Description

It is not too late to add a new short to Chinese domiciled compnaies.  Wanda Commercial Properties' recent IPO attracted big money -- but the stock is basically an ETF or proxy for the Chinese property market.  However, it will not correlated on the upside with the EWH for fundamental reasons: Low earnings quality.  Returns generated by asset transactions helped by government incentives; ROE continues to decrease as these incentives begin to wear off, no internal catalysts.  Company appears to be partly set up as a “financing” vehicle for Wanda Group, given the inter-party transactions.  EWH (the MSCI Hong Kong ETF) could be used as a hedge.

Company & situation summary

Wanda Commercial develops Wanda Plazas, a chain of mixed-use developments that feature shopping malls, hotels, movie theaters, arcades, and apartments. It operates more than 60 five-star luxury hotels under various international brands, including Hilton, Hyatt, Sheraton, Sofitel, and Westin. In addition, the parent company, Wanda Group owns more than 50 Superstar karaoke bars, 40 Van's department stores, and its chain of Wanda Cinema movie theaters offer IMAX screens. Wanda Commercial Properties is the world's largest real estate enterprise and the biggest five-star hotel owner in the world.

Wanda’s IPO price represented 1.0-1.15x 2014E P/B. Its gross margin declined from 48% in 2011 to 45% in 1H14, while its ROE going down on rising land costs and declining property development segment gross margin. Its ROE is also much lower than competitor, Vanke’s 18%, with a more volatile earnings prospect due to the oversupply of commercial properties in China.  The bottom line is that Wanda is a good proxy because their market is affected by many factors (out of the company’s control), including changes in political, economic and legal environment and changes in the PRC government’s fiscal and monetary policy. There are also sensitive to changes in the economic conditions, consumer confidence, consumer spending and customer preferences of the urban Chinese population.  Other factors beyond their control, such as levels of personal disposable income, may also affect consumer confidence in their geographic markets and demand for our properties.

Sales by City tier type:

The Chinese property market

What the Street thinks:

• Supportive policies (lower down payment, lower rates, other incentives) are in place to support low tier property markets;
• Wanda is better shielded from the slowdown in luxury market as they are mostly in Tier 2 & 3 cities.
• Oversupply of malls is no longer a concern as occupancy remains high due to mix, geography, traffic.
• Good rental trend should continue w/ rising rental income;
• Generates most rental income from shopping malls, rising leas floor area; occupancy at 99%.

What you should consider

• Since 2014 these policies to help property sales have not been very effective as expected, more is needed. (rates were slashed 6 times) to sustain demand; 70% of revenues are from contract sales;
• Tier 2 & 3 market exposure not as exciting as many believe, they will perform worse and require more government support;
• Best days are behind us: expect fierce land competition given well-capitalized competitors;
• More limited pricing power than people think: leases are capped given nearly 20% of tenants are owned by Wanda Group
• Rising online retailing in China will change, but cap rates… Currently, online sales are having a noticeable impact on Chinese shopping behavior (has grown 53% CAGR from 2011 to 2014).

Profitability

What the Street thinks:

• Overall gross margins remain high 43% to 51% despite declining profit across the sector;
• Rent rates will rise as the company introduces fixed percentage of tenant’s sales.
• Reducing finance costs (due to lower rates) will increase profitability (finance costs ~21% of EBIT).

What you should consider:

• Profit have been propped up with cheap government land grants and incentives (lower tier market got most incentives); these profits are mostly generated by selling office, residential and ground-level shops for one-off gains which should garner a low multiple
• Low earrings quality given the related-party transactions (department stores & cinemas is at 20% of rental income, owned by Wanda Group)
• Is rental income peaking or being miscalculated?: 32% yoy, traffic up 30%, 21 new plazas on books (not seeing data of mature SSS)
• Substantial government grants to purchase land and developed are wearing off while and costs are rising
• A fixed % of tenant’s sales can be less valuable in this environment

Balance sheet advantages

What the Street thinks:

• Cheap money is an advantage: onshore debt as a % of total debt at Wanda is the highest at 91% among peers, corporate bond offerings better rates (avg. coupon rate at 4.9% vs. 8.2% for offshore ones).
• Financing costs should come down as rates are lowered and company gets favorable borrowing term
• Wanda often able to get bank loans with longer duration than the rest of sector; bond yields suggests
• Replacing Trust Loans (20% of debt) with  bonds will lower financing costs;

What you should consider:

• Unconstrained cash will be a problem: Funds raised from domestic corp. bonds can be used for anything (acquisitions, working capital, other loans, etc.) offshore bonds are for specific projects.  This is great for Wanda Group, bad for 3699.HK owners;
• No results of having borrowing advantages and higher leverage given decreasing ROE (nearly 3 years);
• Rental-income properties used as collateral in bank borrowings to keep debt costs low will implode as asset values soften..
• Net Gearing (at nearly 60%) will rise dramatically, as they put more debt on the b/s, and more bond offerings (are shares also being used as collateral?)…
• Need to raise capital debt (perhaps equity) will grow over time.

Fair value assessment:

Upside/Downside at 2/1
 

Target price =  HKD20, valuing Wanda as a REIT with 6% yld (before dividend cut), we are paying little for land/real estate values held for sales.

Where the stock could go (downside) = HKD41, discounting property held for sale and maintaining the average group discount.  DCF not a good metric, P/ASP per sqft is better.  Consensus using DCF with an average of 11% for their WACC to value properties held for sale.  However, NAV based on DCF has most room for error; as evidence by the fact that Chinese property developers traded at large discounts during good times; Applying a cap rate on investment properties and multiple of Ebitda for hotels are appropriate.

Catalyst

1. Poor results in March 2016 may force the Street to bring down numbers;

2. China will reduce rates – signaling a prolonged slump in property values;

3. We need to start seeing asset write-offs before a bottom;

4. Dividend cut;

5. More supported policies will be launched in 2016, especially in lower-tier cities (lowering down-payment minimums)