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.
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.
I have just published a detailed research article on Tesco (TSCO), which examines in detail some of the financial issues facing the company. Its high levels of debt, which do not appear to be fully understood by the market, gives it limited financial flexibility. The article is available at Seeking Alpha.
Since 2009, Tesco (ticker: TSCO) has used special purpose vehicles (SPVs) to issue nearly £4bn of property bonds as part of its sale and leaseback programme. Despite Tesco being responsible for repayment of the bonds, they are not included on Tesco’s balance sheet, nor are they disclosed in the notes to its financial statements.
I first wrote about Aurora Investment Trust (ticker: ARR) in June last year; I had initiated a position in the expectation that the trust would soon be wound up, given the continuation vote due at the trust’s 2014 AGM (which will be held on 18 July). Such an outcome seemed to me almost inevitable, in view of the trust’s small size and poor performance, and the trust was trading at a substantial discount to its net asset value. I had expected the trust to go quietly; however, the outcome is not now as clear-cut as I had originally thought. While I still own a significant position in Aurora, in view of the increased uncertainty, I have reduced the size substantially.
I have just published a research article on Wheelock & Co (ticker: 20 HK), which is available at Seeking Alpha.
As part of my due diligence on another potential investment, I recently came across 21 Holdings (ticker: 1003.HK), a Hong Kong-listed holding company with a market cap of only HK$205m. This has proved to be a truly terrible investment over the last few years: a story of repeated, dilutive equity issues, share consolidations and dubious acquisitions: 100,000 shares at the end of 2007 have now been consolidated to a single share. During the last six years, the company has raised over HK$800m through numerous equity issues and spent around HK$600m, on what have proved largely worthless acquisitions.
After recently initiating a position in Hopewell Holdings (ticker: 54 HK), I have also published a detailed research piece on the company on Seeking Alpha – Hopewell Holdings: Value and Growth. If you’re interested, check it out now, as it’s only available to non-paying subscribers for a few weeks.