A boutique property developer in Shanghai backed by a powerful parent company. The company invests, develops and operates boutique residential properties and urban complexes in Shanghai and 9 other cities. Its parent company, Shanghai Industrial Holdings (363 HK, unrated), is a large Shanghai state-owned enterprise. We believe the company's core competitiveness lies in its parent company's diverse land acquisition channels in Shanghai (such as urban renewal projects) and low financing costs.
It has high-quality land reserves in Shanghai, and the investment portfolio is expanding. As of mid-2016, the company had 3.8 million square meters of land reserves, of which 21% were located in Shanghai. Furthermore, the company owns investment properties with a total construction area of 600,000 square meters in the city. With the completion of its Shanghai Binjiang City Development Center and TODTOWN Tianhui project, management plans to double the company's total leased floor space and rental revenue.
Disposal of non-Shanghai projects is ongoing. The company sold 35% of Shanghai's Binjiang Urban Development Center and 40% of the shares of its Hebei subsidiary (Shanghai Chengkai Long City). We estimate that in 2016, the company received pre-tax disposal revenue of HK$1.6 billion. Meanwhile, the remaining 40% of the shares in Shanghai's Binjiang City Development Center will also be sold. In addition, management plans to sell the following projects as soon as possible: West Diaoyutai (Beijing), Nature (Xi'an), Shenyang Urban Development Center (Shenyang), and Forest Sea (Changsha). We estimate that these disposals will generate total sales revenue of HK$13 billion and pre-tax disposal revenue of HK$3.5 billion, of which pre-tax disposal revenue in 2017-2018 was HK$1 billion. Proceeds from the sale will be used to purchase land and invest in property development in Shanghai.
1H16 Performance Review: Revenue from property sales and disposal was the main driver of revenue and profit. The increase in total floor area of settlement sales led to a 13% year-on-year increase in revenue to HK$2.5 billion in the first half of the year, with 82% of revenue coming from property development business. Settlement revenue was mainly contributed by two projects, Shanghai Wanyuancheng and Shanghai Jingcheng. The company's property leasing segment recorded sales revenue of HK$319 million, gross margin stabilized at 34%, and net profit increased 274% year-on-year to HK$312 million. The company's sale of Shanghai's Kailong City recorded pre-tax disposal proceeds of HK$1.1 billion.
Property portfolios in Shanghai are undervalued. The company acquired two villa projects in Shanghai in September this year. According to our calculations, the company's land reserves in Shanghai will increase to 1 million square meters in the next two years. Assuming an average selling price of HK$30,000-40,000 per square meter, the reasonable valuation of the company's Shanghai property portfolio is HK$30-40 billion, which is 200-300% higher than its current market value (HK$9.6 billion).
Earnings are expected to increase by 12%/18% in 2016/2017; the first coverage gave a “buy” rating. We expect the company's settlement sales floor area in 2016/2017 to be 200,000 square meters, respectively, with a gross margin of 35% for both years, which will drive two-year profit growth of 12%/18%, respectively. The company's current stock price corresponds to 0.7 times the expected net market ratio in 2017. We believe that the company's net market ratio does not fully reflect the reasonable market value of its Shanghai project. According to Bloomberg data, the average valuation of Chinese real estate stocks is 0.8 times the price-earnings ratio in 2015. Industry leaders China's overseas (688 HK, buy) and China Resources Land (1109HK, buy) both had net market ratios 1.2 times (2015). We believe that the company's reasonable valuation should be discounted by 20% compared to industry leader China Overseas. The first coverage gave a “buy” rating, with a target price of HK$2.80, equivalent to 1.0 times the predicted net market rate for 2017.