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GIVEN the property sector's prosperity and significant impact on the overall economy and society, the Chinese central government has had a hand in the sector over the past 10 years.
Many tightening measures have been introduced, something that investors have got used to. Since 2010, the central government has introduced three rounds of tightening measures. Policies, news and rumours constantly surround the sector. Many investors have got tired of the property sector and have even eliminated it from their attractive sector lists despite its strong momentum and attractive valuations.
We are positive on China's property sector. However, austerity measures are intensifying, particularly in the overheating cities. We also see limited scope for the easing of tightening measures given that property prices have remained resilient and inflation is broad-based. Hence, we remain vigilant and believe a sector-wide re-rating is less likely now.
Even after the government's unprecedented tightening, many structural positives for the property sector still exist, such as abundant liquidity flow in China, real estate as the best investment product in China and land price escalation under the government's monopoly over land supply. Developers that are adapting to the current environment with strong differentiating qualities have been emerging as winners even in a market downturn and as a result they are being re-rated. This partial re-rating that began in 2H10 should continue until 2012.
If developers can maintain strong growth in a tightening environment, we need to reconsider whether policy risk should be the sole determinant to re-rate China property stocks. While some market participants may disagree or have failed to take note, the big names in the sector are candidates for ongoing re-rating.
Partial re-rating could be powerful
In the past 12 months, the China property sector has been pressured by several overhangs. Surprisingly, its share price performance is not as bad as expected, in particular for leading developers.
Over the past 12 months, the China Property Price Index, comprising 34 developers listed in Hong Kong, has performed in line with the overall equity market. Benchmarking it to indexes like the MSCI China Index and HSCEI shows that the 36.6% return of the sector has outperformed the MSCI China Index and HSCEI by 22.9% and 20.3%.
The six major large-cap developers (China Overseas Land & Investment [COLI], Evergrande, CR Land, Longfor, Country Garden and Agile) have outperformed the entire sector as well as the index, up about 67.2% in the past 12 months.
The trend became even clearer after February, when the tightening impact continued to surface. On a three-month basis, Evergrande (+53.4%), Longfor (+25.3%) and COLI (+22.9%) have been the top three performers, well ahead of the 9.4% average return for the sector.
Given the good share price performance of the sector, especially the Big Six, we cannot accept that the China property sector is losing favour in the market. There is no such thing as darkness, only a failure to see.
Sector remains attractive in the longer term
To invest in China stocks, investors need to keep a close eye on government policies. Although China opened up its economy more than 30 years ago, it is still highly policy-driven. But it is unrealistic to rely solely on policy winds to decide on sector investments. China has recorded incredible economic growth in the past 30 years and was the first to recover from the 2008 global financial crisis, mainly due to its powerful administrative supportive measures.
The property sector has been the top target for the central government's tightening since 2007, and the government continues to show strong determination to cool the sector. It has introduced many rounds of tightening in the past several years.
Unfortunately, property tightening measures remain the top priority of the government even after five years of tightening. The root causes of overheated property, such as abundant liquidity, lack of investment channels, the government's monopoly on land supply and close interest correlation between the property market and local governments have to be resolved. It is not constructive to target only developers and home buyers.
We will not argue whether these tightening measures are necessary or not.
In this report, we elaborate that even in the prevailing policy tightening environment, the China property market still offers room for broad growth for real market leaders. For profit-generating companies, earnings will always be the most important yardstick, regardless of the sector, taking a longer-term investment horizon. We believe the China property sector will remain attractive in this aspect; moreover, this would be earnings achieved in the so-called toughest period.
In essence, most developers have been focusing on expanding their landbank and boosting contracted sales in the past few years. While both are critical elements, we believe developers (particularly leading names with a much higher sales base) are increasing their emphasis on profitability and earnings quality in the longer term, which should enhance returns for investors.
In the past three years, the sector has shown robust growth on different parameters. Compared to the 137% growth in market capitalisation, the 19 developers we track recorded 2.09 times and 3.46 times growth in sales and net profit in FY10 against 2008. Amid continued policy noises, the sector has proved its investment value. In 2010, the central government introduced two rounds of tough tightening measures, but the average core net profit margin for the sector scaled up to 16.9% on average, 1.1% percentage points higher than 2009, representing a record high in the past few years.
On our estimates, the earnings growth momentum of the sector should continue in FY11/13, with a 26% compound annual growth rate (CAGR) on the bottom line. Based on the latest share prices, it means the sector is trading at only 10.2 times 2011E price-earnings ratio and as low as 6.3 times PER in 2013. The Big Six, with an even higher base, can still present a robust 28% earnings CAGR in the next three years, stronger than the sector as a whole.
Evergrande and Longfor should comfortably achieve core net profit CAGR of about 35% in FY11/13E, while COLI and Vanke should maintain a profit CAGR of about 28%. This differs from the market's general perception that leading big developers can only maintain stable growth. With stronger execution capabilities and financial positions, these big-cap names should be more favourable amid policy tightening.
Compared with other key sectors such as consumer products, construction materials and banking, the earnings outlook and growth prospects of the China property sector are indeed highly competitive. Based on our estimates and market consensus, we see earnings CAGRs for other sectors range from 17% to 24%, which is even lower than the property sector as a whole. For the Big Six developers, earnings growth of 27% is apparently stronger than that of these hot sectors.
However, the decent earnings growth has yet to be reflected in valuations.
As for the construction materials and consumer sectors, while they are still benefiting from the supportive policy, the China property sector is already close to a trough in a tightening cycle. Policies such as purchase restrictions, tax levy/settlement, and credit squeeze have all been in place. In such a harsh operating environment, if developers can still maintain good growth momentum, we believe the investment case is even more justified on a relative basis.
Although the sector has been in a tough operating environment, the factors underpinning sustainable growth still remain sound, in our view, such as relatively strong economic growth, urbanisation and a living standard upgrade. Over the coming five years, China is still confident of achieving GDP growth of no less than 7%, which offers a favourable macro environment for China's property sector. China is expected to maintain a growth rate in urbanisation of an average 0.8% per year in the coming five years, with the urbanisation rate increasing to 51.5% by end-2015.
Strong income and wage growth should also drive up continuous housing demand.
How valid are estimates to underpin high growth, attractive valuations?
By end-April, the 17 developers under our coverage achieved an average 84% lock-in of our FY11 estimated property sales. By accomplishing FY11 sales targets, developers would offer greater comfort with regard to sustainable earnings growth in FY12/13.
Our in-depth analysis of developers' saleable resources in 2011 shows that most leading developers such as Evergrande, COLI, Longfor, Agile and Country Garden can achieve their sales targets. In 2011, the market share of the top 10 developers could climb to 18% to 20% from 11.3% in 2010.
Our view on the physical market: (i) Tightening unlikely to be loosened, even in 1H12E; (ii) Estimated volume down 15% to 20% year-on-year nationwide in FY11 with tier-1 and tier-2 cities down 25% to 30% y-o-y. Negative impact in second-tier cities has been intensifying; and (iii) Prices down 15% from the start of 2011. Good to see more popular price cuts.
We recommend sticking to large-cap names during the policy uncertainties. Our top picks are Evergrande, COLI, Longfor and Shimao.
We would not be surprised if other new measures are rolled out in 2H11, but the market's sensitivity to policy moves may be diminishing. Leading developers are also more defensive in this environment. The re-rating story of big-cap market leaders should continue in 2H11 given their strong growth momentum with higher visibility, good sales progress, strong financial position and convincing valuations.
This report was made by Citigroup Global Research.
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