KE Holdings May Have A Downside Potential Of Close To 50%
Summary
- KE Holdings offers an online and offline platform for housing transactions and services in China.
- I wouldn’t buy shares. I found five reasons to be very cautious about KE Holdings.
- The PRC seems to have announced several initiatives to promote that the housing industry is not controlled by speculators. The measures include restrictions on purchases along with different credit policies.
- The PRC may impose the price of houses all over the country. In Shenzhen, authorities offer reference prices on existing home transactions. As a result, the total number of transactions decreased significantly.
- I used a WACC of 20%, which implied a valuation close to CNY115 or $15. With all these figures in mind, if I have the shares, I would sell at $20 per share, and may buy at $10-$15.
With many market analysts recommending KE Holdings, I am actually quite pessimistic about the stock. In my opinion, most analysts have failed to understand that the PRC is already fixing some housing prices in Shenzhen, and could do it all over the country. I found a total of five risks coming from industry regulators, which may represent a disaster for the company’s stock price. The company may also be involved in investigations to fight monopolies. I believe that the company’s stock price is expensive at the current valuation, and the fair value is close to $10-$15. Traders are buying and selling shares at $15-$20.
KE Is Performing, But I Smell 5 Risks
KE Holdings Inc. offers an online and offline platform for housing transactions and services in China.
Among the company’s capabilities, I would highlight the proprietary technologies, big data, and artificial intelligence that KE uses to enhance customer experience. There is plenty of information on the website about the company’s solutions:
Source: KE Holdings – About us
If KE Holdings operates outside China, I would be really allocating close to 5% of my portfolio to the company. The fact is that the company’s business model appears to be a clear success. From 2017, total sales increased from CNY25 billion to more than CNY70 billion in 2020. If we only look at the company’s figures, the business model appears promising:
Source: 20-F
Despite all being said, I wouldn’t buy shares. I found five reasons to be very cautious about KE Holdings Inc.
First, the company’s business model depends on the conditions of China’s residential real estate market. After many years of good performance in the real estate market, there are many situations in which the industry could become overheated right now. In my opinion, the risk of inflation because of COVID-19 is one of the most worrying factors.
Second, the real estate industry in China is subject to government regulations, which is, in my view, one of the most serious risks. The PRC seems to have announced several initiatives to promote that the housing industry is not controlled by speculators. The measures include restrictions on purchases along with different credit policies and limits in the monthly debt service payments. If the government increases such type of regulations, KE’s financials could suffer significantly:
In particular, central and local government authorities introduced the policies to specifically stabilize the residential real estate market, including limiting the maximum amount of monthly mortgages and the maximum amount of total monthly debt service payments of an individual borrower. Source: 10-K
Third, an increase in taxes associated with residential properties will most likely damage KE’s financial results. Notice that the PRC imposed an increase in taxes for second-hand properties. With this in mind, families may not want to buy many properties. They may not decide to invest in the real estate industry:
Imposing a 20.0% individual income tax on the gain from the sale of second-hand properties. Source: 10-K
Four, there are new regulations that enforce an increase in the minimum sum of downpayment of the price of a family house. If the PRC continues to increase that percentage of the purchase price, the number of buyers will decrease. As a result, the price of houses may decline, and KE’s business model will not perform as expected.
Five, the PRC may impose the price of houses all over the country. According to the company’s most recent annual report, in Shenzhen, authorities offer reference prices on existing home transactions. As a result, the total number of transactions decreased significantly. If the PRC decides to use the same policy in other cities, KE Holdings Inc. will suffer significantly:
For instance, on February 8, 2021, the housing authorities in Shenzhen issued a circular and a list of reference prices on existing home transactions, which established a mechanism of reference sale prices for existing home transactions in Shenzhen and specify a tailored reference price for each of the nearly 3,600 residential communities in the city. Source: 10-K
If the policy is expanded to other cities, our business and results of operations in these cities, in particular to the business of existing home transactions, may be materially and adversely affected. Source: 10-K
Expectations Of Analysts Include 10%-19% Sales Growth From 2021 To 2023
In my opinion, the expectations of analysts are disconnected from the current state of the real estate industry in China. I wonder whether financial analysts took a look at the new initiatives started by the housing authorities in Shenzhen or any of my five risks for KE Holdings.
Market estimates include 10%-19% sales growth from 2021 to 2023, double-digit EBITDA margin in 2023, and positive net income from 2020 to 2023. Analysts also expect that the company’s free cash flow will increase until 2023:
Source: Market Screener (Numbers In CNY)
I am less optimistic than other analysts because of the recent initiatives of the Government of China. In addition, KE’s previous financial figures were not beneficial at all. As shown in the image below, the company’s EBITDA margin was negative in 2020, and started to decline again in May 2021. With these figures in mind, I wouldn’t be expecting a double-digit EBITDA margin in 2021:
Source: YCharts
Optimistic Expectations Lead To Unrealistic Valuations
I used optimistic expectations based on the market estimates to execute a financial model. I wanted to know how far the implied valuation is from the current market conditions. The result is quite interesting. With sales growth of 18%-19%, FCF margin of 6%-10%, and a WACC of 7%, the sum of the free cash flow stands at CNY31 billion:
Source: My figures (Numbers In Millions of CNY)
With a long-term growth rate of 4% and a terminal FCF of CNY9.8 billion, the equity valuation is equal to CNY255. The target price is equal to close to $35, which is too expensive. Take into account that the company is currently trading at $20:
Source: My figures (Numbers In Millions of CNY)
Source: YCharts
My Target Valuation Is Lower Than The Current Market Price
In my opinion, the financial models that most investors are running don’t include the risk from regulatory actions. We need to increase the WACC in order to include the country’s risk premium. Taking into account the risks in the real estate industry in China, I would be using a WACC of 20%. In that case scenario, most investors wouldn’t buy shares because the implied target price is lower than $20.
In a DCF with a WACC of 20% and moderate sales growth, I obtained an equity value per share close to CNY115. In that case scenario, the company is not at all interesting at $20 per share:
Source: Author
Source: Author
The Financials Don’t Look Detrimental
With that about the risks involved, the fact is that the company’s financials do look good. The company reports $4.7 billion in cash with $16 billion in assets:
Source: 10-Q
The total amount of liabilities is equal to $5 billion, with $1.5 billion in employee compensation and welfare and $1.4 billion in customer deposits. Clearly, the company’s financial state is healthy, which does not mean that its valuation should skyrocket:
Source: 10-Q
Final Risk: Anti-monopoly and Competition Laws
If you didn’t get scared with the current regulatory risks in the real estate industry, read about the following issue. KE Holdings Inc. reported in the last report that the company may be involved in investigations and complaints connected to the new anti-monopoly and competition laws enacted by the PRC. If you are a shareholder of KE Holdings Inc., in my opinion, you need to read this:
We may be involved in investigations, claims and complaints in relation to anti-monopoly and competition laws and regulations in the PRC from time to time, which regulate various potential monopolistic actions or arrangements, such as monopoly agreements, bundling or tie-in sales, unfair pricing practices, imposing unreasonable terms on the counterparties, requiring the operators on the platform to choose “one out of two” competitive platforms, charging additional and unreasonable fees, refusing to transact with certain counterparties without any reasonable ground, as well as concentrations of undertaking, and these investigations, claims and complaints are subject to the uncertainties associated with the evolving legislative activities and varied local enforcement practices. Source: 10-K
My Takeaway
Most market analysts didn’t seem to be understanding the risks of KE’s shareholders. They are expecting unrealistic financial figures. Clearly, the market does not believe the expectations of analysts because the share price does not reflect their estimates.
I appreciate the company’s business model, but I believe that there are too many risks. I cited five main risks coming from regulators that may depress the company’s valuation in the coming years. I assumed that the PRC will probably intervene in real estate prices like it already did in the home transactions in Shenzhen. In that case scenario, I used a WACC of 20%, which implied a valuation close to CNY115 or $15. With all these figures in mind, if I have the shares, I would sell at $20 per share, and may buy at $10-$15.
Author: Monplanet Capital Management, Seeking Alpha