Description

We believe shares in China Evergrande Group (3333 HK), one of China's largest property developers, represent a timely and compelling short opportunity.  We will keep this fairly brief as we think the crux of the thesis is fairly obvious and the idea is time sensitive and prone to a sudden collapse given a sudden vertical move in the stock price that will likely prove completely unsustainable (a cursory review of the stock chart will likely spark any short seller’s interest...  the stock is up almost 200% this year and ~70% in May alone).  The company’s market capitalization now exceeds $25 billion, with roughly $5 billion in the free float.

Reasons Behind the 200% Stock Surge

We believe several technical factors have come together to result in this remarkable stock price move:

1. Aggressive buyback by the company during April 2017, totaling ~5% of outstanding shares and ~20% of the free float (the company hit its buyback limit per Hong Kong rules so this should no longer be a risk to the short)

2. S&P credit upgrade from CCC+ to B- on May 19th (the stock was up 9% that day)

3. Excitement around a recent capital raise that appears to be misconstrued by the market (more on this below)

4. A Morgan Stanley initiation report with a HKD 12.00 price target on May 24th (the stock was up over 17% that day) (more on this below)

The Crux of the Short Case 

Even as China bears warn of impending doom in the China property market, Evergrande is trading at 4x tangible book and 33x 2016 earnings (which included a bunch of one-time gains).

Fundamentally, Evergrande has a lot of issues:

1. Evergrande is extraordinarily levered:  31x assets to equity vs peers at 3x to 8x.

2. The company hasn't generated positive operating cash flow since 2009 and leverage has continued to march higher and higher every year.

3. 50% of cumulative net income over the past five years has come from revaluation gains on the company's extensive investment property portfolio, along with a smaller amount of other one-time gains
1. While allowed under IFRS, we think these mark-to-market gains are dubious given the limited rental income and NOI being generated by the investment portfolio
2. At year-end 2016, Evergrande reported RMB 132 billion in investment property asset value (with RMB 5.1 billion in fair value gains recorded in the year), representing 3.1x the entire company's tangible book value
3. However, these properties generated just RMB 647 million in total rental income last year and RMB 517 million in net operating income
4. Even excluding investment properties still under construction, Evergrande is carrying these investment properties at an implied cap rate of just 60 basis points!

4. The Company’s insurance subsidiary, Evergrande life Insurance, has been banned from making investments in the stock market for one year due to the "vicious social impact" of its short-term trading (according to the regulator)
1. The regulator also banned 2 executives from the insurance industry for up to 5 years

Excitement Around Recent Capital Raise

Bulls are also excited about the company’s attempt to list most of its real estate assets on the A-shares market.  In advance of that potential listing, Evergrande has raised RMB 30 billion from local investors at a headline implied equity value to Evergrande of ~HKD 15.50 per share (slightly above the current share price).  Some analysts highlight this as a benchmark for Evergrande's H-shares listing, but we think that is extremely flawed. 

1.       It is unclear how much debt is staying with Evergrande and therefore it is hard to know the real valuation implications for Evergrande’s stock.  To highlight the potential issues in comparing these valuations, Evergrande has disclosed that the entity where it raised the capital (Hengda), generated net profit after tax of RMB 18.3bn in 2014 and RMB 21.3bn in 2015.  Curiously, these net profit figures for the entity to be listed in the A-shares market totaled 170% of the fully consolidated net profits reported by Evergrande in Hong Kong. 

2.       In addition, as part of the fundraising, Evergrande provides a profit guarantee to these investors over the next three years along with a 60% dividend payout on that guaranteed profit number. 

3.       Given these factors, we believe this capital raise can't reasonably be used as a valuation benchmark for Evergrande overall.  And that is assuming the regulator approves Evergrande's A-share listing -- if it does not, Evergrande has to repurchase the recently issued shares.

Morgan Stanley Initiation Report Key Flaws

We will pick apart Morgan Stanley's recent initiation report to highlight the absurdity of the current situation (this report helped really get the share price moving over the past week).  Their price target of HKD 12.00 per share (which is actually now below the current price) is based on an extremely flawed NAV methodology. 

Just to highlight a few of the most egregious errors:

1.      Their NAV analysis does not subtract the company's perpetual preferreds as debt in calculating the equity value of Evergrande's stock

a.       Deducting the December 31^st balance of RMB 113.0 billion alone would result in a reduction in their target price of at least 50%.

2.      MS adds back the company's restricted cash in its NAV analysis, but Evergrande's annual report highlights that this restricted cash is mostly for deposits for construction projects or land acquisitions and therefore not free cash available to equity holders.

3.      Further, they do not make any adjustment for deducting advance payments from customers as a debt-like obligation of the company, which amounted to RMB 195.0 billion at December 31^st:

a.       Morgan Stanley's land reserve DCF is flawed as the company will not receive 100% of the selling price as they model it due to significant past down payments that have already been received.

b.      Correcting this mistake alone would leave the property development business with negative equity value based on their methodology.

Separately, we would note that Morgan Stanley's NAV analysis actually applies a reasonable value to Evergrande's investment properties of RMB 9.5 billion based on the actual net operating income generated by the properties.

1. However, if this valuation is correct, it represents a 92.8% discount to the company's carrying value of RMB 132.0 billion, highlighting the Company’s ridiculous valuation methodologies.

2. If MS is right, the company's fair value tangible book value would be negative RMB 79.9 billion, implying that Evergrande is insolvent.

3. Further, it would imply that all of the company's historical fair value adjustments taken as income through their income statement have been erroneous and would call into question the credibility of the company's entire accounting function.

Put Option on a Potential Chinese Property Bubble

Evergrande represents a put option on what could very well be a Chinese property bubble.  While a full discussion of the excesses in the Chinese property market are beyond the scope of this write-up, government officials have begun tightening policy and trying to cool property prices (after a strong first quarter of residential sales, there have already been indications of sequential weakness in April and May).  In addition, there has been a general tightening of liquidity in China’s financial markets, with wealth management product issuance no longer growing (these have fueled a lot of asset purchases in China) as well as stresses in the interbank lending market.  While it is hard to know when or if things might take a more significant turn down, it is not unreasonable to think that a modest hiccup in China’s property market could render Evergrande’s highly levered common stock worthless.

Catalyst

• End of the technical factors driving the price higher

• Any weakness in the China Property Market

• Sanity prevailing