20Appendix.pdf?dl=0

https://www.dropbox.com/s/guhjj9turjqzsl0/Baoye%20Group%20Verification.pdf?dl=0

But I will lay out the general idea why this is not a fraud by analysing the cash flow. I look at the total amount of cash Baoye took from shareholders and bank loans vs. the total amount of cash that they have to pay out (shareholders in the form of dividends + share buybacks & government as tax & announced land purchases).

They raised a total of ~RMB 1.5bn between 2003 and 2007 through rights issue and have paid out cumulative dividends of RMB 0.9bn and RMB 0.3bn of share buybacks. They also paid at least RMB 417m of land purchases in the last 5 years which I can confirm via Chinese government sources. (Chinese land purchases is a surprisingly transparent sources nowadays.) They also paid at least RMB 1bn of verifiable tax given local government’s willingness to praise high tax-paying local companies.

So you end up with RMB 1.5bn of cash from investors and RMB 2.6bn of confirmed cash output. They would have to be a very unprofitable fraud if it is one.

I have also independently checked the construction project that they claim they did in China and visited a few of their residential developments. I am very confident that they are a real company.

A little history of Baoye

Baoye is a vertically integrated company with operations in construction, real estate development and building materials. It traced its roots back to pre-economic reform era before 1990s when the founder Pang Bao Gen (PBG) assembled a team of local carpenters, builders and craftsmen to work under a profit-seeking entity that was allowed under the political regime at the time. The company was listed on HKSE in 2003 and raised a total of HKD 1.2bn between 2003 and 2007 on four different occasions.

Given this historical root, construction business is still at the very core of the company’s operation and culture. In the early 2000s, Baoye, lured by the obscene profit at the time, ventured into real estate development. During this period from 2003 – 2009, Baoye’s real estate development business grew spectacularly. However, Baoye’s conservatism towards expansion through debt and refusal to pay up for ever-increasing land price did not bode well for growth. Overtime, Baoye did not emerge as a significant real estate residential developer. This is probably the start of investors losing patience with the company.

Business Overview - Construction & Building Materials

Baoye is involved in both government and private construction projects such as schools, library, government administration building and sports centres. On the private side, it has been involved with both commercial buildings (factories, office building and shopping centres) and residential development projects. The split between public vs. private is roughly 70 / 30.

As the Chinese economy shifts to consumption-driven activities, the deceleration of construction sector growth has been affecting Baoye’s construction activities too. However the backlog / revenue ratio has remained comfortably above 300%.

Baoye operates as a general contractor. It leverages on its client relationship and a very comprehensive set of construction qualification to bid a wide range of contracts. It subsequently sub-contracts portions of the project which significantly lowers the working capital requirement for the company. Hence its construction business is asset light business with relatively high return on capital.

As compared to its competitors, Baoye is a mid-tier construction company with good reputation in China. It has been pretty selective about the projects it undertook.

Construction business’s net operating profit margin has been consistently above 3% margin mark for the past 13 years and has an average operating margin of ~4%. In the sector, 3% margin reflects a very strong operating efficiency.

Building materials business has been largely developed to support the construction business. Its growth has tapered down due to the slowdown in construction activity in China. It is a RMB 2bn revenue and RMB 80m operating business (4% OP margin).

Business Overview - Residential real estate development

Conservative operation – profitable but low growth

Baoye’s involvement in real estate development began in 2000s and has grown steadily in size since then. The company first started its development business in ShaoXing where it is based and expanded slowly to include Shanghai, Hangzhou, Wuhan and Hefei. These are relatively wealthy and prosperous regions in China with a good mix of Tier 1 and Tier 2 cities.

A key pillar of the real estate development strategy is to consistently buy land as cheaply as possible. But in a booming real estate market, it is not uncommon to see many developers bidding up land prices to ridiculously high level anchored by an expectation of ever increasing house price. The average price premium that Baoye paid in excess of the asking price is 16% over for 6 years.

Generally Baoye has been anti-cyclical in terms of land purchase which indirectly leads to the lower land price premium paid over the last 8 years. In fact the land price weighted premium is only 1% (while the arithmetic average is 16% as shown above). It is important to note that this premium average is not regionally weighted i.e. Shanghai would naturally see higher premium while Tier 2 cities like ShaoXing and Hefei would naturally see a lower land price premium.

I am arguing that Baoye has been buying land to replenish its land bank for the past 5 years rather than expanding its land bank. (See Figure 5 below) The total sales area for the last 5 years is 120k sqm and the total acquired land area is 200k sqm. This means approximately an increase of 20k sqm annually. The total land area under development is around 200k sqm as of the end of 2015. The value of the land reserve also stayed pretty constant around RMB 3.9bn during 2011 – 2015.

Insisting on paying low premium leads to losing on many bidding for land sales. And without an increase in land reserve, it is impossible to see strong revenue growth. So we end up with a very profitable but low growth real estate development business. See chart below.

The mid-cycle operating profit margin is around 25% and the average return on real estate assets is around 30%.

Housing Industrialisation - the growth story

In very simple terms, housing industrialisation is about industrialising the process of construction of buildings. Traditionally houses are being built on-site with raw building materials being transported to the construction site. Housing industrialisation is about separating the construction process into two distinct stages - 1) production of components in factories (prefabrication factories) and 2) On-site assembly of finished components. Imagine houses made of lego bricks with the bricks being manufactured in factories and you putting the bricks together on-site.

So why is Chinese government pushing this sector all of a sudden? Two reasons - rising labour cost and protecting the environment. Housing industrialisation has three key advantages.

1. Requires a lot less labour:  As building components such walls and stairs are mainly done in a factory off-site, labour is only needed to assemble the components on-site.

2. Massive reduction in construction waste: Given that the exact amount of material needed for construction are carefully calculated beforehand, the prefab factories only produce what is needed and hence little waste

3. Reduced construction time: If done right, the construction process is dramatically reduced thanks to high degree of industrial productions.

Chinese government  has been acutely aware of the need to protect its environment while pursuing economic growth. And construction waste represents more than 60% of China’s total wasted resources. Plus the labour cost has been rising steadily for the past decade. It has gotten so expensive that housing industrialisation is considered to be very economical in comparison.

Housing industrialisation is going to require an integrated approach to design and construction. Currently in China, the design and construction are done by two separate companies under two separate bidding process.  Going forward, housing industrialisation is going to need design-production-build to become one seamless process.

Baoye has been pursuing this approach for many years (you can go back to their IPO prospectus in 2003 and they have been talking about it since then). However unfortunately for Baoye, labor cost used to so low that building through housing industrialisation method was more expensive for a long time. Baoye has been too early - 10 years too early.

But this is changing now. I am certain housing industrialisation is China’s solution to decades of urbanisation at a low cost to the environment and Chinese government seems to think so too. For example Shanghai has introduced a minimum of 60% prefabrication requirement for all civil construction projects in Shanghai since 2016. Similar policy documents are being launched in many other cities in China such as Hefei and Wuhan.

https://www.ciac.sh.cn/newsdata/news2016080801.pdf  Shanghai - Official policy document (Chinese)

http://precast.com.cn/index.php/subject_detail-id-2178.html Intro to housing indusrialisation in China (Chinese)

In my conversation with the group management, Baoye is planning to build 5 new prefabrication factories with 2 in Zhejiang province, 1 in Shanghai, 1 in Anhui province and 1 in Hubei province. Each costing around RMB 300m. The capacity is around 300k to 1m sqm in term of construction area. They currently have 4 prefab factories.

Again I emphasis that the timing of the growth remains uncertain but the certainty of growth materialising is very certain.

Based on my estimation, if they build the 5 factories and assume a 70% utilisation of capacity, I am guessing about RMB 10bn of revenue conservatively. If we put a 5% operating margin on that, it is RMB 500m of operating profit. Currently they are on RMB 18bn of revenue and RMB 1bn of profit.

One other interesting thing to note is the economics of prefabrication factories work in a very similar way to cement business where the transport radius dictates the formation of local monopolies. Now just imagine the earliest entrants building up local monopolies and Baoye is going to be one those companies.

Can this be a value trap?

Now this investment is clearly not risk-free too. After all, the management has been competent but it has not been too keen on sharing the wealth created by the company with minority shareholders.

I argue that this company is different from most companies that are trading on dirt cheap valuation because the company is on the decline and investors have to bet that it declines less than the market valuation. This is a fundamentally sound business with even promising growth prospect. It is cheap because the market believes that the cash that is sitting on b/s has zero value.

We disagree because the cash can be used to do the following:

• Share buybacks which the company has been doing but limited the constraints on HKSE on how much they can buyback

• Opportunistic on buying new land when it is cheap (unfortunately land prices has been very expensive lately)

• Build new prefab factories (this is going to be majority of the use)

• Privatisation (unlikely at the moment)

By doing any one or a combination of the things above, the cash on b/s will yield satisfactory returns for the shareholders.

On privatisation, we asked management if they thought about privatisation. They said yes. However they would only privatise and relist the company in mainland China if they need a lot more capex to build prefab factories. Issuing new shares at current valuation would be destructive to their own shareholdings. I.e. if we are right about the housing industrialisation trend, the mgmt would privatise and correct the mispricing even if market does not.

Valuation

I use SoP valuation for Baoye. I believe it is self-explanatory and the cheapness should explain itself. Note that I value the real estate not based on profit but rather based on the land they currently own. I use 50% discount of the land purchase price they paid for. If I use the proper valuation for the NAV of the real estate assets i.e. valuing on based on how much they can sell the flats for. The real estate NAV will be in the range of RMB 4bn NAV.

Also note that I applied 50% discount to the cash on b/s. Why did I do that? I just want to even more conservative.

A few more catalyst on share price

Continued integration of Chinese stock market and Hong Kong stock market

If management’s domestic shares become tradeable on HKSE, they would be very interested in a high share price.

China IPO market reform

Management is reluctant to privatise because relisting on Chinese A shares is currently a highly regulated process where one has to wait for years before being allowed to IPO. If that changes, management would be privatising the company to relist in mainland China.

Finally….

This is, in my view, a highly asymmetric opportunity to invest in a quality company with limited downside and significant upside (though uncertain upside). I believe unlike most companies that are valued this cheap, time is our friend as we are more likely to surprised by positive events than negative. However patience is required. Happy to discuss in the Q&A section.

Historical financials

Catalyst

1. Housing industrialisation growth materialising

2. Continued share buybacks

3. Privatisation

4. China IPO market reform

5. Opening up of Chinese capital account