Talking Point

Playing his cards right?

Investors ponder sustainability of China Evergrande’s $94 billion debt pile

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Xu Jiayin: Evergrande has expanded quickly but borrowed heavily to do so

The late Hong Kong multibillionaire Cheng Yu-tung was an enthusiastic fan of the card game Big Dee (dee in Cantonese means “two” or “brother”). In the game four players compete to dump all their cards first, forming ad-hoc alliances to inflict the greatest damage on those with the weakest hands. Cheng said observing how people reacted under the pressure of a high-stakes version of the game helped him to pick his business partners. And over the years his card-playing mates formed what has come to be called the “Big Dee Club”. This exclusive circle comprises some of China’s richest tycoons and financiers, many of whom have joined forces in the equity and property markets.

China Evergrande’s boss Xu Jiayin is arguably the biggest gainer from the Big Dee connection. Joining the card group as a junior about 10 years ago, Xu has grown his Guangzhou-based firm into China’s biggest property developer in terms of sales. This title, however, has been fuelled by a series of risky bets as Xu brought his high-stakes mentality to his board room, and transformed Evergrande into the world’s most indebted real estate firm.

This week Evergrande published its 2016 annual report, offering the latest financial details on how the poster child for China’s overleveraged property industry is doing. Investors are wondering: will Xu’s gambles continue to pay off?

Going all-in from day one…

Christopher Langner, a Bloomberg columnist, has described Xu as “China’s own Mr Trump” because, like the American president, Xu’s fortune is closely linked to property and built on a mountain of debt.

In fact, the duo were once business partners in bidding for a landmark project in Guangzhou 10 years ago. The plan was to put Trump’s name on the tallest building in the southern Chinese city and boost Evergrande’s image as it prepared itself for a mega IPO in Hong Kong.

The partnership fell apart after Evergrande aborted its listing attempt in March 2008 amid the escalating global credit crisis. The rights to develop the 530-metre skyscraper went to Chow Tai Fook Enterprise – the investment holding company of ‘Big Dee’ Cheng’s property conglomerate New World Development.

Cheng was always good at bottom-fishing. In 1994 he led a Hong Kong consortium to invest in a Manhattan project owned by Trump when the mogul was in dire debt trouble (see WiC318). And 14 years later, when Evergrande was on the verge of collapsing after the delays to its IPO, Cheng came to the rescue.

At the time Evergrande had began to expand nationwide and accumulated a land reserve of 51 million square metres – the biggest among all the Chinese developers. But the untimely credit crunch deprived Xu of conventional financing routes at a time when Evergrande was staring straight into a funding gap of Rmb15 billion ($2.2 billion).

What did Xu do? He played cards. “In order to win Cheng Yu-tung’s trust, Xu would have dinner and play Big Dee with Cheng every week for three months,” NetEase Finance notes.

Cheng then helped Xu clinch some crucial financing deals, including commitments that were conditional on Evergrande’s listing timetable and post-IPO share price.

One agreement, Apple Daily reports, saw Xu personally fork out HK$1.2 billion ($154.1 million) to a group of strategic investors because Evergrande’s post-listing share price failed to meet a guaranteed minimum.

Evergrande eventually went public in Hong Kong in October 2009 and Xu was briefly named China’s wealthiest man by the Hurun Rich List. But questions about Xu’s speculative management style and Evergrande’s financial health have never gone away.

How big is Evergrande now?

Its land reserve today stands at 220 million square metres which is the largest in Chinese real estate and equates to about 10% of the land area of Shenzhen. Its total assets have also expanded: by nearly 80% year-on-year to Rmb1,350 billion ($195.7 billion) by the end of 2016. In 2012 the figure was merely Rmb239 billion.

In January Evergrande passed another milestone by eclipsing Vanke as the country’s largest homebuilder in sales terms. Its contracted sales climbed more than 85% to Rmb373 billion in 2016, compared with Rmb365 billion made by Vanke (Country Garden, another Guangdong-based firm, is the only other developer in the Rmb300 billion club).

The central government’s economic policies in recent years, especially its urbanisation drive in less developed areas, have buoyed Evergrande, which has expanded to 209 cities including small prefectures in Inner Mongolia and Xinjiang. The company has also diversified out of real estate, with additional interests in finance, tourism, healthcare and a hugely successful football club in Guangzhou Evergrande Taobao (a 50-50 joint venture with internet giant Alibaba).

According to 21CN Business Herald, Evergrande has set itself a sales target for its property division of Rmb450 billion this year, 20% higher than its 2016 figure, and Rmb550 billion by 2019. However, Evergrande’s scale has not been translating into investment value. Its market capitalisation was HK$70 billion when it debuted on Hong Kong’s stock exchange eight years ago and it was still trading at around HK$70 billion at the beginning of 2017. Since then a HK$6 billion or so share repurchase scheme has pushed Evergrande’s stock price 68% higher. That means its market value stood at HK$110 billion as of this week, but that is still less than half what Shenzhen-listed Vanke is worth.

How profitable is Evergrande?

Evergrande’s breakneck expansion hasn’t been accompanied by similarly surging profit. Its net income (listed as “profit attributable to shareholders”), nearly halved to Rmb5.1 billion last year. On this count, Evergrande’s price-to-earnings ratio stands at 19 times, versus 10 times for Vanke, which reported a 16% increase in net profit to Rmb21 billion last year.

Moreover, Evergrande has relied on the issuance of perpetual bonds – a form of borrowing with no repayment deadline – as a major source of financing in recent years. According to its 2016 annual report, outstanding perpetual capital instruments totalled Rmb113 billion by the end of last year (up from Rmb75.7 billion in 2015) with an average annual distribution rate of 10%.

Interest payments to these perpetual bondholders eats into Evergrande’s profitability. For the first time since 2012, it decided against paying a dividend to shareholders for 2016. Its distributable earnings (classified as “total comprehensive income attributable to shareholders”) plunged 98% to Rmb199 million last year.

“Evergrande’s decreasing distributable earnings should be quite worrisome to shareholders, as the company’s declining return on equity suggests an inefficient balance sheet,” Brock Silvers, managing director of the Shanghai-based investment advisory firm Kaiyuan Capital told WiC. “The issue is whether the company can use its heavy debt load to start effectively returning higher profits to shareholders.”

The company has tried to refocus investor attention on Evergrande’s potential to deliver much greater returns and since last year it has been working on a spin-off of its property unit, provisionally titled Hengda Real Estate, through a backdoor listing via Shenzhen SEZ Real Estate, a vehicle controlled by a Shenzhen state firm.

Citing internal documents, 21CN notes that Evergrande thinks an A-share listing will value Hengda at Rmb228 billion. And it also sounds like another punt is in play – Evergrande has promised to compensate Shenzhen SEZ if Hengda’s annual profit is less than Rmb88.8 billion within three years of coming to market (those lucky ‘8’s should do the trick, WiC reckons…).

How leveraged is Evergrande?

The Financial Times notes that with gross debt of around $94 billion, Evergrande has roughly the same amount of borrowings as the government of Hungary. Reuters has pointed out that Evergrande’s debt is almost six times its market value and that only the oil major PetroChina has more debt among all Chinese firms.

In its annual report Evergrande has suggested that its “gearing ratio” was 39.6% at the end of last year, fractionally higher than 2015’s 39.2%. This is obtained by measuring total borrowings (Rmb535 billion) against total assets (Rmb1,350 billion).

But the picture would look entirely different, Bloomberg’s Langner suggests, should the company’s debt-like preferred shares and perpetual capital instruments – which are treated as equity by Evergrande’s accountants – be moved onto the opposite side of its book.

“If those are factored in, the developer owes $91 for every $9 of common stock on the balance sheet – a leverage ratio of more than 10 times [1,000%],” he writes.

Citing data from Wind Information, the FT notes that Evergrande’s net debt of $50 billion was 777% of its equity at the end of 2016 against a sector average of 90% as of June 2016.

“Evergrande’s strategy of ramping up debt in order to buy up the largest land bank in China has made it vulnerable to the slowdown in the country’s property market and a government crackdown on lending to property developers,” the newspaper warns.

As Evergrande’s leverage has grown, S&P Global Ratings has moved the company from a BB score to B- (both junk grades) with a negative outlook. “Given the increase in debt ratios, the likelihood of a downgrade to the C category now looks high,” Langner opines.

Xu pledged earlier this year that Evergrande would repay half of the company’s perpetual bonds. But its borrowing costs will stay high. A $1 billion, 7-year issuance in March came with an interest rate of 9.5% (for comparison, China Overseas Land, a state-run developer, has an outstanding $500 million bond – due in 2023 – with a coupon of 5.375%).

And Evergrande’s cash situation?

“We are sitting on Rmb300 billion of cash and you are still talking about a cash crunch. What has happened to the world?” Xu rebuked reporters at a fractious press conference this year, rebuffing concerns that the company is facing a liquidity crisis.

As matters stand, it had Rmb304 billion of cash at the end of last year, of which unrestricted cash and equivalents totalled Rmb198 billion, or nearly double the Rmb103 billion in 2015.

Further proceeds from sales of residential units have helped build up reserves, Evergrande says, but the capital inflow is also a result of more bank borrowing, which increased to Rmb424 billion from Rmb189 billion during the period (repayments of loans were also up to Rmb238 billion from Rmb105 billion).

The company seems to have received more substantial support from lenders now that it has entered into strategic cooperation agreements with a number of state banks and secured Rmb673 billion of total borrowing facilities.

Evergrande’s cash position also got a lift from an advance of Rmb44 billion, which came mainly from investors buying into the potential backdoor listing of Hengda. A group of eight investors paid Rmb30 billion for a 13% stake in Evergrande’s property unit in January this year. The deal values Hengda at about Rmb230 billion (or four times Evergrande’s market cap at the time). However, in a move reminiscent of the deals that Xu struck before Evergrande’s Hong Kong listing in 2009, the company has committed to repaying these investors in full if Hengda’s A-share spin-off isn’t completed before February 2020.

“Those transactions are eye-opening, as new equity investors received a 3-year buy-back guarantee against any loss. This may have been the result of the company facing increasingly uncooperative debt markets,” Silvers of Kaiyuan Capital says, although he also reckons that Evergrande has raised significant capital in a difficult environment and shareholders “shouldn’t begrudge the company’s long-standing relationships”.

Will the Big Dee Club help again?

A number of Big Dee’s senior members invested in Evergrande’s Hong Kong IPO back in 2009. Besides Cheng Yu-tung, the group included Joseph Lau (a man who splashed out $48 million on the “Blue Moon” diamond for his seven year-old daughter in 2015) and Cheung Chung-kiu, who has emerged as an active investor in London properties (see WiC357).

Will the tycoons be as supportive as Evergrande chases its potentially lucrative A-share listing? The signs are that Xu’s connections with the close-knit card players are as important as ever. Many of the top Hong Kong tycoons are major holders of Evergrande’s senior notes and perpetual bonds. And the commercial relationships within the group have been crucial too. NetEase Finance notes that the Cheng family and Joseph Lau have been actively selling down their property interests in mainland China to Evergrande, for instance. “In the year 2015 alone, Evergrande acquired mainland assets from Big Dee Club members that are worth Rmb55 billion,” the news portal reports. There have been sales of real estate assets in Hong Kong as well, like the record $1.6 billion Evergrande paid for an office building owned by Lau’s listed firm in 2015.

Cheng passed away last October aged 91 and we asked soon afterwards if his death marked the end of post-handover era in which Hong Kong’s property bosses steered the former colony’s business affairs (see WiC342). Now Lau is battling failing health and he said in March he would be giving HK$50 billion of his assets to his wife (see WiC357) – though on hia advice she has also been an active buyer of Evergrande’s debt issues. That would suggest the Big Dee Club continues to support Xu. Perhaps they calculate that he has created an empire that is now too big to fail.


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