Even if Evergrande (SEHK: 3333) Stocks started to fall in 2020, it was not until May that the decline accelerated. Fueled by rumors of defaults, the stock finally passed 80%.
This might be slightly confusing for secondary observers, given the importance of real estate in the Chinese market. Yet a perfect storm can sink any ship.
This article will look at the business model, slowing demand and a policy change that ultimately capsized Evergivenbig.
Xu Jiayin founded Evergrande Industrial Group in 1996. It is a real estate company with more than 1,300 projects in more than 280 cities. Currently, he is committed to building approximately 1.4 million individual properties. Through more than 200 offshore subsidiaries and 2,000 national subsidiaries, Evergrande’s 2 billion assets are equivalent to 2% of Chinese GDP.
Besides real estate, the company has been involved in many other projects including electric vehicles (Evergrande New Energy Auto), media (HengTen Networks), sports (Guangzhou FC), mineral water (Evergrande Spring) and others.
Although in direct competition with more established competitors, the company successfully launched the first project, Jinbi Garden, in 1997.
Selling at a very competitive price of US $ 40 per mÂ², the company achieved sales of US $ 12 million and immediately launched 13 new projects in Guangzhou. Introducing an ambitious plan, the company began a nationwide expansion in 2006, with the intention of ” recreate 20 Evergrandes in just 3 years “At that time, 15 years ago, the company had $ 1.2 billion in assets and $ 1 billion in debt.
During the 2008 financial crisis, the company was expanding nationwide, executing over 30 projects when it began to run into cash flow problems. At that time, Evergrande’s liabilities were around US $ 2 billion.
Eventually, the company entered into a pre-IPO deal worth US $ 506 million from domestic and foreign investors, led by the Chow Tai Fook group. The IPO took place in November 2009 at a valuation of HK $ 70 billion or US $ 10 billion. Meanwhile, the diversification effort proved unsuccessful, especially the promising Evergrande Spring mineral water which was finally sold in 2016.
By the time Xu Jiayin announced the strategic changes, liabilities had soared to $ 178 billion. He planned to reduce debt and deleverage the business while keeping revenue high and cost low.
However, the comparison of balance sheets shows an increase in short-term debts until 2017.
Comparison of Evergrande’s balance sheet; Source: wsj.com
Meanwhile, the latest expansion included the US $ 7 billion investment in an electric vehicle brand Hengchi, operating through a subsidiary of Evergrande Auto. The company announced 9 concept vehicles in July 2020, leading to a valuation of the subsidiary of US $ 87 billion in April 2021 before falling below US $ 5 billion. As the examples with Nio and Tesla show, car production is very capital intensive and often takes years to become profitable. Not the best activity for a company looking to get out of debt.
As always, every party must come to an end. Faced with growing debt and rising land prices, government regulators drew up a plan in August 2020.
They established a list of criteria that regulators at the People’s Bank of China should use to assess real estate developers. These included:
- Liability / asset ratio (excluding anticipated receipts) less than 70%
- Net debt ratio less than 100%
- Short-term cash-to-debt ratio greater than 1x
Essentially, this was forced deleveraging, limiting annual debt growth by the following table.
3 Red Line Plan, Source: UBS
If we look at Evergrande’s situation at the time, the results are catastrophic:
- Passive / active ratio: 82%
- Net debt ratio: 199%
- Short-term cash-to-debt ratio: 0.4
Evergrande’s real estate operations followed the same pattern: build quickly in the previously unattractive area and set an attractive price for the middle class.
They did it in 2 steps:
- Sell ââdebts to raise funds for the purchase of land development rights
- Pre-sell the developing property and use most of the money to buy more land rights
This strategy works well when land rights continue to appreciate, which occurs when demand is high, allowing the company to stay ahead of the cost of debt.
Building on the ” invisible hand âthe market to dictate the value of your assets while simultaneously holding a large number of liabilities is not the best idea, as it had already shown in 2008.
As a result of the forced deleveraging policy, the company responded with a plan to reduce the prices of its new projects by 30% to reach $ 15.4 billion in monthly sales. Cutting prices to offload inventory and raise funds isn’t the worst idea, unless it affects the value of the assets on your balance sheet.
And there we come to catch 22.
Evergrande holds a significant amount of real estate on its books as assets. In the past, this was not a problem as the price increase would ensure that it was sold at a profit.
Suppose he engages in aggressive selling tactics to increase cash flow to pay off some liabilities and improve the liability-to-asset ratio. In this case, it will simultaneously reduce the value of those assets.
Even so, potential buyers would be inclined to wait for a better deal with the blood on the streets as the build-up of liabilities put the company under pressure.
While it is impossible to speculate on the outcome of this situation, there are 2 critical factors to keep in mind.
- 1.5 million people made down payments for housing that had not yet been built
- Liquidation could create real estate crash
Although we are talking about China, one of the largest nations in the world, 1.5 million people losing their deposits is not a negligible number. The government prefers to avoid social unrest, especially with the National Party Congress scheduled for 2022.
In addition, a liquidation of the company would flood the domestic market with its assets and likely destabilize the real estate market, possibly causing the domino effect with other real estate developers whose assets would now depreciate while facing closer scrutiny of the market. their banks and other lenders. While the company owes about 171 domestic banks and 121 other financial companies, only about US $ 19 billion of the total debt of US $ 300 billion is foreign.
Under these circumstances, anything but government intervention appears to be a lose-lose scenario for all parties.
Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no positions in any of the companies mentioned. This article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents.
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