Evergrande is seeking to perpetuate a number of myths. The first is that both its profits and business are growing rapidly. The company’s narrative—that it is investing for growth—is used to justify its high debt levels. In reality, while gross profits have increased in line with sales in recent years, the additional profits have gone to other providers of capital, specifically minority investors and holders of its perpetuals, while underlying profits attributable to shareholders have actually fallen. The large cash outflow during this period was needed to correct the previous failed strategy focusing on peripheral locations; future growth will require additional investment.
The second myth is that contracted sales equate to cash inflows. Despite the growth in contracted sales, advance payments have actually declined. Related to this is the myth that cash collections have been good. In fact, the total amount collected in recent years has been lower than recognised sales, partly because the company has in effect been lending money to buyers of its properties. The final myth concerns value creation. Investment properties are growing at an exponential rate, generating negligible income, while only a tiny fraction has actually been sold.
Evergrande’s recent interim results showed a further deterioration in the company’s financial position. Cashflow remains weak despite reduced investment in property development. The rapid growth in restricted cash raises concerns about the level of hidden debt in the form of bank acceptance notes. Moreover, off-balance sheet mortgage guarantees are a real risk that is generally ignored.
Evergrande recently resumed share buybacks, which it has aggressively used to push up the share price, further eroding its already small equity base. This should be a major concern for holders of the company’s offshore bonds, particularly given the ever-increasing amounts of onshore debt and other liabilities, and the declining quality of its assets. Despite being labelled “senior”, the bonds are a form of mezzanine finance. Bondholders should focus on shareholders’ profits as it is out of these that they are paid.
Given the on-going manipulation of the share price, I have closed my short position. Investors should consider shorting the company’s offshore bonds. For the full text of my report see below.