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.
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.