The leader of Chinese real estate, Evergrande, is making headlines again

China Evergrande (“Evergrande”) has once again made the headlines of various media. With alarming titles like “A-Share Listing”, “National 30% Off” and “Red Light Developer” appearing on the news, investors may be worried.

On 24 September, a letter from Evergrande to the Chinese Government was circulated on the Internet, leading to panic in the market. The Group’s stock and bond prices dropped significantly on the same day. However, it is important to note that the information disclosed in this letter is not new, and markets would have already had prior knowledge. The only difference is the tone of the letter, which sounds threatening and worrying.

We will not be discussing the authenticity of the letter within this article. What is concerning though, is the Group’s severe underperformance compared to its own subsidiary, Evergrande New Energy Vehicle Group (“Evergrande Vehicle”), whose market capitalization has previously surpassed its parent company (see Chart 1). This is in spite of the Group owning shares of several large-sized listed companies.

Chart 1: Year-to-Date Market Capitalization of China Evergrande (3333.HK) and Evergrande Vehicle (0708.HK)

While Evergrande owns about 75% of Evergrande Vehicle, it also controls 64% of Hengda Real Estate (with an estimated valuation of RMB 420 billion after the third strategic investment in 2017, as well as other companies such as HengTen Networks and Jinbi Property Management. So why is the Group’s valuation subjected to such a huge discount? Is Evergrande’s debt situation really that poor?

We outline our analysis below on Evergrande’s current credit profile, to determine if the Group can improve its financials with its sales amid this “Golden September, Silver October”.

Updates on China Evergrande

Decline in Operating Performance; Failed to Meet All Three Red Lines

The most disappointing part of Evergrande’s interim results is definitely the further deterioration in its operating and credit performances. Profits attributed to shareholders plunged by over 50% for two consecutive years, with net core profits dropping by 37%. As laid out in Table 1, the profit margins were also weakened.

Table 1: Evergrande’s Operating Performance

In Billion RMB	1H20	YoY Change	1H19	1H18
Revenue	266.6	+17.5%	227.0	165.8
Profits Attributed to Shareholders	6.54	-56.2%	14.92	30.81
Net Core Profits	19.25	-36.6%	30.35	55.01
Gross Margin	25.0%	/	34.0%	36.2%
Core Margin	7.2%	/	13.4%	18.3%
Source: Interim Results, Annual Report, iFAST Compilations Data as at 30 June 2020

Furthermore, the Group’s credit indicators also did not improve. In spite of the deleveraging target set earlier this year, the results were not reflected in the interim results. The total borrowing amount continued to increase with several key credit metrics deteriorating. Evergrande failed to meet the “Three Red Lines” requirements issued by the Ministry of Housing and Urban-Rural Development, and thus became a “Red Light Developer”, indicating a fervent need for the Group to improve its credit profile immediately (see Table 2; the net gearing and cash to short term debt ratios are not adjusted).

Table 2: Evergrande’s Credit Metrics

In billion RMB	June 2020	December 2019	“3 Red Lines” Requirements
Total Borrowings	835.5	799.9	/
Cash Balance	204.6	228.8	/
Net Gearing (%)	199%	159%	< 100%
Cash to Short Term Debt (times)	0.52x	0.61x	> 1.0x
Adjusted Liabilities to Assets (%)	85%	83%	< 70%
Short Term Debt Ratio (%)	47%	47%	/
Average Borrowing Cost (%)	9.14%	8.99%	/
Source: Interim Results, Annual Report, iFAST Compilations Data as at 30 June 2020

Enormous Short-Term Debt Pressure Becoming A Norm

In fact, this is not the first time Evergrande is holding such an enormous amount of short-term debt. As at June this year, the Group’s amount and proportion of short-term debts did not increase significantly compared to last year. However, with its shrinking cash balance, the cash to short term debt ratio fell (see Chart 2).

Chart 2: Evergrande’s Short Term Debt Distribution

We mentioned previously in “When yields cross 12% — a comprehensive analysis on Evergrande” that the Group heavily relied on “non-standard” refinancing, which has a higher cost and lower tenure, and would lead to a vicious cycle of replacing old debts with new ones. The average cost of borrowings continues to grow every year and has already exceeded 9%.

Considering that the size of Evergrande’s land bank has been reduced from 293 million sq.m in December 2019 to 240 million sq.m this June, it is evident that the Group is cutting land reserves as promised. Perhaps due to the cash collection period, the results were not reflected on the debt structure as shown in the interim results.

With a clear direction of reducing its land bank, the Group should be able to improve its leverage level. However, in the long run, Evergrande still has to further increase its sales revenue, given it has other expenses such as land acquisition and construction, as well as the cash interest expenses of RMB 41.8 billion.

In the first eight months of 2020, Evergrande’s sales growth was superior to its peers, with the contracted sales standing at RMB 450.6 billion, up 21.8% YoY and achieving an approximate 70% of its sales target. In the continued pursuit for sales, the Group’s Chairman Xu Jiayin announced that Evergrande will hold a nationwide discount promotion during the “Golden September, Silver October” where buyers will enjoy a 30 % off on all flats. The target? To attain RMB 100 billion sales in a single month.

Promotion is merely a Gimmick; Reducing Debts is a Must

It is common for Evergrande to hold promotions. In last year’s “big sales month”, some homes were sold at a discount of 20% to 40%. In February this year, it rolled out another nation-wide discount of 25%.

Therefore, even though the promotion this time was larger than before, it was not a surprising move. Moreover, this slogan is more gimmicky as the discount benchmark was the official price instead of the usual selling price. Furthermore, local governments may not allow developers to start a price war which could affect local housing prices.

Admittedly, with the recent re-emergence of local housing regulations and the tightening of developers’ financing channels, Evergrande has to increase its cash collection through sales.

According to the early guidelines, “Red Light Developer” cannot increase the size of borrowings (compared to its balance in mid-2019). With all this considered, Evergrande must start to reduce its debt by the end of the year in order to be aligned with its management’s goal, which is to halve their debt by end-2020.

Will Evergrande be able to achieve its goal?

Sales Revenue Could Cover the Short-Term Debts, but Land Purchase Expenses will Deteriorate Its Solvency

Vice Chairman Xia Haijun once said that it is not difficult for the Group to accomplish the RMB 650 billion target this year. Evergrande has more than RMB 800 billion saleable resources in 2H20. If the sell-through rate equals that in 1H20 (57%), it is possible for the Group to surpass their target, and even achieve a total of RMB 800 billion sales this year.

Nonetheless, in spite of the impressive sales growth from Evergrande this year, we should not be overly optimistic.

With reference to its 1H20 performance, the Group recorded a total contracted sales of RMB 348.8 billion. With an extremely high attributable ratio and a 90% cash collection rate, the Group received a record-high sales return of RMB 312.0 billion, amounting to 80% of its total debt due in one year (RMB 395.7 billion). This percentage was higher than those of previous years. If Evergrande can maintain this sales number in 2H20, it should be able to cover its short-term debt and the interest expenses.

Nonetheless, we cannot ignore the other payments such as land-buying expenses. The latest sales to land reserves ratio (by area) decreased to 3.1x in June 2020 from 5.0x in June 2019, reflecting a weakened growth outlook. Although the Group had a large amount of urban renewal projects that were not yet included in the land bank, we expect it to spend a certain amount of capital on acquiring new land every year.

With reference to data from China Index Academy, Evergrande spent RMB 82.2 billion on land purchases from January to August, more than all the other Chinese developers. This may further increase pressure on the Group’s capital flow.

Electric Vehicle Business Has Limited Impact

Some investors worry that Evergrande’s electric vehicle business will eat into the Group’s cash reserves. Indeed, the continuous growth of Evergrande Vehicle’s borrowings is one of the reasons contributing towards the Group’s worsened leverage.

However, Evergrande Vehicle is currently a listed company and responsible for its own investing activities. As the parent company, Evergrande will consolidate the financial statements. If capital injection is required, unless it is in the form of issuing new shares, it should be done through borrowing. When Evergrande Vehicle acquired Faraday Future and NEVS, the US and Swedish electric vehicle companies, Evergrande lent about RMB 5.6 billion and USD 1.1 billion in a form of three-year unsecured loans at the annual interest rate of 7.6% and 8% respectively.

Since the market value of Evergrande Vehicle has soared in recent months, it will bring about a positive effect on its refinancing ability. In September, the company successfully completed a share placement to raise about HKD 4 billion, with investors such as Tencent, Sequoia Capital, Yunfeng Capital and Didi. Therefore, we believe this segment will not have a significant impact on Evergrande’s cash flow.

Strategic Investments Can Be Repaid with Asset Liquidation

It is still uncertain if Hengda Real Estate will be listed as A-share, and Evergrande has to once again face the prospect of refunding the RMB 130 billion principal and RMB 13.7 billion cash dividends in the previous strategic investments in January 2020. Last year, the Group successfully extended the repayment for one year, and we expect it to do the same this year. If it fails to do so, the Group has to further liquidate assets on hand to process the refund.

There are rumors that Evergrande is planning to sell over 200 non-core assets including offices, hotels, shopping malls, etc. Xia Haijun also stated that Jinbi Property Management has already completed a RMB 23.5 billion strategic investment in August, which should lower the net gearing by 19pps. They also planned to list the company within the year to further raise funds from the market. With reference to other property management giants, Evergrande’s valuation should exceed RMB 100 billion.

In mid-September, Hengda Real Estate successfully raised RMB 4 billion cash through onshore bonds, and Evergrande Vehicle announced its plan to launch a secondary listing in Shanghai Stock Exchange, showing that the Group is trying to explore different funding channels.

Huge Assets could Help Sustain Cash Flows, but Only Short-Term Bonds are Worth Considering

As Evergrande is the largest real estate developer in China, its huge assets on hand can help sustain its cash flows for a certain period. We believe there are still a lot of ways to refinance, such as some off-balance sheet financing tools like ABS or disguised debt into equity.

Here’s the worst case scenario: taking Tahoe as an example, it took two years for this giant corporation to go from signalling liquidity risks to actually default. Given the huge land bank owned by these developers, the tangible assets can still be a reliable source to obtain funding from creditors, implying that the risk of an abrupt default is relatively lower.

However, given the recent worsening performance of Evergrande’s credit status coupled with the degenerating long-term solvency, the possibility of its credit rating being downgraded is quite high. We continue to emphasize that short-term bonds should be considered when investing in highly leveraged issuers, such as Evergande.

Bonds Due on or before 2022 are Better

A significant portion of Evergrande’s debt capital comprises of non-standard financing, and this part of debt lacks transparency. If we look closely at its onshore and offshore bonds, we can see that the peak repayment period of these bonds is in 2023 (see Chart 3).

Chart 3: Evergrande’s Corporate Bonds Maturity Distribution

Unless Evergrande can demonstrate a significant improvement in the future, we do not suggest that investors invest in its bonds due 2023 or after.

We remain positive on its short-term bonds due on or before 2022. As these bond yields continue to fluctuate with the market’s movements, investors should view the bond factsheets for the latest price (see Table 3).

Table 3: YTM of Three Evergrande Bonds

Bond Name	Years to Maturity	YTM
EVERRE 6.250% 28Jun2021 Corp (USD)	0.744	18.657%
EVERRE 8.250% 23Mar2022 Corp (USD) (Available in Bond Express)	1.478	23.101%
EVERRE 9.500% 11Apr2022 Corp (USD)	1.530	23.090%
Source: Bondsupermart Data as at 29 September 2020 (10.47 AM)

Corporate Risks

In 1H20, Evergrande’s average selling price was RMB 9,029/sq.m, down by 12.2% compared to 2019. Now in 2H20, the continuous discount promotion may cause the subpar gross margin to drop further, weakening profitability.

Like the bonds issued by Guangzhou R&F, Evergrande’s bonds performed poorly after the release of the interim results, and the long-term bonds may experience higher price volatility under pressure. If the credit agencies downgrade Evergrande’s credit rating, bond prices may fall further.

Conclusion

In 1H20, Evergrande’s operating results and credit indicators further worsened. Not only did the Group fail to meet the “Three Red Lines” requirement, it also remained exposed to high short-term debt pressure.

With that said, the Group’s property sales growth was impressive among its peers. With the large-scale discount promotion, the sales revenue should be able to cover its short-term debts. Liquidating assets may also be another source of funding to repay the strategic investment, but the expenses on land acquisition will deteriorate its solvency.

As an industry leader, Evergrande’s huge asset base would help sustain its cash flows. However, given its weakened long-term debt-servicing ability, we maintain our view that only short-term bonds are worth considering, which include the bonds due 2022 or before.

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Our podcast series, Yield Hunters, is available on Spotify, iTunes Podcasts and Google Podcasts. In this episode, we explore the stability and growth of the Chinese real estate developers as they continue to raise debt.

Disclaimer:

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 who produced this report holds a NIL position in the abovementioned securities.