Description

Please see the link for the pdf of the full write-up (with pictures): https://www.dropbox.com/s/6boprdt0bmwsjmi/1538%20HK%20Memo%20S%26S%20v7.pdf?dl=0

We believe Zhong Ao Home Group (“ZA” hereon, 1538 HK) offers a rare 3x opportunity within 12-18 months + a free option on making 5-10x one’s money through ZA’s stake in burgeoning tech platform, all with strong downside protection given the 15-20% FCF yield, world-class strategic investors like David Wei protecting minority interest, and shareholder-friendly, value-signaling actions including heavy insider buying, buybacks, and dividends.

The company consists of a well-run, medium-sized property manager in a rapidly consolidating industry, trading at 5x ex-cash FY17 P/E, while peers trade at 15-30x P/E (US peer FSV trades at 25x+). This industry is known for its high ROE business model enjoying high switching cost, captive customers, and long run-way of synergistic, acquisitive growth. There is a strong possibility that ZA is acquired as the industry further consolidates. Additionally, through ZA’s ~66% fully diluted stake in Aidaojia, an O2O tech platform with an ex-Alibaba team handpicked by David Wei, ex-CEO of Alibaba.com – investor owns an option that could be worth 5-10x of ZA’s current market cap.

There are ample catalysts to crystalize value within the next 12 months:

• The company started its repurchase since August 23rd, 2016. ~3% of float had been repo’ed within the past 40 days alone.

• The one-off costs associate with IPO and tech platform initiatives will roll off while acquisition growth kicks in by YE16/1H17, leading to an effective triple digit annual CAGR of EPS over the next 2 years.

• The VC fundraising for ZA’s O2O tech  platform putting a value on the venture as evident by the convertible note issuance.

Base case target of $3.00 HKD / share, 160% upside within 12 months; 16x 2018 EPS of 15 cents HKD = $2.40 / share for core ZA, 60 cents HKD for net cash + investment properties, no value assigned to O2O App.

We believe this opportunity exists for the following reasons:

• Market myopism: the market does not differentiate core earning power and one-off expenses associated with IPO, acquisitions and tech initiatives that deflate headline EBITDA by as much as 50-60% -- a phenomenon set to correct itself in 2017 where the true earning power of 14-15 cents HKD / share will shine through. Currently the market incorrectly prices the stock based on a depressed consensus 2016 EPS of 7 cents HKD / share (16x P/E). See appendix for detailed bridge.

• Illiquidity: ZA is only 1/5-1/8 the size of its closest peers in the H-share market with 75%+ of the shares outstanding effectively locked up. The stock trades on average $150k USD per day over the past 3 months and company accounts for 40% of the volume over the last month. Nonetheless, it is possible to acquire a multi-million dollar position in the open market as evidenced by the entry of Briarwood Chase Management.  We believe ZA can rerate very quickly: whatever sellers are remaining in the free float will likely soon be bought by the share buybacks and the stock price is likely to increase based on simple supply and demand.

• Capital Allocation Concern: the market is assigning mid-teens multiple on the losses ZA’s tech platform generates and effectively assumes these losses will foreseeably continue. Based on the IPO earmark, our conversation with management, and their long-standing track record as cost-conscious operators, we believe this loss-funding venture could cease as soon as 1H17.

• Corporate Governance & Operational Concerns: Micro/ small caps in Hong Kong have a tendency to be deemed guilty until proven innocent. As we will show in the next section, minority investors have unusually strong protection in the case of ZA.

Corporate Governance: we contend that ZA is exemplary in this regard:

• Key strategic investors with sterling reputation: Key strategic investors own ~20% of the company: Ex-Alibaba.com CEO David Wei (Vision Knight Capital, or VKC, ~12-13% stake) + E-House CEO Xin Zhou (Decision Holdings, ~6-7% stake). Vision Knight Capital, in particular, invests for some of the wealthiest and most successful merchants in Hong Kong, SE Asia, and Europe, some of which signed the LP agreement without going through the terms out of trust to David Wei. Anchor investors for VKC included leading merchants in China as well as respected United States and European endowments, pensions, and sovereign wealth funds. Based on our due diligence, we believe extensive background checks and forensic accounting checks were done on ZA prior to investment. We also performed background checks on our own and the results came back equally clean. Indeed, we spoke with more than 10 competitors, customers, and former executives of ZA, and every one had positive things to say about the founder and the management team in terms of ethics, integrity, and high competence in the property management sector.

• The voting and board -level checks-and-balance is strong: as-per the articles of association, a special resolution (such as sizable acquisitions) can only by passed by a majority of 75% -- offering a comforting margin given management’s 54% ownership. Additionally, the board is composed of 3 VKC members, 4 independents (3 of which brought in by VKC and 1 by founders), and 4 founders  – meaning that the management cannot force issues through without it being logically reasonable. In other words, this is as close to a well-balanced western board as one can get in China – and if Briarwood Chase Management (owns 7.5% stake) is sensible; the Trio can effectively block any unethical attempts.

• Track record thus far had been credible: Aside from sticking with the plan on IPO proceeds (~25% towards O2O, ~60% towards acquisition), the founder purchased >4 mm shares back in January 2016 as stock slid towards the $1.20-1.40 area, declared a dividend of 4.5 HKD cents, and had the company commence share repurchases starting at August 23rd, 2016. Anecdotally, we heard that when the old O2O team was fired, the founders picked up the cost personally as they felt it was their fault. We believe the actions so far speak volumes regarding the management’s integrity and attention to shareholders.

If we can agree that ZA’s action and board composition indicate strong corporate governance, then the only other valid reason to value the stock at a material discount vs. peers would be that ZA is a materially worse company (ZA ex cash is trading at ~ 5x 2017 P/E vs. HK peers trading at 15-30x P/E). Again, we believe this assumption to be false. If anything, ZA’s operation is highly efficient, quality admirable for the price / sqm paid (certainly no worse than roll-ups such as Colour Life), and growth not lower than its peers.

As observed above, ZA enjoys 10-20 pts higher gross margin than its peers, thanks largely to its tight cost control as evident in the meaningfully lower overall headcount per GFA managed. The payments to employees appear in-line with the industry as evident in the COGS / total lump-sum employees (full-time + subcontract) and in-line with our checks where a typical property management staff makes 2-3k RMB per month as an entrance-level staff and 5-8k RMB in more senior positions. Many anecdotes with industry practitioners suggest that ZA emphasizes the cost control culture in the whole organization (given founder’s military background), puts a strong amount of pressure on mid-to-low level employees, run a very efficient operation, and offers very good training programs – in fact, a lot of employees obtain more senior positions in other property managers upon departure and were actively poached. This low cost structure allows ZA to be very competitive within its price range ($2 – 3 RMB / sqm)  and we believe ZA makes money on over 99% of its properties on each individual complex, very different from industry average – for instance, 20% of China Oversea’ properties are loss making – since typically property managers, typically associated with property developers, has a main job to help sell the properties with a non-optimized cost structure and suppressed fee.

Operational checks aside, we also believe that ZA does not control cost at the expense of quality. For $ 2 – 3 RMB / sqm, we have often heard that ZA offers above-average quality the money’s worth with service caliber much better than Colour Life. This remark is evident in both the company’s collection rate and receivable impairments: ZA’s collection rate is north of 90% (Vanke is 96%) whereby a typical tier 1 manager does 80-85%, and regional tier 2-4 players do 60-70% -- this is an impressive track record given that at least 3-5% of customer never pay management fee China, which ties with ZA’s annual impairment being only 3-4% of sales over the past few years. This impairment charge may appear to be higher than its peers of 1-2%, but we would note that ZA’s peers may only recognize 80-90% of revenue (i.e. ignore the uncollectible portion, while ZA recognizes 100%) and understate receivables at the same time – leading to an optically lower impairment balance. Net-net, if we were to adjust for the O2O, listing fees, and advancements on non-trade receivables for 2014/15, ZA’s core EBITDA-to-Operating Cash Flow conversion averaged 70-75%, representing actual and effective payment collection. The FCF profile is very strong for ZA’s core business given the mere 1-2% CapEx as % of sales spend.

ZA’s strong and Imminent Growth Prospects:

As seen above, there is substantial earnings growth ahead of ZA simply based on the reversal of non-recurring expenses. In addition, there are two significant growth drivers ahead:

• Delivery of 7-8 mm sqm of GFA (gross floor area): as of 1H16, ZA still has ~9.3 mm sqm of “undelivered GFA”; these are the plots of contracted areas where ZA will manage but the final hand-off has not yet happened – as the area could currently be under construction, being furnished, or being pre-sold. Over the next 2-3 years, by simple completion and hand-off of the properties to tenants, ZA will begin to manage these properties and accrue revenue.

• >20 mm sqm of acquired GFA: The recently announced Beijing (1.6 mm sqm) and Ningbo (18 mm sqm+) acquisition @ 6-7x PE are set to hit ZA’s income statement starting 2H16/1H17.

• We see the area that ZA generates revenue on (“revenue-bearing GFA”) doubling by year-end 2017 with high certainty (from its current ~17 mm sqm GFA.

Despite the slow-down in sales assistance revenue, lower fee / sqm for acquired properties, and potentially compressing gross margins, ZA is still on track to 2x its revenue and core EBITDA by 2017 and is set to generate 100-110 mm HKD of net income for shareholders (or 14-15 HKD cents per share). Furthermore, the ~400 mm RMB cash pile + ~150 mm RMB in investment properties by YE17 can fuel further add 5-10 cents HKD in EPS upon intelligent acquisitions – whereby the cheap valuation multiples are available as many small property management companies in China are associated with small property developers whose businesses are shutting down and are seeking to exit their property management arm. ZA is amongst the few publicly listed property management companies who can do so. This utilization of the cash balance in the next 1-2 years is likely as ZA is set to spend 300-315 mm RMB in acquisitions since its IPO in December 2015 and has an active pipeline of further prospects. To date, ZA’s acquisitions have been at a projected 5-7x P/E range, and we assume 7x P/E for future acquisitions.

From our extensive reference checks, we believe ZA’s management may be among the best operators in the property management industry in China. A few anecdotes suggest that their passion and dedication are likely to carry the business for years to come:

• The founder Liu Jian works very hard- spent half year traveling around China tracking quality on the ground.

• Wanda tried to poach CEO Liu Jian and VP Liang Bing for 2 mm RMB when the team first started, but the team declined because they believed in their business and aimed for a long-term development.

• One former had a very high opinion of the team and mentioned that all the four founders are still there: “When they started the business, money wasn’t a big driver. It was about impact…Founder is down to earth and practical.”

• Another employee talks about them having a strong vision; also mentioned that a few years back some other companies tried to acquire and offered price of 1.5 Bn RMB but founders declined  with the goal to build very strong brand equity for ZA.

• According to a manager at Zhujiang property management (close rival to ZA in its HQ in Guangdong), ZA’s management team is “bold, risk-seeking but can get things done…peer companies do admire what they do”

• According to another competitor – they seek to hire people from ZA and learn from them.

Given that ZA is a highly efficient operator with quality and growth no worse than its peers, we believe that it deserves at least a market-level multiple of 18-20x (14-16 ex-cash PE). If anything, the small-cap discount due to liquidity constraints should be more than offset by ZA being a potential take-out target by the bigger players such as Vanke and Colour Life, especially given the current valuation disparity and synergy in public company cost-takeout.

Aside from an undervalued core property management business, investors in ZA also receive a free option on ZA’s property management/O2O tech platform called Aidaojia. Currently, Aidaojia allows users to order food (e.g. fruit), home services (water delivery, housekeeping, appliance maintenance), and local merchant services (hair salon) as well as to perform standard property management tasks such as paying property management fees and reporting an issue at the property. ZA and VKC’s thesis behind the platform is that the frequent interactions between property management butlers and residents can be leveraged to:

1. Acquire users at nearly zero cost. Butlers interact with residents nearly every day and, from these interactions, butlers can discover the residents’ preferences and interests. If properly incentivized, butlers can encourage a resident to download the app and can also highlight products/services on the platform which the resident is likely to consider purchasing. Aidaojia’s customer acquisition costs of RMB 0 – 8 per user is fractions of the level of more established players like JD.com.

2. Achieve lowest last mile delivery costs in the industry. Butlers collect packages from merchants at a central location at the community and then conduct route-optimized delivery runs to bring packages to residents’ doors. At RMB 2 per delivery (paid to directly to the butler so as to incentivize them), our research suggests that Aidaojia’s last mile delivery costs are among the lowest in the industry. This is achieved by minimizing the number of delivery runs, saving on excessive packaging, and benefitting from free storage areas at properties. The platform is proving especially popular with the elderly and stay-at-home mothers due to an important security benefit for residents – deliveries are made by butlers, whom residents already know, as opposed know as to strangers sent by e-commerce vendors.  

ZA is aiming to offer an attractive value proposition to all the participants in the O2O ecosystem. Residents enjoy tailored offerings as well as safe and convenient home delivery by butlers. Merchants can benefit from the last-mile delivery solution offered by O2O platform and increase their sales by cherry-picking the properties where they want to offer their services and promotions. Finally, butlers are paid for deliveries and can receive bonus earned from promoting the sales on the O2O platform.

The Aidaojia team was hand-picked by VKC and is mostly composed of experienced ex-Alibaba and ex-NetEase engineers. Having spoken to all the listed property management companies and several of the largest property developers in China, to our knowledge, there is no other O2O property management app with such a high-caliber, properly-incentivized team (most O2O property management apps are just run by the IT team of the property management company earning a salary instead of participating in the upside) and with a value proposition aimed at third party property management companies (over 97% of properties covered by the app are not managed by ZA). Aidojia’s current June 2016 run rate of 15k orders / day across 4.6k communities on 465k registered users (62% repeat purchase ratio) is comparable to the metrics which Aixianfeng enjoyed when it raised funding at a 300 mm USD valuation in early 2015. Moreover, we believe that both ZA and VKC are actively looking for VC funding to put a valuation on this asset – this is evidenced by Aidojia’s issuing a convertible note to VKC (expiring April 2017) with a conversion price contingent on the valuation achieved at subsequent fundraising round with a third party.

As with any early-stage tech investment, Aidojia’s ultimate value carries significant risk, BUT the blue-sky case for Aidaojia can be extremely rewarding to ZA shareholders. In one path alluded to in ZA’s 1H results (see discussion on pg. 19 on SaaS), Aidaojia can become the property management front-end vertical software of choice in China. Any property management company can simply sign up for Aidaojia’s license and obtain a packaged solution for providing the services described above. While this will not only create savings on R+D for property managers, our conversations with third-party property management companies which have implemented Aidojia suggests that the app actually increases collection rates by reinforcing a positive association with butlers; that is, butlers are associated with delivering value to residents rather than simply hassling residents for collections. To quantify the opportunity, there are about 300k residential complexes in China according to Gaode Map (2); assuming 1/3 of it being in tier 1-3 cities that can afford Aidaojia’s service, a 5% penetration rate, and 250-300k RMB annual fees for each complex (justifiable on savings from increased collections alone), Aidaojia can generate RMB 1.5 Bn in revenue. At a 30% operating margin and 25x PE, this fee stream is worth 8-9 Bn RMB. Perhaps an even simpler framework for thinking about Aidojia’s upside is relative to other successful O2O platforms – GrubHub and GroupOn, for example, are worth in the range of 15-30 Bn RMB. In summary, if Aidojia is a hit, ZA can easily be a 10-bagger.

Appendix:

True earning power bridge:

• The core ZA property management business generated 114 mm RMB in EBITDA in 2015.

• The listing expense of 36 mm RMB, additional O2O cost of 13 mm RMB, and 14.6 mm grant of pre-IPO share Options, however, effectively deflated EBITDA by 50% in the headline.

• In particular, the suppression to EPS continues in 2016 – we estimate another 55 mm of expense associated with O2O and 20-25 mm of fees associated with acquisitions – and again deflating the ~130 mm core EBITDA by ~60%.

• As we enter 2017, the IPO charges and acquisition fees would have lapsed, ZA’s O2O investment would have reached the IPO promise of ~60mm RMB cash-burn and be actively managed downward, all while the pending acquisition closes and adds meaningfully to ZA’s earnings.

• The true earning power of 14-15 cents HKD / share should show through by 2017/18.

• As illustrated below – assuming ZA had always stayed as a private company and never launched an O2O initiative, it’s EPS would have always been growing – from 8 cents HKD to Est. 16 cents HKD by 2018.

Catalyst

The company started its repurchase since August 23^rd, 2016. ~3% of float had been repo’ed within the past 40 days alone

The one-off costs associate with IPO and tech platform initiatives will roll off while acquisition growth kicks in by YE16/1H17, leading to an effective triple digit annual CAGR of EPS over the next 2 years.

The VC fundraising for ZA’s O2O tech  platform putting a value on the venture as evident by the convertible note issuance.