Country Gardens is the largest property developer in China focusing on rapidly constructing high-end buildings for the Chinese elite
The business is supported by domestic macroeconomic trends, alongside a strong competitive moat in lower-tier markets, where the business aims to revolutionise cities using green technology
With Evergrande near bankruptcy and the recent regulatory crackdowns this has created significant headwinds – which looks to shape China’s economic future
(Reading time: 24 minutes)
Country Garden Holdings Company Limited (stock code: 2007.HK) is China’s largest residential property developer by revenues and currently ranks 147th in Fortune Global 500. Its vision is to support China to become a more technologically advanced country.
Country Garden as one of the largest property developers offers a broad range of products to cater for diverse demands, namely residential projects such as townhouses, condominiums, car parks and retail shopping spaces. The Group also develops and manages hotels at some of its projects with the aim of enhancing the properties’ marketability. As of late the company is becoming increasingly involved in robotics and modern agriculture to supplement its property development business.
Since its establishment, Country Garden has benefitted from China’s thriving economy. Its presence has expanded from Guangdong province to other economically vibrant regions of the country. Its business boundary has also become increasingly diversified, from property management to value-added community services and non-owner value-added services between 2011 to 2014. In 2018, it entered into the one-stop philosophy of “three supplies and one industry” (water supply, power supply, heat supply and property management). As of 2021, Country Garden operations covers 360 cities and 2,958 projects in Mainland China with over 4 million clients.
1. The Company
Country Garden Holdings Company Limited, invests, develops, and constructs real estate properties primarily in Mainland China. It develops residential projects, such as townhouses and condos; and car parks and retail shops. The company also operates and manages hotels. In addition, it researches and develops robot intelligence; develops electronic hardware and biomass energy.
The company also sells food; and provides interior decoration, landscape design, agriculture and animal husbandry, investment consulting, cultural activity planning, and real estate consulting services. Country Garden Holdings Company Limited was founded in 1992 and is headquartered in Foshan, the People’s Republic of China.
2. Qualitative Analysis
Country Gardens has three main areas of operations, including property development/management, robotics and modern agriculture .
From 2016 to 2020, the sales growth rate was approximately 25%, owing to the rapid expansion of the Chinese economy. By 2020, the percentage of contracted sales outside of Guangdong Province was 81%, which strongly reflects the company’s effort towards geographic diversification.
Geographical Distribution of Ongoing Projects
Country Gardens is also diversified in its contracted sales in terms of tier cities. Overall, 54% of contracted sales were contributed from projects in tier 3 and 4 cities, with 32% of sales located in tier 2 cities and the rest in tier 1 cities and smaller settlements.
The company also has a concentrated project portfolio in five city clusters that contribute 73% of salable resources. The rest are located in pocket areas, primarily in Henan, Hainan, and Fujian .
What is worth noting is that approximately 98% of these projects are in regions with a population of over 0.5 million and 93% are in areas featuring positive net immigration – which are key fundamental drivers towards growth and signal a positive sign for long-term sustainability.
A key area to investigate is the demand in third and fourth-tier cities – given its high weighting to revenues.
The popularity of third-and fourth-tier cities is lower than those of first-and second-tier cities due to information asymmetry . Despite this, lower-tier cities are still an essential carrier of urbanisation. The vast amount of land in China results in more third-and fourth-tier cities than first and second-tier cities, 293 compared to 40 . – Thus, creating an opportunity for large property developers to expand “vertically” to smaller cities and accelerate urbanisation.
This opportunity is evidenced by the proportion of commercial housing sales in third-and fourth-tier cities at 70% which is much higher than first and second-tier cities at 55% according to the 2019 National Bureau of Statistics in China .
Lower-tier housing markets are characterised by a low supply of high-end development properties. With rising wages and the growing Chinese economy, the demand for high-end properties is rising. However, in these markets, the supply of high-end brand developers is relatively low, creating an opportunity for Country Gardens to capitalise from the mismatch in supply and demand .
Per Capita Disposable Income: Rural Residents (CNY)
A key characteristic of third-and fourth-tier housing markets is low house price elasticity. This has several important implications on the Country Garden’s operations as the cost margins become price sensitive to house/land price fluctuations.
We expect that as lower-tier cities become more urbanised – the housing markets will become more asymmetrical with the average house price increasing. This is evidenced in tier-one cities where housing prices hover around 14 times the average salary. In tier-two cities, homes cost 7 times the average salary. And in tier three, four, and five cities, home prices are 5 times the average salary .
Therefore, for a property developer to become successful in lower-tier markets, it must demonstrate robust cost control to maintain a healthy profit margin, alongside a high cash flow turnover rate to create a robust and sustainable competitive moat.
Excellent cost-cutting practices create a competitive moat
Country Gardens has adopted a hybrid differentiation focus and cost focus strategy, meaning that the business is focused on developing properties with a standardised and high-quality offering – to reduce costs and at the same time offer unique higher-end properties to differentiate the business. Their target audience are well-educated upper- and middle-class consumers – Hence why Country Gardens management openly describes the business as an “elitist community” .
In terms of the business model, the home improvement products of the company have strong competitiveness in third and fourth-tier cities, through excellent cost control due to the use of automation and robotics in the construction of a property, which allows the company to operate efficiently in a low margin market .
Furthermore, the company has formed a mature cost control culture, with aligned incentives and regular cost analysis using a data-driven approach. These processes include completing the planning scheme and apartment design before land acquisition to ensure rapid construction. Also, through the cooperation of its entire industrial chain, the company can realise the fast and flexible allocation of resources.
An advantage of operating in lower-tier cities is high bargaining power over local government authorities, enabling Country Gardens to generate more favourable deals, than in larger cities with more regulatory oversight .
High turnover drives the economics of scale
We believe that the demand for high-end properties in third-and fourth-tier cities has structural expansion opportunities primarily driven by rising wages . This combined with Country Gardens high turnover can result in the business quickly acquiring market share through expanding its business operations horizontally.
Country Gardens’ high turnover can be attributed to its standardised land acquisition strategy which helps the company replicate its operations in other lower-tier cities (horizontal expansion), and grow in a weak-demand market driven by high turnover.
As of June 2020, the investment conversion rate (accumulated equity sales/equity land investment) after 18 months of acquisition is 1.28 for third and fourth-tier cities, compared to 0.73 for projects in first-and second-tier cities reflecting the advantages of Country Gardens turnover efficiency in lower-tier markets.
Country Gardens turnover rates reached 28.9% in 2019, which is the leading ROE metric in the industry. To illustrate this point on average, it takes 4.6 months from buying land to relisting a new property back onto the market, and it takes another 4.1 months to gain revenues from the property after relisting.
Country Gardens excellent cost control and turnover has deterred other housing developers from lower-tier markets enabling the company to potentially improve its market share. This is evidenced by an 8% market share in 2020 in third and fourth cities, compared to a market share of 5% in other city groups – reflecting the success of Country Gardens business strategy.
Urbanisation supports market demand
The drivers behind urbanisation in lower-tier cities is due to expansion in smaller towns and cities brought about by industrial upgrading and advantageous government policies, rather than the process of rural population transferring to larger cities like in the past – which is enforced by law known as “Hukou”.
Urbanisation is an important source of demand for the property market. By the end of 2019, China’s urbanisation rate reached 60.6% for the first time . However, there is still room for improvement compared to developed countries such as the United States with an urbanisation rate of 82.5% in 2019 .
China’s population density is much higher than the world average, and the per capita resources are relatively small. As the middle class continues to rise driven by increasing wages this may translate to higher urbanisation .
China’s urbanisation is also a process of “relisting counties and establishing cities”. When the scale of a county reaches a certain level, it will be upgraded to a “city”. In contrast, when a “city” is reduced to a certain level, it will be classified as a “county” level . From 2006 to 2019, about 31 county-level cities were reclassified, while 54 new cities have been established. Some of these county-level cities have been merged into prefecture-level cities in the form of municipal districts. As highlighted in the figure below.
Number of Cities by Population Over Time
Grey: (Small City 0.5 to 1 million) – Red: (Large City < 4 million)
A one-stop process creates brand differentiation
One-Stop Industrial Value Chain
The brand premium brought by specialising in developing high-end housing combined with cost savings resulting from the industrial chain layout has improved Country Gardens profit margin.
As Country Gardens standardises its land acquisition and development practices, the company can rapidly acquire projects horizontally and grow its market share. As the company has the highest turnover metrics its return on investment is shorter – allowing the company to quickly reinvest its profits to new projects. This combined with the low cost of land in lower-tier cities = fast growth.
Evergrande – China’s Lehman moment?
The Evergrande liquidity crisis pertains to the financial situation of Evergrande Group a large property developer in China. The event has been labeled as the “Lehman of China” due to its similarities during the 2008 financial crisis in the US .
As of 21 September 2021, Evergrande has 2 trillion RMB ($310 billion) in liabilities. The difference between Evergrande and Lehman Brothers is the type of assets it held. Evergrande primarily holds physical assets such as property and housing developments, compared to Lehman Brothers which held $600 billion in financial assets. This key distinction means that Evergrande assets have lower liquidity allowing the property developer more time to plan and restructure its finances, unlike Lehman where its assets basically evaporated overnight .
The problem is a result of Evergrande’s aggressive debt financing strategy, combined with regulatory changes in September 2020 to control housing debt  – Creating a situation where Evergrande can no longer keep up its payments to debtors. This makes it’s difficult for Evergrande to liquidate (sell-off) its assets at a fair price – due to low bargaining power caused by time pressures and a damaged reputation.
In the event of a default, Evergrande will be forced to liquidate its properties at a lower price to pay investors which could have a material impact on other property developers such as Country Gardens. This could result in an influx of cheap property into the market and thus lowering the profit margins of Country Gardens.
Furthermore, given the $310 bn in liabilities, this could have a material impact on the Chinese economy in the event of a default. As it is estimated that 29% of China’s gross domestic product (GDP) comes from property and housing developments .
Our opinion is that the Chinese economy is fairly insulated relative to the 2008 US financial crisis. Firstly, as we believe the liquidation process will likely prioritise domestic Chinese investors over foreign investors – per the capital structure .
We also believe that due to Country Gardens market positioning primarily in lower-tier cities, that this segment is well insulated due to low price elasticity alongside less exposure to Evergrande’s property portfolio. Where its portfolio in Tier 1 and 2 cities will be more materially affected.
Overall, our opinion is that Country Gardens will likely take a material impact in 2021-22 as the house prices begin to restabilise in accordance to demand which should recover faster in lower-tier cities. In the long-term, we believe that Country Gardens has long-term upside given its astute financial management combined with a strong demand for housing and urbanisation that is supported by the government .
3. Quantitative Analysis
Country Gardens is a business that is sensitive to the economic growth of China, therefore over the last 3 years its revenue growth has been volatile primarily due to the economic slowdown in 2020 caused by the pandemic. In 2021 we see revenues recover and surpass pre-pandemic levels hinting at strong demand in the sector. Despite, higher revenues its gross profit margins have contracted – primarily driven by higher costs in construction material and labour due to recent supply chain issues brought about by the pandemic . We expect these supply chain issues to worsen in the short term driven by the recent energy crisis in China  – however, will begin to recover in the medium and long-term as China begins to adapt and become less reliant on fossil fuels and on more sustainable energy sources .
As a result of lower gross profit margins, other margin metrics below the gross profit line have also been negatively affected. – Suggesting a temporary reduction in the Country Gardens cost efficiency. Despite this on an absolute basis net income from 2020 to 2021 grew thanks to higher revenues and demand for new properties being sustained – Which is a positive long-term indication. Overall given the circumstances, this is a good income statement.
From the sheet above, we see that Country Gardens has consistently the highest revenues over the last 6 years compared to its competitors. It rivals Vanke (CHVK.Y) in terms of net income for the top position. A major issue with Country Gardens is that its net income margins are the lowest among its peers. As highlighted below.
This is due to Country Gardens Cost of Goods Sold being significantly higher. The explanation for this is that Country Gardens specifically targets the elite and high net worth individuals, therefore are prepared to spend more on high-quality materials, a more skilled labour force, and more on the quality of production – resulting in lower gross and net profit margins.
The company’s profitability ratio has decreased year-on-year again due to lower profits caused by the pandemic, between 2020 and 2021 these ratios have stabilised – hinting at signs of recovery. This can be better highlighted in its turnover ratios which have shown consistently higher ratios in 2021 compared to the previous year suggesting that the company is becoming more efficient in generating income from its assets and investments despite the ongoing value chain and energy crisis – which are indications of strong financial management.
The company’s short-term liquidity for the most part remains consistently through the 3-year period. Average days payable has shown consistent signs of improvement – suggesting the company is better at slowing down its payment to lenders which is a sign of strong bargaining power.
Lastly, quite positively the debt ratios have consistently decreased year-on-year which is very positive for the long-term health of the business. Lower leverage means that the company’s credit rating has improved allowing the business to borrow debt at lower interest rates thus potentially reducing its weighted cost of capital (cost of raising money). Low leverage also means that more money can be allocated towards reinvesting its profits rather than paying off its debts, which is advantageous in a lower margin market (e.g., Lower tier cities). Overall, this is a good balance sheet.
The cash flow statement shows a company that is operationally profitable in 2019 and 2021, there was negative cash flow from operations in 2020, due to lower changes in inventory meaning the company during 2020, kept fewer properties on its books potentially as a strategic move to maintain liquidity. This is partially offset by higher changes in accounts receivable.
Cash from investing has been increasing year-on-year – on a superficial level this is a negative sign for investors, however, the increase is a result of gains from “other investing activities” which offsets capital expenditure and investment in marketable securities in which both of these line items have been decreasing – a strong indication of future growth for the company. Lastly, the company for the most part finances through raising long-term debt – an indication of the strength of its balance sheet. Due to its strong financial management highlighted by decreasing debt on the balance sheet – Several rating companies have upgraded their credit rating. As seen below.
We will take you through each phase of the Discounted Cash Flow Model (DCF) and provide our key assumptions. Our analyst selected an average of the DCF Perpetuity Growth and DCF Multiple Exit models, where the driver of value is based on the forecasted cash flow of the company and relative value of real estate and property developers trading on the market. Furthermore, our analyst extent the growth period for 5 years, as we expect the growth period of Country Gardens to be short due to the company being in its early maturity phase. As highlighted below.
Step 1: Calculate the Weighted Cost of Capital (WACC)
Cost of Equity (CAPM)
We will treat Country Gardens as a Chinese business given where it conducts the majority of its operations. Furthermore, treating the company this way should produce conservative estimates. We will use a “bottom-up levered beta” which is the volatility (risk) of a stock compared to similar businesses within an industry, averaged with a regression beta – The risk of a stock compared to the risk of the market.
Using the Capital Asset Pricing Model (CAPM) the inputs used is as follows:
5-Year Risk-Free Rate = 2.63% (5-year China Government Debt) – Data from DataYes
5-Year Risk-Free Rate = 2.63 % (5-year China Government Debt) – Capital IQ
Plugging these figures into the equation:
Cost of Debt = (Risk-Free Rate + Default Spread + Country Default Spread) x (1-T)
Cost of Debt = 4.3725%
Weighted Average Cost of Capital (Discount Rate)
Total Debt = Current Debt + Long Term Portion of Debt + Current Leases + Long Term Leases
Market Equity Value = Diluted Shares Outstanding x Current Share Price
Weight of Debt = 30.4%
Weight of Equity = 69.6%
Weight of Preferred Shares = 0%
WACC = 6.77%
Discounted Cash Flow Analysis
Using 3-year median analyst forecasts up to 2024 provided by DataYes and Capital IQ. We extend the forecast period to 2026 using conservative assumptions provided by our internal team and corporate partners. Our analyst used the XNPV function (XNPV = Discounted rate, cash flow, date) with midpoint discounting alongside the year fraction to ensure cash flows are discounted appropriately according to the fiscal year-end date. We use a 2.63% perpetuity growth rate which and is in line with the 5-year risk-free rate which is a reliable proxy to estimate the 5-year future growth of an economy and should produce conservative assumptions.
Low Case – $3.99 – Worst case scenario
The Chinese government doesn’t directly step in with the Evergrande liquidity crisis (i.e., let the property developer fail)
Evergrande defaults and has contagion risk to the industry and economy
Higher than expected migration rates in low tier cities
Mid Case – $4.89 – Most probable scenario
Chinese government partially steps in with the Evergrande liquidity crisis (i.e., encouraging property developers to buy Evergrande assets)
Evergrande defaults and has high contagion risk to only the industry
The continued trend of migration rates in low tier cities
High Case – $5.82 – Best case scenario
Chinese government directly steps in the Evergrande liquidity crisis (i.e., bails out Evergrande)
Evergrande doesn’t default and has a low contagion risk to the industry
Lower than expected migration rates in low tier cities
The price pattern of Country Garden Holdings shows a mixture of bullish and bearish sentiment from the market on the weekly timeframe. The primary Bullish indicator is the strong multi-year dynamic support which is a psychological barrier in which price has failed to break through twice based on history. This alongside a falling wedge pattern is indicative of a potential shift of momentum to the upside – however, it is too early to tell as downwards momentum has not been broken. The biggest indicator of bearishness is strong downwards momentum – which will be very difficult to shift and will likely take a couple of months to a year, alongside a strong fundamental catalyst to drive the price higher. Overall, the technical analysis shows a slight bias towards the downside – however, shows signs of this trend weakening.
Evergrande Contagion Risk
Resulting of the Evergrande liquidity crisis we expect the property market to be heavily affected. Housing prices could plummet due to the surplus of cheap housing being liquidated from Evergrande’s balance sheet, consequently leading to Country Gardens assets becoming devalued.
This will make it harder for Country Garden to raise capital at the same rates due to higher perceived default risk from investment banks. Given the size of real estate in China accounting for 29% of the country’s GDP, this could have a negative effect on the economy and have a knock-on consequence on other businesses . Our opinion is that Country Garden given its astute financial management will cope better than most of its industry peers, where we expect a material slowdown in the overall property market in the short and medium-term.
Slow Economic Growth
The property development industry is dependent upon economic growth. A slowdown of economic growth could adversely affect housing demand resulting in lower revenues for Country Gardens. Over the last decade, China’s economic growth has begun to slow as the country transitions into a mature country . We expect China’s economic growth to be slower than expected in the short term due to the Evergrande liquidity crisis . In the long-term we expect China’s economy to continue growing and surpass the US by 2032.
Weak Property Demand Net migration rates from tier 3 and 4 cities may be higher than expected creating a slowdown in demand in property . Given that Country Gardens has well-positioned its operations in cities where there is positive net migration – this, for now, mitigates this risk .
5. Conclusion & Investment Strategy
Country Garden is a well-managed and diversified business catering to the elite of China. Based on our valuation the company looks highly undervalued from a purely quantitative perspective. On the qualitative side, Country Gardens has plenty of opportunities to expand its reach especially in low tier cities where it has a competitive moat in its high turnover and its effective cost management strategy. We expect Country Gardens to continue better than its peers in the long-term, however, headwinds in Evergrande and the knock-on effect on the real estate and the overall Chinese economy pose a real threat to the company. Overall Country Gardens Holdings Limited deserves a Hold (C) recommendation.
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