By Anna Zhong and Venant Chiang Challenges of growth China Real Estate March Disclosures and Disclaimer. This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, that form part of it. M ar ch07 Ch ina R ea l E sta te Ch all en ge s o f g ro wt h Venant ChiangReal Estate Analyst, Asia-Pacific + 852 2822 4297venantchiang@hsbc.hk Venant joined HSBC in August . Before this, Venant had worked in various roles in the financial industry, including a spell at the Securitiesand Futures Commission of Hong Kong and portfolio management at a private hedge fund. Venant has a BA in Business Economics and a Specialisation in Computing from University of California Los Angeles, UCLA. Anna H. Zhong Global Head of Real Estate Research + 852 2822 4337annazhong@hsbc.hk Anna Zhong joined HSBC in August . Prior to joining HSBC, Anna managed regional property funds for two years; she also worked as aregional property and conglomerate analyst for six years, both positions based in Hong Kong. Anna has an MBA from Columbia University, an MS degree in Systems Engineering and BS degree in Computer Science from University of Maryland. We are bullish on the long-term growth prospects of China’s property market. We believe economic expansion and the urbanisation trend will drive development of the China property market for many years to come. At the same time, we believe a favourable industry backdrop does not ensure automatic success for all industry participants. We see changing government policies and nationwide expansion as two key near-term challenges. We differ from consensus in that we believe going national is not the only way for China property companies to grow. A strategy of aggressive expansion entails high execution risks. We like companies that have proven track records and those that have found their niches, geographically or product-wise. We see risks and challenges for volume-driven companies that are on the cusp of nationwide expansion, as they leave behind their local advantages and head into unproven territories. We are Overweight Greentown China (3900.HK), Hopson Development (0754.HK), and Shui On Land (0272.HK). We are Neutral on Agile Property (3383.HK), China Overseas Land (0688.HK), and Shimao Property (0813.HK). 11902R~1(dtp).QXP 3/19/ 3:08 PM Page 1Real Estate China Real Estate 19 March abc Long-term bullish We have a bullish long-term view on the China property market. Long-term growth in the property market is being driven by a combination of economic growth and urbanisation. China’s emergence onto the world stage also means that property prices in key cities could catch up with other major Asian cities. The dual potential of volume and price growth paints a favourable industry backdrop for developers. Challenges of growth We also believe that a favourable industry backdrop does not translate into automatic success for all industry participants. We see two recurring themes in the sector, one on the macro front and one at the company level. They are changing government policies and nationwide expansion. We see these as key challenges that property companies must overcome in order to ensure long-term success. The challenge of nationwide expansion Exchanging pricing power and margin for volume As first-tier cities are becoming increasingly competitive, some developers have embarked on the strategy of nationwide expansion in search of growth. While the strategy may yield long-term benefits, we believe it also presents a number of challenges and risks. For developers moving from first-tier to second-tier cities, the key risk is exchanging pricing power and margin for volume. If the process is not managed well, a property company could potentially face declining profitability. Execution is of paramount importance Nationwide expansion means leaving behind local advantages and heading into unproven territories. We raise a number of questions: 1) Why go national 2) If you can’t compete locally, can you compete nationally 3) Are you going up or down the value chain 4) Can management handle the explosion of projects and volume production 5) Do you have the balance sheet to fund aggressive expansion At the end of the day, we believe property development is not about raising equity and debt to buy land, but more importantly about building and selling products. Summary We believe a favourable industry backdrop does not lead to automatic success for everyone. We differ from consensus in that we see challenges in China property developers’ strategy of nationwide expansion. Going national is not the only way to grow. Aggressive expansion, while presenting long-term potential, also entails high execution risks.Real Estate China Real Estate 19 March abc Realistic expectations We believe, for some China property stocks, investors have built in too much potential without accounting for the time, cost, and execution risks. For example, we cannot incorporate NAV accretion from a piece of raw land without accounting for the potential cash requirements and corresponding dilution for developing the project. In addition, the bigger and longer-term a developer’s land bank, the larger its NAV – but the execution risk is also higher. We cannot justify the larger NAV without applying a larger discount for execution risks. Investment strategy We initiate coverage on five property companies with this report (Shui On Land already under coverage). Strategically, we like companies that are proven national players as they have overcome the challenge of nationwide expansion. We also like some companies that are finding their niche, either geographically or product wise, as they understand their strengths and are positioning themselves accordingly. We believe as the China property market develops it will not only grow bigger but also grow deeper to accommodate different type of players. For those that choose not to compete on scale, going for niches could mean pricing power and better profitability. On the other hand, we see risks in volume-driven companies that are on the cusp of aggressive nationwide expansion, as they are heading into unproven territories. Stock picks Overweight: 抐 Greentown China (3900.HK) – Highly profitable regional player at attractive valuations 抐 Hopson Development (0754.HK) – Focused in and around key first-tier cities, attractive valuations 抐 Shui On Land (0272.HK) – Value creation by focusing on differentiated master-planning projects Neutral: 抐 Agile Property (3383.HK) – Highly successful in Guangdong, awaiting execution on nationwide expansion 抐 China Overseas Land (0688.HK) – Proven national player with well-known brand, core-holding for China property exposure, but prefer a lower entry point 抐 Shimao Property (0813.HK) – Highly successful in first-tier cities such as Shanghai and Beijing, awaiting execution on nationwide expansion, fairly valued Figure 1.1: Summary valuation table Ticker Price (HKD) Mkt cap (HKDm) _______PE_______ NAV per share (HKD) NAV prem/ disc (%) Target price (HKD) TP set at% upside Rating FY06e FY07f FY08f FY07 Agile 3383.HK 7.07 26,482 20.5 13.9 10.7 9.25-23.6%7.915% NAV disc11.3% Neutral (V) COLI 0688.HK 8.25 58,138 25.0 18.5 13.5 7.983.4%8.810% NAV prem6.4% Neutral (V) Greentown 3900.HK 12.80 17,618 10.4 9.7 8.2 18.38-30.3%15.615% NAV disc22.0% Overweight (V) Hopson 0754.HK 18.10 23,287 15.6 11.1 7.9 25.23-28.3%22.710% NAV disc25.5% Overweight (V) Shimao 0813.HK 14.16 43,399 25.7 20.5 13.6 17.09-17.2%14.515% NAV disc2.6% Neutral (V) SOL 0272