* Note: As I need to fulfill my idea contribution for this year, I am posting an abridged version of the writeup.  I will post a more detailed analysis in the comments section shortly.

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I am recommending a short on RenHe Commercial Holdings (1387 HK).  While the stock is almost uniformly loved by the sellside, I believe many analysts are ignoring the numerous red flags with the company's business model.  Renhe relies on "gain-on-sale like" accounting which overstates earnings (while incurring significant negative FCF).  If/when the music stops (in the form of growth opportunities or deterioration of credit) in China, Renhe will be exposed to significant earnings and balance sheet pressures.

 

While trading at 4x earnings with a 7% dividend yield, Renhe stock appears cheap.  However, FCF has been negative for the past 3 years.  I believe the stock is worth $0.85 (representing 30% downside).

 

• Renhe has flawed business model which depends on “gain on sale” type transactions to fund capex and growth.
• Significant off balance sheet liabilities
• Company has engaged in several questionable (potential fraudulent?) real estate transactions over past few years.

Summary Company Description

Renhe Commercial develops underground shopping malls primarily catering to wholesalers and mom and pop retailers in China.  The Company converts underground civil air defense shelters for retail use.  In exchange for 40-year real estate operating rights, Renhe bears the total costs related to construction and maintenance of the malls.

Bear Case

1)      Business Model

• Business depends on increasing levels of real estate sales in order to fund operations
• GAAP earnings primarily generated through “gain on sale” from real estate transactions
• Underground shopping malls catered to mix of wholesale/ mom and pop retail trade in middle of city centers does not make sense
• Companies “earning” 25-30% ROEs should encounter significant competition – but Renhe does not
• Cash flow issues – Renhe must outlay capex upfront while waiting up to 12 months to get paid by property buyers.  The industry typically gets paid 100% upfront and then builds the development for delivery in 12-18 months.

2)      Very Aggressive Accounting

• Mismatch of net income and cash flow
• Aggressive revenue recognition – recognize 100% of sales upfront while not getting paid until 9-12 months later
• Renhe has significant off-balance liabilities – they must guarantee buyer financing with bank.  Currently over Rmb 1bn of off b/s liability which will only increase as they build more developments
• Huge accounts receivables – AR days in 2010 was 150.

3)      Potential corporate governance issues

• Large property sales transaction in 2010 (over RMB 5 billion) to unidentified BVI buyer with 12 month credit term.  Balance of receivables could be repaid in November (key catalyst)
• Egregious salary - Chairman/CEO gets paid HK$48mm / year (US$6mm + plus options).  Key lieutenants make over US$1.2mm.  As example, the CEO of SOHO China, Renhe’s closest comp, makes about US$700k per year.  Another comp, Hang Lung properties, CEO makes about $650k per year.  Another example, Jack Ma had a salary of Rmb 2-3 mm (<US$500k)

4)      Company has issued stock 3 additional times since going public in 2008.  Renhe would likely consider doing another equity offering above price of last offering ($1.86 in July 2009)

Risk to Investment Thesis

• Overall industry pre-sales seem to be strong.  Pre-sales do not lead to cash but can bolster top-line number.
• Progress on accounts receivables – largest slug of A/R not due until Nov 2011 but Renhe has made some progress in collections in 1H2011.
• Sell-side loves the name as it is focused on commercial (over residential) and not subject to gov’t austerity measures.

 Variant View

• Most sell-side analysts covering Renhe has lack of focus on the balance sheet and cash flow risks in Renhe’s business model. 
• Commercial real estate is not as overheated as residential but will likely exhibit negative trends as China continues to slow down.

 Primary Research

• Hired investigator in China to do calls with lease offices and site visits.
  
  • Some cities had low occupancy – Chongqing had 80% but others were at full capacity.  Many times real estate brokers cited full occupancy in “Phase 1” but availability in “Phase 2”.
  • Renhe malls typically have 2 underground floors.  While vacancy rates of basement floors are typically low (sub 5%), sub-basement levels appear to charge significantly lower rents and have higher vacancy
  • Our visit to Wuxi and Chongqing showed very empty malls with limited foot traffic
• Call with former Renhe general managers of various cities.
  • Conclusion: Success depends on ability to continue hiring solid project management professionals in each city.  This will be harder to do as Renhe expands into 20+ cities over next 2 years.
  • Employee indicated that construction costs is roughly Rmb 1,400/sqm, almost 2x what company has indicated. 

 Valuation

I believe a P/BV approach is the best way to value Renhe.  Currently, real estate comps trade at roughly 0.8x P/BV.  At 1.6x P/BV, Renhe appears grossly overvalued.  Assuming a target P/BV multiple of 1x (very generous) given Renhe’s lower exposure to regulatory and austerity measures, yields a target price of ~$0.85 per share.

• Pre-sale data for upcoming mall projects 

• A/R repayments in 4Q (likely November timeframe).