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.
There have been a number of examples recently of Chinese companies whose valuations seem to have lost touch with reality. One of these is Mascotte Holdings (ticker: 136.HK); its share price had already nearly tripled between the start of April this year and early June when trading in its shares was halted. Mascotte subsequently announced that Evergrande and Tencent would acquire a 75% shareholding in the company through a subscription of new shares. When trading resumed on 3 August, the share price immediately jumped by as much as 150%. It has since fallen back somewhat, closing at HK$0.48 on 5 August. Though this is still nearly 70% higher than the pre-announcement price and gives Mascotte a pro forma valuation of HK$78bn.
In just a few years, Evergrande Real Estate Group (ticker: 3333.HK) has grown from a mid-sized, regional property company into one of China’s largest developers. Its extraordinary growth has been mainly debt-financed. Evergrande is highly leveraged with large borrowings and other liabilities balanced on a small sliver of equity: total debt is now over four times shareholders’ equity. It is reliant on its lenders continuing to roll over short-term borrowings. With interest payments spiralling out of control and cash profits likely to be negative this year, the company may already have reached a tipping point where interest can only be paid out of more debt. Moreover, its liabilities probably exceed the value of its assets. In my view, there is a strong possibility that Evergrande is insolvent.
There has been some strange behaviour recently from Evergrande, even by the company’s standards. Just a month after raising HK$4.6bn through a share placing, the company started buying back shares. It has since repurchased more than the number of shares placed, pushing the share price up by more than 40%. Furthermore, it has bought shares at prices above the placing price taking into account the recent dividend.
Tesco’s share price has increased by around 40% from its low point in December last year. The renewed optimism reflects investors’ favourable response to the new chief executive, Dave Lewis and a growing belief that the UK business has reached a turning point. The current share price is discounting a rapid return to “normal”, as the company reasserts its still dominant market position. The implicit assumption is that a resumption of growth in the UK business will automatically lead to a strong recovery in profits, even if margins do not return to prior levels.
However, this ignores the underlying structural issues facing the UK business. Sales productivity, measured in sales per square foot, has consistently fallen since 2007. At the same time, Tesco is saddled with high legacy costs that will be difficult to reduce: rental payments have ballooned following a decade of sale and leasebacks. It risks losing out to more nimble competitors. The level of future profitability is unclear, but will inevitably be much lower than it has been historically. Given the deep-rooted problems and considerable uncertainties, the shares are expensive. I am short Tesco.
Sometimes foresight may not help. If someone had said on 28 August last year (just before Tesco announced its second profit warning of 2014 and a 75% cut in its interim dividend) that over the next few months the company would issue three profit warnings (halving expected profits for the year), stop paying its dividend and admit to a major accounting misstatement, which company would you have expected to perform better: Tesco or Sainsbury? If you’d guessed Sainsbury, you would have been wrong. The chart below shows the performance of both since then: Tesco has fallen by “only” 15%, while Sainsbury has declined 17%. The market may, of course, be supremely efficient, having already discounted Tesco’s problems (Tesco has fallen more over the last 12 months), just as it is now starting to anticipate a recovery. Perhaps.
I warned in August about Tesco’s high debt levels and that it risked losing its investment grade credit rating (see “Aggressive accounting hides financial weakness”). At the interim results, the new management identified “strengthening the balance sheet” as one of their three priorities. As part of its post-Christmas trading update on 8 January, the company has said it will give more details on its future strategy. It is widely expected to announce the disposal of a number of non-core assets, and possibly some or all of its operations in Asia. However, the problem facing Tesco is that its debt is so high and its profits are currently so low that whatever it decides to do, even spinning off its Asian business, will not completely resolve its balance sheet issues and is unlikely to prevent a downgrade in its debt to below investment grade.
In an earlier note, I highlighted the nearly £4bn of off-balance-sheet property bonds that are not fully disclosed in Tesco’s financial statements (see Tesco’s hidden debt). In the earlier note, I discussed in detail how the transactions were structured. In this note, I focus on the relevant accounting issues; in particular, whether the underlying leases were correctly accounted for as operating leases. In my view, it is clear that they should have been treated as finance leases and capitalised on Tesco’s balance sheet, which would increase on-balance-sheet net debt by around £3.5bn to £11bn.
Tesco (ticker: TSCO.L) delivered another shock to investors on 22 September, announcing an estimated £250m overstatement of its first-half profit guidance (for the year to February 2015) “principally due to the accelerated recognition of commercial income and delayed accrual of costs” in its UK food business. Describing the issue as “serious”, the company delayed the announcement of its interim results and appointed Deloitte to conduct an independent review with the help of its external lawyers.
Following the recent announcement by Tesco of accounting issues in its interim results, the FT published an article on its website, Tesco’s off-balance sheet wheeze, courtesy of Goldman Sachs, setting out the main points in my recent post, Tesco’s hidden debt.
The specific irregularities have not yet been revealed, but it was clear from my analysis of Tesco that for a number of years, some of their accounting had been questionable. Therefore, while the precise nature of the issues may not have been predictable, the warning signs were there; as I pointed out in my more detailed research on Tesco, Aggressive Accounting Hides Financial Weakness, this “calls into question the reliability of its profit figures”.