KE Holdings: Spotlight On Commission Cap And Home Renovation Business (NYSE:BEKE)

Elevator Pitch

I have a Hold rating for KE Holdings’ (NYSE:BEKE) (2423:HK) shares.

I discussed the potential for a recovery in Mainland China’s secondary residential property market and the risks of unfavorable government policies in my previous November 14, 2022 article for BEKE.

With my latest write-up, the spotlight is on news flow regarding potential regulations for real estate brokers and the growth outlook of KE Holdings’ home renovation services business.

The key negative for BEKE is that the company’s actual financial performance for 2023 might not live up to the market’s expectations, if Chinese regulators do initiate a cap on commission rates for property transactions. On the flip side, KE Holdings’ home renovation services business could turn out to be a meaningful contributor to the company’s future top line and bottom line, which will be a positive surprise.

I think that a Hold rating for KE Holdings is justified on the basis that there are both positive surprises and negative risk factors that emerge from my assessment of BEKE as a potential investment candidate.

Potential Commission Cap Is An Overhang For BEKE

Bloomberg published a news article on January 5, 2023 highlighting that regulators in China “are considering a range of 2 percent to 2.5 percent of the sale price as a guide” for “a nationwide cap on real estate commissions”, according to its sources.

In terms of timing, Bloomberg’s sources noted that Chinese policymakers might make an official announcement about the commission cap at the end of this month at the earliest. In other words, there is a risk that KE Holdings’ shares might possibly de-rate on negative news flow in the very near future.

With regards to the market’s expectations, a 2.0%-2.5% property commission cap could come as a major negative surprise for investors. Asian sell-side broker DBS Group Research mentioned in a January 5, 2023 research report (not publicly available) that the speculated commission cap in the 2.0%-2.5% is “more severe” as compared to its earlier prediction of a “progressive rate cap.” A “progressive rate cap” refers to a tiered commission structure where higher (lower) commission rates are charged for real estate transactions that are of lower (higher) value.

In my earlier mid-November 2022 write-up for KE Holdings, I cited research from Morgan Stanley suggesting that the investment bank could potentially cut its FY 2023 bottom line forecast for BEKE by approximately -37% using a 2.0% commission cap rate assumption.

A worse-than-expected commission rate cap will also affect the morale of individual property agents, who might be less motivated to close more deals as a result of the reduction in financial incentives. This might in turn affect the pace of recovery for the Mainland Chinese residential real estate market as a whole.

The potential commission cap that could be implemented for property deals in China acts as an overhang for KE Holdings’ shares. Until there is official confirmation from regulators in China on the actual commission cap that will be put in place, it is tough to forecast BEKE’s 2023 financial performance with a high degree of confidence. This uncertainty will inevitably limit KE Holdings’ share price upside to a certain extent in the near term.

Home Renovation Could Be An Unexpected Growth Driver For KE Holdings

In the first nine months of 2022, KE Holdings generated around 4% of its revenue from emerging and other services. Investors typically don’t pay much attention to BEKE’s emerging and other services business segment, because this segment contributes a very small percentage of the company’s top line and is expected to remain in the red for a long period of time. But this could be an unexpected growth driver for KE Holdings.

As highlighted in its IPO prospectus, KE Holdings’ emerging and other services business segment comprises of home renovation services and other property-related financial services.

Jefferies (JEF) issued a research report (not publicly available) titled “Takeaways From Asia Internet Conference” on January 6, 2023, which summarized insights from BEKE’s presentation and management comments at JEF’s early-2023 investor event. According to Jefferies’ report, KE Holdings’ management is of the view that its home renovation services business as a whole can achieve “monthly breakeven” in end-2024. BEKE’s confidence stems from the fact that its home renovation operations in Hangzhou and Beijing have already broken even.

The growth prospects of the company’s home renovation services business appear to be good for both the short term and long term.

In the near term, KE Holdings saw its home renovation services revenue and home renovation order volume expand by over +40% and in excess of +50%, respectively in Q3 2022 as disclosed at its third quarter earnings call. A key growth driver has been more active cross-selling. BEKE revealed at its Q3 results briefing that the proportion of orders generated from “referrals” coming from its core real estate brokerage platform business increased substantially from 25% in the second quarter of the prior year to 43% for Q3 2022.

In the long run, Chinese market research CIC estimates that the Mainland Chinese home renovation services market has the potential to expand by a reasonably healthy +9% CAGR from RMB6.9 trillion for 2021 to RMB10.4 trillion by 2026. Also, BEKE mentioned at its most recent quarterly results call that its home renovation services brand Beiwoo has the biggest market share in Beijing, China. It is natural that market leaders like Beiwoo will be well-positioned to grab further market share as the Chinese home renovation services market consolidates over time. It is worthy of note that CIC had described the home renovation services market in China as “fragmented” in its report.

Final Thoughts

I stick to my Hold investment rating for BEKE’s stock, following an evaluation of policy risks and growth drivers for the company.