8 Lessons Indian investors should learn from the Evergrande Debacle

Shenzhen-based Evergrande Group has been making headlines of late for its potential fiasco due to the unsustainable debt position. Many experts are calling it a Lehman Brothers moment of China. Right from falling stock markets to sliding commodity prices—the tremors are being felt across the world markets already.

Experts have debated and speculated a lot about the topic of China’s ghost cities over the last decade. Has the Evergrande episode brought us a step closer to now acknowledging the real threat China’s property market poses to the world economy?

Well, the jury is still out on the potential domino effect of the Evergrade fiasco on the global financial system. Needless to say the too-big-to-fail giant, Evergrande, has served as a clarion call to the global investors.

How big is Evergrande and why is it causing so much upheaval?

Evergrande has a land bank of 231 million square meters spanning across 234 Chinese cities. As on December 31, 2020, Evergrande had 751 unfinished projects. Of these 149 were launched in 2020 alone.

It had total liabilities of more than USD 300 billion as on December 31, 2020, of which USD 111 billion were interest-bearing financial borrowings. Nearly 24% of the borrowings have been US dollar and HK dollar denominated while the rest are in Renminbi. Evergrande has borrowed from 171 domestic banks and 121 other financial institutions.

The trouble starts when millions of homebuyers who have paid Evergrande advances for their unfinished properties neither get their money back nor get their homes.

Furthermore, employees of Evergrande who exercised stock options in the last two years are also staring at huge losses. The group employs more than 1.23 lakh people. Experts are of the view that the revival of Evergrande is a big challenge unless the Chinese government intervenes.

Finances of Evergrande are in bad shape

As per the annual statement for 2020, Evergrande reported a gross profit of RMB 122 billion (~ USD 19 billion). And, the cash flow statement reveals that the company paid interest of RMB 78 billion (~ USD 12 billion) in 2020. Notes to accounts show that Evergrande capitalized the interest cost to the tune of USD 10.7 billion in 2020 which is 35% higher than the USD 7.9 billion in 2019.

The average interest rate on the company’s borrowings increased to 9.49% in December 2020 from 8.99% in December 2019. The total cash and cash equivalent on the books have been ~ USD 28 billion. Despite its tricky financial position, the company paid dividend, albeit paltry, in December 2020.

The potential impact of Evergrande saga on the Chinese economy

According to a paper published by NBER (National Bureau of Economic Research) ~24% of the country’s GDP is affected by the performance of China’s real estate sector. Recently introduced regulatory caps on property loans as a percentage of total outstanding loans of a bank, have been hitting debt-laden borrowers such as Evergrande harder than anticipated.

For now, most of experts agree that Evergrande is China’s domestic problem; however, slowing down of the Chinese economy isn’t good news for the world economy. Commodities and metal prices in particular take cues from Chinese markets.

Is an unsustainable growth agenda responsible for Evergrande’s debacle?

With an aim of tapping high growth opportunities in sunrise sectors, Evergrande diversified into multiple business verticals. They include electric vehicles, healthcare management, food and beverages, amusement parks, and media and entertainment amongst others.

Apparently, Evergrande took out all the stops to grow each of these businesses. For instance, Evergrande Auto simultaneously worked on developing 14 vehicle models. According to the company’s claims, its vehicle models are furnished with aerospace-class smart cockpits.

Evergrande Spring offers 50 products catering to 4 major segments—mineral water, grocery, dairy and fresh food. It aspires to become the number one mineral water and grocery brand of China.

HengTen Networks—a non-wholly-owned subsidiary of Evergrande—is an online streaming media platform and provides personalized ad-free viewing experiences. It acquired Pumpkin Film and Ruyi Films to create high-quality original content. As on February 28, 2021, HengTen had 3.9 crore registered users of which 84lakh were paid subscribers.

You see, the greed and fear phenomenon is not applicable just to institutional and individual investors but even to corporate houses as well.

More than the overheating of the real estate market in China, it seems the questionable capital allocation strategies of the Evergrande Group have dragged it to the brink of bankruptcy.

Can you draw any parallels for Indian markets? If you remember, some well-known real estate companies in India followed the same path back in 2007-08. Real estate giants not only acquired massive land parcels with unsustainable debt but also dabbled in other unrelated capital intensive businesses, such as telecom.

The same goes true for companies operating in other sectors too. Another case in point could be that of a liquor baron splurging on airline businesses and doing acquisitions with borrowed money.

What should we learn from the Evergrande fiasco?

  1. Don’t go by the brand value of any company. It fades quickly when faced with financial difficulties
  2. Track record of the management still remains the most crucial factor to watch out for
  3. Be careful about companies that do unrelated diversifications, that too on a massive scale
  4. Be wary of companies that follow a poor capital allocation strategy
  5. Be careful of companies that accumulate unsustainable debt to fuel high growth
  6. Tread with caution when high-growth companies having large-debt on the books acquire other companies
  7. When stocks fall as much as 80% in a year’s time, they are rarely mispriced. Don’t look for any bargain in them
  8. Last but not the least, when booking a house, pay attention to the developer’s financial condition

 

You may also like to read: Orient Electric: Cool stock to watch out for in a hot market?

Disclaimer: The blog is for information purposes only and anything mentioned herein shouldn’t be construed as a fundamental reason to buy/hold/sell any stock. Furthermore, the information provided in the blog and observations made therefrom shouldn’t be treated as the extension of recommendations made on the other properties of Ventura Securities. We strongly suggest you to consult your financial advisor before taking any decision pertaining to your finances. Asset allocation becomes extremely relevant.

We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:

We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.

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