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.
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.
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.