When yields cross 12% — a comprehensive analysis on Evergrande

Note: An earlier version of this article was first published on our affiliates on 25 Sep 19.

Highlights:

• Bond prices of Evergrande dropped due to a confluence of negative factors, namely the RMB depreciation, declining first-half performance, tightening funding environment, and high indebtedness.
• However, the outlook remains promising given its high-quality land bank, strong sales capability and low land cost.
• Evergrande’s abundant cash reserve provides financial flexibility, and its increasingly conservative business approach and implementation of deleveraging will be the focus in the next few years.

Introduction: a tricky situation

Falling bond and stock prices

Year to date, the stock price of China Evergrande Group has declined 23%, making it one of the worst performers among Hong Kong-listed Chinese property developers. Meanwhile, its bonds were also hit hard, with prices of its USD notes plunging since early August (see Figure 1), triggering concerns among bond investors.

Figure 1: Year-to-date price movements of Evergrande bonds

As one of the leading players in China’s property market, it is worth keeping a keen eye on the current situation of Evergrande. In this article, we offer a comprehensive analysis on the headwinds facing Evergrande and its still existing advantages.

The triggering factors of falling bond prices

A victim of RMB Depreciation

Known as the “king of debt” among mainland developers, Evergrande has over 16 outstanding USD and HKD bonds totaling to about USD 21.2 billion (RMB 151.2 billion). According to its interim report, 25.4% of its debt is denominated in USD and HKD, which is equivalent to about RMB 206.5 billion.

In other words, when USD/RMB increases by 1%, the group has to pay an extra RMB 2 billion for the principal of its debt, and that is without considering the impact on interest expense. Among all mainland developers, RMB depreciation hits Evergrande the hardest, given its large offshore debt.

As can be seen from Figure 1, the decline in Evergrande bonds began in early August, when the RMB fell below the key level of 7 yuan to the dollar. The tumble in RMB followed escalations in the US-China trade war.

As time went by, RMB began to stabilize, but the drop in Evergrande’s USD bonds saw no signs of stopping, and actually accelerated since mid-August. So while the bearish views on RMB played a part, a bigger factor behind the decline in bond prices was the wave of negative news that followed.

Plunging interim results

After issuing a profit warning in August, Evergrande released a disappointing interim report for the first half of 2019. Operating income, gross profit, and net profit all declined compared to the same period last year. Operating income dropped 24.4% YoY to RMB 227 billion, while net profit declined 51.6% YoY to RMB 14.9 billion. Excluding non-recurring items and non-property development business losses, the core business profit slipped 44.8% YoY to RMB 30.4 billion.

The group attributed the decline in earnings to the reduction in delivered floor area, as it was 25.8% less compared with the corresponding period of 2018. However, total contracted sales in 2017 and 2018 recorded YoY increases of 34.2% and 10.1% respectively. With its relatively short sales cycle, Evergrande should be harvesting the earlier sales growth now through higher revenue. Thus the decline in the group’s operating results was out of the market’s expectation.

Besides, both contracted sales amount and contracted sales area decreased in 1H19. The former fell 7.4% YoY to RMB 281.8 billion and was overtaken by Vanke, dropping Evergrande’s ranking in China to third place. The group’s underperformance relative to its peers was reflected in its share and bond prices.

Figure 2: Evergrande’s operating performance

Market participants do not expect significant improvements in Evergrande’s earnings growth in the near term. On 4 September, S&P lowered its outlook on three companies within the group, including Evergrande itself, from positive to stable.

Contracting funding environment

As mentioned in a previous article—“China's curbs on property developers funding bring opportunities in high-yield bonds”—the Chinese government decided to tighten regulations on the funding channels of developers, including bank loans, onshore and offshore bond issuances, and trust financing.

Known for its high leverage, Evergrande had been unable to meet its large funding needs through standard financing methods, including banks loans and onshore/offshore bonds. Thus the “non-standard” ways, such as loans by trust companies, became one of Evergrande’s primary tools to obtain capital. However, the maturity period of such loans is usually short, and they entail a high cost.

Based on Evergrande’s 2018 annual report, the percentage of borrowings acquired through non-standard financing means is much higher than its peers, accounting for 32.4% of its total debt. As these “other borrowings” usually require collateral, Evergrande’s ratio of secured debt over total debt exceeded most of its peers and stood at 90%. Under tighter government restrictions on trust financing, it will be more difficult for the group to raise more secured borrowings; its access to capital will be weaker.

The group was also hit by high funding costs. Its latest announced average effective interest rate of borrowings was 8.62%, but the coupon rate of a USD bond issued late last year by Tianji Holding Limited (an Evergrande subsidiary) was 13.75%. The high coupon rate showed that Evergrande’s credit profile was worrying to the extent that it had to pay a rate that high to attract investors.

High short-term debt pressure

The interim report not only showed Evergrande’s sales performance, but also gave us a glimpse at its indebtedness.

As at end-June, the total debt of the group amounted to RMB 813.2 billion, representing an increase of RMB 140 billion over six months. Its net gearing was 152%, similar to that of last year-end. When deleveraging is the current norm among Chinese developers, Evergrande’s indebtedness situation is unsatisfactory.

Although Evergrande’s debt amount has always topped the list of developers, we see a surge in its short-term debt as the amount is now 3.3x more than that of Country Garden, which is ranked second in terms of total borrowings. As short-term debt now accounts for 46% of its total debt (see Figure 3), the group is now facing a huge pressure from short-term debt repayment.

Figure 3: Top 10 developers in terms of debt amount

Due to Evergrande’s high dependence on non-standard financing, most of its debt are due within one to two years, and its short-term debt adds up to RMB 375.8 billion (+18% YoY). Based on CRIC data, this amount is equivalent to 71.7% of the group’s attributable contracted sales in 2018.

From the perspective of cash flow, even if we disregard this year’s declining sales, assuming about 80% cash collection rate from sales and bearing in mind its RMB 31.7 billion in actual interest expense, it is practically impossible for Evergrande to pay down its debt with just cash collection from sales.

Besides, if the group is unable to achieve its planned A-share listing before January 2020, it has to spend RMB 70 billion to buy back shares transferred in two strategic deals made in 2017, and another RMB 60 billion in 2021. Not only would its cash flow be squeezed, shareholder equity would also drop, further driving net gearing upward.

However, does this mean the group will be unable to repay its debt? We shall attempt to answer this question by looking at Evergrande’s competitive advantages.

Why Evergrande is still the sector leader

Positive Sales Outlook

Although Evergrande turned in a rather disappointing performance for the first half of this year, the primary factor was not because of sales, but rather the property development cycle. Revenue from property sales is recognized only upon the completion and delivery of properties. As we expect the group’s property completion and handovers to be concentrated in the second half of the year, core business profit should increase correspondingly.

In terms of sales, Evergrande does not have many joint development projects, causing overall contracted sales amount to fall flat. In actual fact, its attributable contracted sales rank second in China, outpacing third-placed Vanke by RMB 60 billion. As mentioned by Mr Xia Hai Jun, CEO of Evergrande, the group’s estimated attributable saleable resources in 2H19 stood at RMB 800 billion. The group can achieve this year’s sales target by hitting a sell-through rate of just 40%.

Given the upcoming “Golden September and Silver October”, we expect sales for 2H19 to be better than that of 1H19. The rich land bank Evergrande possesses will be its greatest advantage.

Smart land acquisition strategy; land reserves top in country

According to CRIC, as at end-2018, the land bank of Evergrande stood above all other developers with an attributable land bank value of RMB 2,549.6 billion (see Figure 4).

Figure 4: Top ten developers in terms of attributable land bank value

Another advantage of Evergrande is its extremely low land acquisition costs. In 1H19, the average sales price of the group reached new heights at RMB 10,756 per square meter (“psm”), while its average land cost was only RMB 1,639 psm. As a result, the group achieved decent gross profit margin of 34.0%.

The reason behind Evergrande’s land cost advantage was twofold. Firstly, with its brand name, Evergrande was able to obtain numerous cheap lands through redevelopment projects in rural areas. Secondly, by joining the electric car industry, it was also able to get relatively cheap lands from the government as a manufacturer.

The group’s estimated land bank value as at June is yet to be announced. Nonetheless, it has acquired an additional 44.5 million square meters of land, which based on its current average sales price are worth roughly over RMB 400 billion. In the meantime, according to China Index Academy, the group’s land acquisition cost in 1H19 was only RMB 22.7 billion, indicating that it was able to acquire large amount of land at a very economical cost.

Taking into account the large amount of land from redevelopment projects yet to be included in the land bank, we think the group has enough land reserves to meet its sales needs for the next four to five years. In terms of Evergrande’s current land distribution, 53.3% of the land are in first- and second-tier cities, and it has also been hoarding lands in Shenzhen for years. As property prices come under pressure in 2H19, we believe the group is more resilient given its land distribution, which should support its profitability.

Evergrande’s debt servicing capacity

Decent cash reserve and current ratio; has the financial flexibility to maneuver debt repayment

According to its interim report, Evergrande’s cash and cash equivalents rose around 60% over the six months ended June to a rich level of RMB 207 billion. Although there is still a significant gap with its RMB 375.8 billion of loans due within a year, we think the group should be able to repay the interest-bearing debt, after taking into account its cash collection from sales and RMB 81 billion of restricted cash. Despite the existence of other current liabilities, Evergrande’s liquidity is still acceptable given its adjusted current ratio of 1.48x.

Most of the group’s current assets are properties under development. If the Group is unable to cash out through sales, it would need to acquire funding through refinancing. Besides the usual financing channels, we discuss below some methods that the group may adopt to alleviate its debt burden.

First, the group has delayed the approval of its 2018 dividend, which helps to reserve cash and facilitate major asset reorganization efforts, as part of its plan to achieve A-share listing before the end of 2019. Even if it fails to be listed in Shenzhen, Evergrande can still apply for an extension period for the return of the capital injected by strategic investors. When push comes to shove, the group can compensate the investors with shares of its subsidiary, Hengda Real Estate Group.

Second, Evergrande can extend the maturity period of its trust loans albeit with a higher funding cost, to avoid running into a liquidity crunch. The group reportedly has a number of innovative non-standard financing methods. Although we are unable to verify this, but it is likely that lenders are still competing to provide funding to Evergrande, with the confidence that the group is able to repay its debt.

Last but not least, looking at its property sale prices and land bank, we think Evergrande has the ability to maintain its cash flow through price cuts. For instance, in a promotional campaign starting from August, a 10% discount was applicable to all residential units across the country. Furthermore, Evergrande can follow the footsteps of Seazen and Tahoe by monetizing its land bank in times of need.

Once it overcomes the near-term maturity wall, with its manageable net debt-to-EBITDA ratio of 4.98x and expected growth in 2H19 earnings, the group’s long-term solvency is still decent.

Diversified asset portfolio pays off; taking a more conservative approach going forward

Evergrande has long been criticized for over-diversifying its asset portfolio. For instance, the recent move of spending RMB 280 billion to enter the electric car industry has worsened its net gearing. However, the group has benefitted from it with a reduction in land cost. In the long run, even if the electric car business fails to bring profits to the group, its investment would still be compensated by the low land cost.

Besides, Mr Xu Jiayin, chairman of Evergrande, has promised that the group will not expand into other industries within the next five years. Together with its conservative land-buying strategy, we believe that the group is still able to deleverage and its liquidity is expected to be on the rise.

Which Evergrande bonds to invest in?

With around 140,000 employees, Evergrande has a place among the group of corporates that are “too big to fail”. Nonetheless, considering its current debt structure and policy headwinds facing the property sector, we believe its mid- to short-term bonds are more investment worthy.

We have highlighted a number of attractive Evergrande bonds in a previous article, “China Evergrande: Which bonds issued by the real estate debt king are worth investing in?” Although the YTMs of its bonds have generally increased quite a lot recently, we continue to prefer the three notes due in 2021, March 2022, and April 2022 (see Figure 5).

Figure 5: YTM of three Evergrande bonds

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) has a principal position in EVERRE 8.250% 23Mar2022 Corp (USD) and EVERRE 7.500% 28Jun2023 Corp (USD). The analyst(s) who produced this report holds a NIL position in the abovementioned securities.