Interactive Investor

Stockwatch: is Evergrande really a write-off?

21st September 2021 11:20

Edmond Jackson from interactive investor

Our columnist examines the crisis-hit Chinese property giant topping the market news agenda this week.

What substance is there behind China Evergrande Group (SEHK:3333) at the centre of global fears for financial contagion?  

Asian equities have set a highly volatile stage for markets today – with the Hong Kong Hang Seng recovering after an initial 1.4% fall but the Tokyo Topix down 1.7% after being closed on Monday. 

Around HKD 2.20 today, an all-time low from 31.55 in November 2017, it is capitalised around 29 billion Chinese Yuan or £3 billion equivalent – which is substance to trade, potentially continuing to attract short-selling if allowed. 

Western debate polarises between whether the Chinese government will take control of said “property developer” - with foreign investors taking a big haircut on its bonds, so as to ensure domestic smaller investors and home owners are relatively protected.

In such a scenario you can probably write off the equity value: who wants to own part of something controlled by the Communist Party? 

But if the government takes a pragmatic line – selective haircuts and debt roll-overs, a managed restructuring where other developers take on Evergrande’s uncompleted projects in exchange for a share of its land bank – then Evergrande 3333 will remain on share dealing pages.  

Potentially at least, a chance it becomes a recovery play akin to Greek bonds in that crisis of 2007-08. Although examining it, I see greater parallels with indebted property companies and conglomerates in the late 1980s that proved flaky. 

Does this finally trigger a China debt crisis, bears warned of? 

As China’s second largest property group by way of revenue, Evergrande has more than 1,300 projects in more than 280 cities – a main line of business is selling flats to relatively affluent citizens.  

The context forms a long-time story – whether the Chinese economy can avoid a hard landing, given property development is very significant and operators run high debts. Short sellers such as American Jim Chanos have warned for years, this cannot end well. The likely trigger of a slump would be a banking failure due to the collapse of a major property developer. 

Since Covid intervened, all such problems were covered by a colossal tide of monetary and fiscal stimulus – globally. As it eases, Evergrande may be an early example of that old adage, how you next find out who has been swimming without a costume. 

Last month, a record number of cases were filed against the group by contractors, became apparent. Also, Chinese developers generally are said to be under repayment pressure on dollar-denominated bonds. 

Last week, Evergrande was reportedly unable to pay interest on two loans due for repayment today, and is expected to default. In the event the company failed, some 1.5 million customers would lose their deposits on homes yet to be built.  

A key reason the Chinese government is likely to make foreign investors bear more cost, is the “wealth effect” of impacting its own institutions and citizens. Beijing is already pushing domestic listed real estate groups to cut housing costs.

Evergrande is already straining banks and suppliers, and over the last week individuals have been protesting outside its Guangdong headquarters. The government will therefore also be keen to prevent social unrest. 

Allegedly, some 3.8 million jobs a year are created by Evergrande, hence hard to imagine China would let it collapse akin to the parallel example of Lehman Brothers in September 2008. 

A man walks past a housing complex by Chinese property developer Evergrande in Guangzhou, China. (Photo by Noel Celis /AFP via Getty Images)

The world’s most indebted property company 

The global story is Evergrande currently having more than $300 billion equivalent – or £219 billion – liabilities including some $100 billion debt repayment pressure on dollar denominated bonds. 

When I study its end-2020 balance sheet however (first-half 2021 results are yet to be published) gearing does not appear so grossly high – for an asset-backed property developer – in an era of very low interest rates. 

Note that Chinese companies report in renminbi, which is the official currency, versus the yuan being the unit of account of the financial system. 

Net assets were RMB 350.4 billion (£39.7 billion) with RMB 381.1 billion long-term debt and RMB 335.5 billion short term; therefore gearing of 205% or respecting RMB 158.8 billion cash, net gearing of 159%. Moreover, the chairman’s statement targeted a net debt to equity ratio below 100% by last June-end. 

While I just recently advocated Tritax EuroBox (LSE:BOXE) with gross gearing of 34% and net of 8%, over decades I have seen property groups geared over 100%. So long as the supporting financial system is sound, also the business model, some might say around 100% gearing is “optimising” the balance sheet for an asset-backed operation.

Evergrande, for example, had RMB 1,258 trillion development properties under end-2020 current assets, and RMB 169 billion investment properties, also scant goodwill. 

What stick out for me, in terms of potential strain, are RMB 829 billion trade payables – up 15% on 2019 - versus RMB 142 billion trade receivables, and relative to RMB 507 annual revenue. That suggests a business growing on the back of squeezing suppliers, sub-contractors and the like – but if they were to revolt?  

You could also say is symptomatic of over-trading and hardly surprising there are rumours Evergrande cannot pay its bills. But if auditors PWC can be relied on with their declaration of “a true and fair view”, the end-2020 ratio of current assets to current liabilities was 1.26 and there was RMB 159 billion free cash. 

Evergrande Group - summary income statements
CNY million

Total Revenue311.0466.2477.6507.2
Cost of Revenue198.8297.2344.6384.6
Gross Profit112.3168.9132.9122.6
Operating Expense34.135.745.859.1
Operating Profit 78.1133.387.163.5
Interest Charge-4.8-4.5-14.2-6.9
Pre-tax Profit77.5126.874.268.2
Net profit24.437.417.38.1

Fast-growing and diversifying  

I am also concerned at a culture of rapid growth and diversification, despite perception of Evergrande as a property developer.

Its numbers soared around four-fold in 2017 and the 2020 annual report reminds me of 1980’s conglomerates trying to do many things – also with debt. This contributed to over-stretch and such businesses hitting financial trouble in the early 1990s recession.  

The annual report described “a whole industry chain intelligent ecosystem”. Evergrande has completed the transformation from real estate to “diversified industries plus digital technology” and created a diversified industry ecosystem focusing on fixed space and mobile, and formed closed-loop data serving millions of users, linking eight major industry platforms.” 

That sounds quite an edifice, if it cannot pay its bills. Doubtless the management would argue it is a modern agenda for the digital economy, in contest of the Chinese economy forecast to grow over 8% this year. 

In fairness, a Western perspective may have limitations to interpret Chinese growth by our standards. But that was said of Japan also, until the late 1980s exposed inherent weaknesses – like short sellers more recently have alleged of China. 

It makes Evergrande a “moment of truth” for the Chinese economy, with far wider ramifications than one listed stock. 

Broadly, avoid the stock for now 

There is a scenario where Evergrande becomes a recovery play if Beijing decides, foreign investors should be treated respectfully enough – i.e. do not lose all their money on Evergrande bonds – and does not take full control of the company. China has incentive to do so, for its international economic reputation.  

Strictly speaking, I can but assert a “sell” stance given too many red flags to assert “hold”. This can yet, however, turn up from HKD 2.20 if Beijing has its act together, with a wider conscience. Sell. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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