Abstract: despite the recent tightening of China's housing market policy, Shangshi City has launched a carefully planned project, and the company is expected to continue to record stable revenue and contract sales in 2017 and 2018. As a local state-owned enterprise in Shanghai, Shangshicheng enjoys low land costs in Shanghai, and we expect projects such as TODTOWN Tianhui to contribute considerable profits to the company. The company's share price has lagged behind its peers, with a price-to-book ratio of just 0.66 and a 62 per cent discount to our estimated net asset value of HK $4.57 per share. We expect that the restructuring of SSIC and its sister company, Shanghai Real Development [600748.CH, unrated], will continue to be a potential catalyst.
Company background: Shanghai Real Estate Development is a mainland real estate developer with 20 real estate projects in 11 major cities (Shanghai, Kunshan, Wuxi, Beijing, Shenyang, Tianjin, Xi'an, Chongqing, Changsha, Fuzhou and Shenzhen). Shanghai Industrial Holdings [363.HK] became its parent company after it acquired a 71.01% stake in Shanghai Real City Development in 2010. Most of the projects developed by Shanghai Real City are medium to high-end residential projects.
Core profits improved significantly in mid-2017. Due to the delivery of projects such as Wanyuan City and Shanghai City Kailong Court, the company's revenue in the first half of 2017 increased by 71.8 per cent year-on-year to HK $4.2 billion. As the gross profit margin of the Shanghai project can be as high as 50%, the company's overall gross profit margin in the first half of the year reached 50.04% (first half of 2016: 33.6%).
As a result, while interim profit attributable to shareholders on the statement rose only 3.4 per cent year-on-year to HK $322.8 million, core earnings rose sharply. In the first half of 2016, the company recorded a sale profit of HK $1.114 billion as a result of the sale of its interest in Chengkai Centre. Excluding this huge sale gain and fair value change income (HK $47.5 million), the company's core profit in the first half of 2016 was significantly lower. Core earnings are expected to be stronger in 2017, mainly due to (1) an increase in recorded income, (2) a decline in interest costs, and (3) a reduction in exchange losses due to the foreign currency effect of RMB.
The sales target of 9.3 billion yuan in 2017 is expected to be achieved. In the first half of the year, the company's contract sales rose 2.5 per cent year-on-year to 4.645 billion yuan, reaching 50 per cent of the full-year sales target of 9.3 billion yuan (excluding the amount attributable). The Shanghai (Wanyuan City and Shanghai City) project accounts for 60.9% of the contract sales, while the Xi'an Nature Project accounts for 29.1%. According to the company, although the purchase restrictions in Shanghai have been more stringent since October 2016, the company's sales in Shanghai have maintained a good level. The average selling prices of most items have improved.
As for the second half of the year, the focus of contract sales will be on (1) TODTOWN Tianhui, a project jointly developed by the company and Sun Hung Kai Properties in Shanghai; and (2) Chengkai Zhong Geng Xianghai World Project. However, since Shangshicheng has less than 50 per cent interest in these projects (20.7 per cent for TODTOWN Tianhui and 26 per cent for Chengkai Zhong Geng Xianghai World Project), the contribution of these projects will be recognized through "attributable associate performance" at the time of project delivery and accounting.
The lower debt ratio and financial costs help to increase land reserves. As of June 30, 2017, the company's net debt ratio fell to 6.5% (8.1% at the end of 2016). Because the company is a state-owned enterprise, the weighted average financing cost also fell to 4.20% in the first half of 2017. The management believes that based on this favorable financing condition, the company has a lot of room to increase its land reserves.
In the short term, the company can accept a net debt ratio of 60-70 per cent, in which case the company can easily borrow more than RMB 6 billion to acquire land. In 2016, the company repaid all its foreign currency debt, so the exchange risk will be significantly reduced in 2017. However, due to rising domestic financing costs and falling offshore costs, the company is reconsidering overseas fund-raising.
Look for opportunities in major cities and seek cooperation with the parent company. Like other developers, Shangshi Chengkai hopes to acquire more land in first-and second-tier cities, with Shanghai as a top priority.
In August 2017, the company won a bid for a piece of office and commercial land in Minhang District, Shanghai, with a land area of 118000 square meters and a winning bid price of 2.22 billion yuan (or 18814 yuan per square meter). Management said the company would be cautious about buying the project and was exploring the possibility of a first-tier development with parent company Shanghai Industries. The old factories owned by Shanghai Industrial Group may have the potential for urban renewal. Shangshi Chengkai can also take advantage of its advantages and make good use of its relationship with the Shanghai government.
The parent company has postponed its restructuring, but Shangshicheng has its own advantages. The restructuring of two real estate platforms owned by Shanghai Industrial Holdings [363.HK, unrated], that is, Shanghai City Development and Shanghai Real Estate Development [600748.CH, unrated], has been the main catalyst for the three companies. Shanghai Industrial Holdings originally planned to solve this internal competition problem within 2017, but it was eventually postponed to 2019. Despite obstacles to the restructuring, Shangshi Chengkai management still believes that the restructuring is feasible; the exact steps of the restructuring process will depend on the decision of the parent company and SASAC.
Valuation: although a number of inner housing stocks have risen in recent days, Shanghai City has lagged behind its peers, with a year-to-date return of only-6.9%. We think there are two main reasons: (1) the company's assets are highly concentrated in Shanghai, while the local regulation is strict; (2) the company used to rely on the sale of assets to balance profits.
That said, as of September 25, 2017, the company's price-to-book ratio was 0.66 times, and the share price was 62% off our estimated net asset value per share (HK $4.57). In terms of valuation, the company's current valuation is at a lower level among comparable companies. The following catalysts are expected to trigger a further revaluation of the company: (1) some major cities may relax controls after the 19th CPC National Congress in October; (2) contract sales are stronger than expected in the second half of the year; and (3) progress has been made in restructuring within the group.