Description

Excellence Commercial Property and Facilities Management (ECPM) is in the business of property management, with a focus on commercial properties but also residential and public/industrial properties. Most property-related companies have been sold down due to fears of property price contagion, but I believe certain companies including ECPM would be beneficiaries in the long run. ECPM’s focus on high-end commercial property management, market oriented third-party developer sourced contracts, as well as a relatively unencumbered connected developer should allow them to survive and thrive years down the road. At an ex-cash recurring earnings multiple of less than 4x, this allows the investor to purchase fractional ownership of this business at an undemanding price.

Broad description of the property management business

ECPM is in the business of property management, which is a distinctly different business from property development. The latter is an asset heavy, cyclical and capital intensive business, whereas the former in general is an asset light business which is not cyclical in nature, though certain segments of the business can have low-margins. In China, property developers have had a property management arm to manage their newly developed properties. The property management business can be divided into these few categories:

i) Basic property management services

ii) Value-added services to property owners

iii) Value-added services to property developers

After the development of a new property by developers, the management of the property is typically (not always, but close to 100% of the time) handled by the property management arm of the developer. After the properties have been sold to individual owners, each apartment block is typically managed by an appointed property owners' association, who takes over the sourcing and giving out of these property management service agreements to property management companies. These contracts might or might not be renewed with the original property manager. According to the Regulations on Property Management, property owners may engage/dismiss property owners at the property owners’ meeting, with the consent of property owners who exclusively own at least 50% of the Gross Floor Area (GFA) of the building, and who account for at least 50% of the total number of owners.

Property developers have their capital tied up and are typically paid on a percentage completion basis. Property management firms however, provide property developers with a stable, cash-generative business, as residents and companies alike require property management services all-year round regardless of business cycles. The owners pay their management fees upfront for the year (for residential, but differs for different types of properties), hence providing property management firms with a recurring source of income as well as cash upfront. This explains why most listed property management firms sit on net cash positions (aside from the fact that most of them have been spun-off only in recent years and are flush with IPO proceeds). The vast majority of property managers operate on a lump-sum model instead of a commission basis, where the company charges property owner fixed service fees for specified time periods and retains unused funds, and in return the property manager self finances. In the commission model, the property manager in effect works as a ‘broker’ in bringing in external service providers, and charges a commission in return.

Since 2014, there have been property management reforms, whereas in the past, property management fees have been subjected to price controls. The property management business is not a high gross margin business (typically around the 10-25% mark for residential, and higher for commercial around 25-35%, figures are ballpark), so this business has not always been profitable in the past. After 2014, price controls were removed for some provinces, and although welfare estates are still subject to pricing regulations, the general trend has been towards deregulation. There has been a trend of consolidation across the industry, although the current landscape is still highly fragmented with more than 100,000 property managers currently in China with the top 100 managers managing ~40-50% of available GFA across the country.

Property developers had been on a leverage-induced developing spree in the past couple of decades following land reforms, coming to a halt since 2018 after implementation of the 'Three Red Lines'. One key trend that has emerged in the past few years has been the spinning off of property management arms from property developers to bolster liquidity, especially after the implementation of the “Three Red Lines”. As property developers have been growing really fast across the past couple of decades, up till recent times, property management firms have been boosting their pipelines via their parent developers.

Generally speaking, at the development stage, the vast majority of property developers give out contracts to their in-house property management arms for the 1st 2 years, before the responsibility is given out to Property Owners’ Associations, who will subsequently take over the decision of either extending contracts with the incumbents, or signing new contracts with new property management firms. Provincial level property management price ceilings apply to the primary contract, after which the secondary contracts are typically no longer subject to these ceilings. As property developers grew rapidly, so did property management firms as they sought to grab as much GFA under management as possible.

In the past few years, property management firms had been growing primarily through the following methods: i) contracts acquired from their parent developers, ii) 3rd party tenders on the secondary market, and iii) acquisition of other property management firms. In recent times after the music stopped for property developers, property management firms that have been depending on their parent for growth in GFA are now at crossroads, given the need to wean off the easy path to growth by latching onto their parent developers. I believe it to be prudent for investors to focus on property management firms with larger 3rd party exposure, given familiarity of these firms with prevailing market pricing and service requirements, as well as less exposure to shrinking pipelines via connected developers.

Partly due to IPO proceeds from the spin-offs, as well as the nature of the business where property management firms typically receive cash upfront for their services, most listed property management firms are currently sitting on net cash positions. For developers who are now cash-starved and unable to convert their developments into liquid cash, utilization of cash belonging to their property management firms becomes a serious option, posing a corporate governance issue for investors. Below are some examples of property management firms that have purchased assets from their parent/connected companies. Such transactions require annual shareholder approvals on related-party transaction thresholds indeed, but pose a question of whether such usage of capital is optimal to the minority shareholder. Connected companies refer to companies where both the developer and the property management firm are owned by the same majority shareholders, while parent simply means the developer owns the property management firm directly. Below is a select list of such transactions.

Another area for investors to focus on would be evaluating the dependence upon value-added services to non-property owners. With the down cycle in the property development market, value added services to non-property owners like property brokerage would certainly be affected and property managers which depend substantially on such VAS would certainly be in for a tough time.  

In most of these tests, I believe ECPM shines.

General business description / segments

Broadly speaking, ECPM focuses on the following segments:

i)            Basic property management services

This segment includes commercial property management (high-end commercial office buildings, comprehensive business parks), public properties and residential apartments, and  contributes 76% of total revenue

ii) Value-added Services

Such services include property consulting services like project planning and design, construction management, space management, leasing/transfer, construction, mechanical and electrical services etc. Contributes 23% of total revenue

ECPM’s focus on commercial property management allows for a more stable source of growth, with about 80% of 3P contracts for large corporates like JD.com, Kuaishou, Tencent, Baidu, Huawei, OPPO etc. These contracts are for managing regional branches and HQs which provides for a more secure source of revenue. In the residential segment, the properties that ECPM manages are focused on higher-end residential apartments. This focus allows for ECPM to command higher gross margins in general. Below is a quick snapshot of some margin figures of ECPM across the years.

Shift towards third party vs primary developments provides sustainable growth

There has been a marked trend across the years of shifting focus from dependence on Excellence Group-developed properties to external third-party developer sourced revenues. This third-party focused business model has and should continue to help ECPM in the coming years, as the primary market is likely to significantly slow down given the challenging environment currently. According to ECPM, based on bidding stats of the property industry, commercial properties accounted for 45% of total 3rd party expansion in the industry, which was 3.5x that of residential properties.

The data below shows breakdowns according to GFA under management as well as by revenue, with some assumptions for 2020 and 2021 necessary given not all data has been revealed in those 2 years.

Cost structure of the business – staff costs are the key cost component

The property management business requires a fair bit of human involvement currently as certain labour-intensive tasks e.g. service-related activities simply cannot be automated at present. As such, it is not surprising that most property management firms have staff costs accounting for between 45-65% of their cost of sales. ECPM is no exception, though their growth in recent years has allowed for some degree of economies of scale. The below pie chart is a breakdown of the cost of sales in 2019, the last year where a detailed breakdown was provided. In comparison to 2021, the staff costs have declined in large part due to economies of scale.

Higher property management fees show focus on lucrative higher-end projects / prime areas

ECPM’s focus on higher-end projects and prime areas are likely to show more resilience in the future, in part due to the fact that tenants/owners in higher-end and prime areas house a larger proportion of tenants/owners which are company headquarters. To put things into perspective, here are some figures of the average commercial property management fees, both in China, as well as the Greater Bay area that ECPM focuses on. In direct comparison are the average fees that ECPM commands, which are clearly higher compared to the industry average. Unfortunately again figures weren’t available for 2020 and 2021, but these figures should be sufficient in providing perspective on the relative fee levels.

Average property management fees have been higher for Excellence Group-developed properties for 2 main reasons:

i)            Excellence Group properties are mostly higher-end projects in prime locations, especially Central Business District (CBD) in Greater Bay

ii)           For commercial properties by third-parties, partial costs have been incurred by ECPM (e.g. utilities in common areas), though these costs are typically included in property management service agreements

High-end properties are defined in general as buildings that reach standards in respect of:

i) location, such as those located in city center or CBD,

ii) building design such as GFA of each floor >= 1k sqm

iii) building décor such as lobby floor made of marble and granite

iv) facilities & equipment such as service area of each elevator <= 5k sqm

Fragmented industry, with cost advantages as scale increases, provides an opportunity for further consolidation

As elaborated on above, staff costs are the largest component of the property management business. I believe that the industry is likely to consolidate over time, instead of remain fragmented. One key reason is because the ability to share staff across multiple properties provides a significant cost advantage to larger property management firms. In 2019, the top 5 commercial property managers accounted for merely 16.7% of total revenue from basic property management services, according to Frost and Sullivan. To put things in perspective, here are some general China and Greater Bay figures which show GFA figures, and although ECPM has been increasing its market share, as of 2019 it merely had a 1.5% estimated market share by GFA under management. The surviving property management firms from this property crisis, coupled with well-capitalised balance sheets without parent/connected developer distractions, could likely be key consolidators in the long run. One area to look out for nonetheless would be prudence in acquisition of third-party peers with ties to debt saddled developers. Buyers need to seek delivery of their targets’ contracted GFA, which can be an issue if developers don’t deliver.

High retention rates show ability to grow without compromising on quality of clients

Properties obtained at the preliminary stage are typically sourced from the parent / connected developer. However, once it transfers to the property owners’ association stage, retention is key as these projects are now subject to open-market competition in the form of tenders. Prices, track record, service quality etc are all variables in the equation, and while such agreements are typically sticky as the benefits (lower pricing and hence savings) tend to be insignificant compared to the costs (additional customer pain points from having to re-educate new property managers of areas of concern), clearly incumbents cannot simply price themselves out of the market as higher pricing translates directly to increased costs for tenants/property owners.

Retention rates for property management service agreements have been at 98.2%, 94.6% and 91.9% respectively for 2017-2019. My conversation with the company revealed that some of the churn has been a result of choosing which projects to get involved with from a margin perspective, as not all third-party projects are worthwhile pursuing.

In terms of total property management fee collection rates, ECPM has been fairing decently here as well, with 90.1%, 92% and 93.2% collection rates from 2019-2021. At least part of this can be attributable to the fact that most of their clients are in higher-end properties and company HQs, which reduces the likelihood of delinquencies. In general commercial property management fees are charged monthly on a pre-specified date, with owners/tenants being charged additionally for usage and maintenance of central air-conditioning. For corporate buildings, office, and R&D centres, fees are also charged monthly on pre specified dates. Public and industrial properties can be charged monthly or quarterly, whilst residential properties are normally charged monthly at the beginning of each month, with owners and tenants paying additional utilities in communal areas, charged based on the proportionate GFA occupied.

A larger proportion of property management service agreements have fixed terms as opposed to those without fixed terms. The latter agreements are obviously less ideal, but are typically agreements at the preliminary phase instead of those at the property owners’ association phase. Property service agreements tend to last at least a few years, in part due to the fact that property managers that take on new projects need to incur fixed costs, and hence projects in the 1st year tend to be loss-making.

Barriers to entry are likely to increase over time and favour incumbents

Prior to the opening up of the property management industry, I believe the barriers to entry to this business were limited due to the fact that small independent developers and their respective property management arms could manage individual apartment buildings with limited competition. As the pricing environment was previously restricted prior to 2014, price competition was limited, and market share grabbing was also muted with little economic incentives. Moving forward however, I believe barriers to entry are likely to get increasingly higher, with the following factors key in determining the winners within this field:

i) Brand reputation / track record

Commercial enterprises are likely to prefer more renowned service providers in general as opposed to trying out unestablished companies, and brand reputation requires time to build up. This effect is likely to be particularly pronounced in public and industrial tenders.

ii) Customer relationships and low price to high value proposition

Property management service agreements have generally shown stickiness due to the fact that property management significantly affects the working environment for enterprises, as well as living standards of residents. For perspective, in the Greater Bay area where price per sqm of commercial property can range around RMB 10-15k per sqm approximately, average annual property management fees of around RMB 100-200 per sqm constitutes merely a fraction of property prices, whereas a good property manager who manages buildings professionally could help retain or even boost property values. Simply choosing to go for e.g. a cheaper property manager with an unknown track record for a 10% cost savings might very well not be worth the risk given the cost savings of RMB 10-20 per sqm are insignificant.

iii) Increasing investments required, due to evolving needs, favour larger companies with excess capital

A pure property management business is asset-light as the nature of the business itself does not require large reinvestments. However, as the industry develops, increasing investments to build a sustainable property management platform are required. Aside from the cost savings from sharing of staff and better negotiating power when outsourcing, other investments are required as well for e.g. in IT platform implementations.

ECPM has been applying new technologies to its services to try to optimize staff costs in the traditionally labor-intensive property management industry. ECPM uses “E+FM Dual Smart Platforms ” to enhance its operational efficiencies and customer experience. “E+FM Dual Smart Platforms” include the FM smart management information platform and the “O+” platform:

a. FM smart management information platform

ECPM has engaged an “Internet-of-Things” technology-based smart management information platform to connect facilities, technicians, and the property management team. With the help of the platform, in Dec 2019, technicians were able to respond to ~82.8% maintenance requests within time limit, as compared to 65.8% in Dec 2018. Monthly average number of maintenance assignments that each project could handle increased from 274 in Dec 2018 to 481 in Dec 2019. As a result, the number of technicians needed has been reduced, and ECPM’s customer satisfaction level has been increased.

b. “O+” platform

This platform provides customers with various services through the “O+” platform. These services help increase the customer satisfaction level and stickiness. Currently, its services provided through the “O+” platform are available at all of its managed commercial properties developed by Excellence Group. The “O+” platform had approximately 900,000 registered users as of 31 May 2020, and approximately 140,000 monthly active users in May 2020.

Standardization and automation is likely to be another source of investment requirement in future as well. Currently, no uniform standard exists for provision of services, and quality varies significantly across property managers. Standardization can occur in the form of intelligent systems in communities, including access control systems and parking management systems, etc. These initiatives will require additional capital investments, but should reduce labour dependency over time.

iv) Consolidation trend through individual project tenders as well as acquisitions

Aside from third-party tenders, as mentioned earlier the cost advantages from consolidation are likely to lead to an increasing appetite by established incumbents to acquire other property managers. The acquisition/disposal track record of ECPM has been limited due to its short history, but nonetheless a look at the acquisition history has been acceptable so far. All target companies have had performance guarantees embedded which show some degree of prudence, whilst sales have so far booked them gains on disposal. Their sale of Shenzhen Zhuotou, which is engaged in micro-lending to their tenants/property owners, was a drag on their return on capital and the disposal appeared to be a sound decision.

Acquisitions

Sales

Shareholder capital returns through dividends and buybacks

Although the company was only listed in October 2020, there have been a number of insider purchases and share buybacks, although limited due to the fact that the free float was at 26.4% immediately after the allotment and issuance of over-allotment shares in Nov 2020, which is barely above the statutory requirement of 25%. Below is a table of the insider buying as well as share buybacks that have occurred.

The insider amount now stands very close to the statutory ceiling, in particular provided the Chairman Li Xiaoping does not exercise 16.2mn of share options whose strike price is currently above the market.

Dividend payout has been decent at around 70% which is certainly one of the things one would look out for in a net cash company to evaluate whether management is hoarding capital unnecessarily. At the point of IPO, there was no dividend policy that was determined, but in the 2021 annual report, management guided that payout ratio shall not be less than 50% for the next 3 years. Assuming profits are maintained, that would result in a dividend yield slightly north of 8% based on current prices.

In addition, my personal interaction with ECPM has been pleasant in part due to the responsiveness of the company in replying to my queries, as well as attentiveness when answering my questions over long phone calls.

Valuation

ECPM sits on a net cash (of all liabilities) of around HKD 1.6bn. Based on shares outstanding of 1,220,348,000 and a share price of HKD 3.13, this equates to an enterprise value of around HKD 2.2bn, which effectively equates to a price to earnings of less than 4x. For a business that has been growing rapidly and could potentially be a consolidator in future, and which has recurring earnings, I believe this valuation to be really attractive without the need to engage in any form of complicated forecasts, as the margin of safety is huge. This is further backed by a current dividend yield of around 12% due to a generous (and sustainable) dividend payout.

Risks / concerns to business

1) Wage inflation

One of the key risks in this business remains wage inflation, given the labour intensive nature of the business. Dependence on labour is unlikely to reduce in the short-run, and in areas like residential property management where gross margins can be exceptionally thin around 7-15%, wage increments are likely to eat into margins significantly. Below is some data from Frost and Sullivan on average commercial property management staff wages both in China as well as the more affluent Greater Bay area.

As of 2021, the number of employees that ECPM employs is 12,277, and management has guided that this number could double by 2025. With total staff costs of about RMB 1.31bn in 2021, this translates to a monthly average wage of RMB 8,888, although this might not be directly comparable to the statistics above partly due to the fact that there are other costs included like equity options and staff benefits that are included in ECPM’s figures. Just a 10% raise in staff costs could bring down net profits by close to 20%.

2) Potential gross margin decline in future

ECPM’s gross margins could decline in future, in part due to the fact that Excellence Group projects, which have significantly higher margins, are likely to play a smaller part of ECPM’s topline in future. As a comparison, below are some GPM trends across the years. 1 saving grace about this situation however is that value-added services are likely to increase the margins of ECPM, and at present I believe it is hard to tell which effect is likely to be larger.

3) Continuing connected party transactions

Continued connected party transactions are likely to be a fixture of ECPM’s future. This is a trait of the business as a whole, given the fact that most property management requirements were borne out of property development needs, and property management had been an inextricable after-service of property development in the past. As the industry slowly moves towards a more market-oriented, third party focused approach, the degree of connected party transactions should decrease over time. I’ve compiled the main connected transactions as well as the caps imposed below.

There are a number of larger caps pertaining to property management services and master supply/installation, but given the trend towards third-party projects, I believe this to be of manageable concern. In particular, there have been no questionable situations where the property manager has had to utilize its cash balance to purchase assets from its connected developer. Excellence Commercial Properties, a wholly owned subsidiary of the Excellence Group, recently issued a USD 100mn, 4.3% credit enhanced guaranteed green bond, due 2025, with an unconditional and irrevocable standby letter of credit issued by CMB Wing Lung Bank as recently as July 2022. There are certainly potential concerns given the aggressive land grab that Excellence Group embarked on in 2021, in particular in May 2021 when they beat competition from China Overseas Land Investments (COLI), Poly, Shimao etc in a number of land auctions in Beijing as an underdog, leading to market rumours of Excellence Group needing to do a ‘land refund’ due to insufficient funds, although these rumours were subsequently dispelled. It is not currently possible at present to evaluate the financial health of Excellence Group given it is not listed and there are no comprehensively publicly available financials, although 2 bond issuances in March and July 2022 do bolster the liquidity positions of the Excellence-related companies. The Excellence Group is currently in the ‘green’ segment with regard to the ‘Three Red Lines’ standards for property developers and has managed to achieve local long-term credit ratings of ‘AAA’.

In conclusion, I believe at current prices, the investor can purchase into an attractive, non-cyclical business with a long run-way, with manageable risks and management who are significantly invested and have continued to purchase their own shares in the open market. A generous and sustainable dividend payout pays the investor to wait while market conditions revert to normal.

Catalyst

Valuation in itself / business performance over time. Continued strong dividend payouts, though share buybacks will be limited due to statutory caps.