Evergrande Real Estate Group insolvent with fraudulent accounting and severe liquidity issues
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Section 1 of the report describes Evergrande's fraudulent accounting schemes that mask its insolvent balance sheet. While Evergrande reports RMB 35 billion in equity, the report identifies six cases of accounting misstatement where assets are overstated or liabilities understated. Adjusting for these misstatements, the report estimates Evergrande's actual pro forma equity is negative RMB 36 billion, indicating insolvency. Other analysts have also identified potential fraud at Evergrande, including China's Ministry of Finance.
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Evergrande Real Estate Group insolvent with fraudulent accounting and severe liquidity issues
- 1. Evergrande Real Estate Group (Stock code: 3333.HK) 1
- 2. Table of Contents • ExecuBve Summary Page 3 • SecBon 1: Fraudulent AccounBng Masks Insolvent Balance Sheet Page 13 • SecBon 2: Bribes, Illegally Procured Land Rights and Severe Idle Land LiabiliBes Page 27 • SecBon 3: Crisis Page 39 • SecBon 4: Chairman Hui Page 47 • SecBon 5: Pet Projects Page 52 • Appendix: Recent development Page 57 2
- 3. ExecuBve Summary 3
- 4. Evergrande ValuaBon Evergrande has a market capitalizaBon of US$ 8.9bn and trades at 1.6x book value. By market capitalizaBon, Evergrande ranks among the top 5 listed Chinese properBes companies. [1] [2] RMB, HKD and USD in billions, except as noted 6/15/2012 in RMB in HKD in USD Share Price 3.80 4.60 0.59 Total Shares Outstanding 14.9 Market Capitalization 56.7 68.7 8.9 + Current Borrowing 10.2 + Non-Current Borrowing 41.5 + Income Tax Liability 11.6 + Cash Advance from Customers 31.6 Subtotal: Debt 95.0 115.0 14.8 - Unrestricted cash (20.1) (24.3) (3.1) Net debt 74.9 90.7 11.7 Enterprise value 131.6 159.4 20.6 Book Value as of 12/31/2011 34.9 Ratio of Equity Market Capitalization to Book Value 1.6x Note: Assuming RMB /USD exchange rate of 6.4 and HKD/ USD exchange rate of 7.75 1] As of June 15, 2012, Evergrande ranked 5th in market capitalizaBon behind China Overseas (668 HK), Vanke (000002 SZ), Poly Real Estate (6000048 SH) and China Resources Land (1109 HK) 2] Balance sheet data as of December 31, 2011 4
- 5. PercepBon • Evergrande, which primarily operates in 2nd and 3rd Ber ciBes, has grown its assets 23 fold since 2006, becoming the largest condo/ home developer in China. – To put Evergrande’s asset growth into perspecBve, Evergrande has grown its assets 5x faster than its Chinese peers. Index of Asset Growth 2,500 2,000 Evergrande China Overseas & land 1,500 Shimao Agile 1,000 Country Garden CR Land 500 - 2006 2007 2008 2009 2010 2011 • Evergrande describes its over-‐sized, cheaply acquired land inventory as a primary compeBBve advantage. Because of its scale, the Company claims that it has been able to achieve a level of centralizaBon and standardizaBon that allows for unmatched cost control and industry leading asset turnover. • As liquidity has Bghtened in the Chinese real estate sector, Evergrande assures investors that it is well capitalized and highly liquid. 5
- 6. Reality • Our analysis and primary research reveal that: 1] Evergrande is insolvent; and 2] Evergrande will be severely challenged from a liquidity perspecBve. • The Company’s management has applied at least 6 accounBng shenanigans to mask Evergrande’s insolvency. Our research indicates that a total write-‐down of RMB 71bn is required and Evergrande’s pro forma equity is nega6ve 36bn. • Over the past 5 years, Evergrande has executed an untoward program of bribes aimed at local government officials in order to build its raw land industry. To finance growing cash flow shorkalls related to these bribes, subsequent land purchases, and related real estate construcBon acBviBes, Evergrande has employed a complex web of Ponzi-‐style financing schemes. These schemes are characterized by a reliance upon perpetually growing pre-‐sales, off-‐balance sheet partnerships and IRR guarantees to third parBes. • Evergrande’s business model is unsustainable, and is showing signs of severe stress. Management is working hard to cover-‐up the company’s precarious and rapidly deterioraBng financial condiBon. However, with presales and condo prices now falling rapidly, with its income statement and assets materially overstated, and with its off-‐balance sheet guarantees looming as more and more imminent liabiliBes, our analysis suggests that the cover-‐up has entered its final inning. • Meanwhile, the Company’s management team has consistently displayed gross lapses of judgment. Ranging from “mail order” advanced degrees, to the diversion of more than US$2.5 billion of company resources to fund frighteningly off-‐strategy pet endeavors, the evidence of management misconduct at Evergrande is shocking. 6
- 7. SecBon 1 describes Evergrande’s fraudulent account schemes. These schemes enable Evergrande to mask its insolvent balance sheet. Evergrande reports RMB 35bn of equity. We have idenBfied six cases of accounBng misstatement, where Evergrande is either overstaBng assets or understaBng liabiliBes. AdjusBng for these misstatements, Evergrande’s pro forma equity is nega6ve RMB 36bn. We are not the only analysts who have idenBfied fraud at Evergrande: On October 10, 2011, China’s Ministry of Finance announced that it would be fining Evergrande for repor6ng inaccurate financial statements. FRAUDULENT ACCOUNTING #1: RMB 23bn balance sheet adjustment related to liability associated with off-‐balance sheet debt (page 15-‐17) FRAUDULENT ACCOUNTING #2: RMB 17bn deducBon from assets and equity due to overstated cash balance (page 18-‐19) FRAUDULENT ACCOUNTING #3: RMB 12bn write-‐down related to overstatement of value of Chairman’s pet projects (page 20) FRAUDULENT ACCOUNTING #4: RMB 10bn write-‐down related to overstatement of value of Evergrande’s investment property porkolio (page 21-‐23) FRAUDULENT ACCOUNTING #5: RMB 6bn write-‐down related to underreporBng of land costs (page 24) FRAUDULENT ACCOUNTING #6: RMB 3bn deducBon from assets and equity due to write-‐down of other segment receivables (page 25) Fraudulent accounting adjustments 1 2 3 4 5 6 Adjustment to reflect in RMB bn 12/31/2011 as reported Adjustment to reflect Adjustment to exclude off-balance debt fake-cash Write-down on pet Write-down on underreporting of land projects investment properties costs Write-down of other segment receivables Total balance sheet Pro forma 12/31/2011 shenanigans balance sheet Assets Cash Restricted cash 8 - - - - - - - 8 Cash and cash equivalents 20 - (17) - - - - (17) 4 Subtotal 28 - (17) - - - - (17) (5) Property Properties under development sale Completed properties held for 91 8 - - - - - - - - - (6) - - - (6) 85 8 Investment properties Subtotal 10 110 - - - - - - (10) (10) - (6) - - (10) (16) (0) 77 Other assets 41 - - (12) - - (3) (15) 26 Total assets 179 - (17) (12) (10) (6) (3) (48) 131 Debt+ liabilities Debt Borrowings 52 23 - - - - - 23 75 Customer deposits 32 - - - - - - - 32 Tax liabilities 12 - - - - - - - 12 Subtotal 95 23 - - - - - 23 118 Other liabilities 49 - - - - - - - 49 Total liabilities 144 23 - - - - - 23 167 Equity 35 (23) (17) (12) (10) (6) (3) (71) (36) Total liabilities + equity 179 - (17) (12) (10) (6) (3) (48) 131 Source: Evergrande filings, Citron research Note: Evergrande reported 35bn of equity including minority interests. For simplificaBon purposes, adjustments are made on a pre-‐tax basis. Corporate income taxes in China are usually 25%. Adjustment #2 related to fake cash assumes that cash balance and equity are overstated by RMB 17bn; an alternaBve might be to assume that liabiliBes (rather than equity) are overstated by RMB 17bn 7
- 8. SecBon 2 describes large risks to Evergrande’s inventory of raw land which stem from the Company’s use of bribes to procure discounted land and its disregard for idle land laws in China. Evergrande acquired its vast land inventory at a deep discount to prevailing market prices by paying bribes to local officials. Evergrande’s bribing schemes are coming to light, and precedent indicates that the central government will force Evergrande to return illegally obtained land. In addiBon, the central government is beginning to enforce idle land laws. Evergrande risks huge fines and the loss of the vast majority of its land inventory if the government conBnues to enforce these laws. • The hyper-‐growth of Evergrande’s raw land inventory in comparison with its stated business plan and with its peer group is a red flag. • The fact that Evergrande has procured its vast raw land inventory at a 67% discount to its peer group is a further red flag. • The notes to Evergrande’s 2010 financials suggest that Evergrande has paid large bribes to local officials in order to acquire land at below-‐market prices. • We present five case studies in which Chinese peers and central government have begun to shine light on Evergrande’s untoward land acquisiBon acBviBes. • In addiBon to Evergrande’s untoward land acquisiBon acBviBes, Evergrande is in gross violaBon of China’s idle use laws. If the government enforces these laws, Evergrande can not survive. 8
- 9. SecBon 3 outlines signs of a mushrooming financial and operaBonal crisis at Evergrande. We have idenBfied 7 red flags that point to severe financial and operaBonal stress at Evergrande. • Crisis red-‐flags: – #1: CollecBon of cash deposits has flat-‐lined despite conBnued rapid growth in reported contracted sales – #2: Debt exploding – #3: Desperately resorBng to senior secured trust financing at an interest rate of 25% – #4: Biggest decline of YTD pre-‐sales among 11 major Chinese property developers listed in HK – #5: Embarking on highly unatracBve projects in order to raise pre-‐sale cash – #6: Heavy discounBng and social unrest at Danyang project – #7: Reports in local Chinese press of large scale corporate restructuring and desperate delays in vendor payments 9
- 10. SecBon 4 describes Chairman Hui’s bogus resume and [sketchy] financial background. Chairman Hui has bogus credenBals. Moreover, he has financed Evergrande uBlizing a maze of Ponzi-‐esque debt and under-‐the-‐table-‐asset swaps. • While Evergrande prominently touts the academic achievement atained by its management team, Chairman Hui secured his Doctorate from what is essenBally a mail order program at the University of West Alabama. • A Bmeline of Hui’s corporate finance tenure at Evergrande shows a consistently recurring patern of raising new debt backed by large personal guarantees in order to pay off old debt backed by slightly smaller personal guarantees. • An examinaBon of HK real estate record provides convincing evidence of the fact that Hui uBlized under-‐ the-‐table asset swaps with at least one HK billionaire to manipulate Evergrande’s IPO price. 10
- 11. SecBon 5 describes the bizarre pet projects that Chairman Hui has compelled Evergrande to pursue. Chairman Hui’s pet projects are comically off-‐strategy and frighteningly expensive for Evergrande’s shareholders. As of December 31, 2011, Chairman Hui has directed at least RMB 16bn (US$2.5bn) to support these bizarre, unprofitable ventures. • Chairman Hui has directed Evergrande to invest heavily in professional sports teams: – Men’s professional soccer: Evergrande spends more than RMB 488mm (US$76mm) per year on the payroll for its soccer team. Evergrande’s budget is 7x the league average – Women’s professional volleyball: Expenditures are unreported • Chairman Hui has compelled Evergrande to invest at least RMB 700mm (US$ 110mm) to build the largest soccer academy in the world. • Chairman Hui has compelled Evergrande to enter various verBcals in the entertainment space. – Evergrande AnimaBon ProducBon Company – Evergrande Film and TV Company – Evergrande ArBsts Agency – Evergrande Record Company – Evergrande Cinema Line Company 11
- 12. The endgame is nearing for Evergrande. We project that Evergrande will face a severe liquidity crisis in 2012. Auer burning RMB 14bn of cash in 2011, Evergrande is on pace to burn RMB 52bn of cash in 2012. With RMB 12bn of “real” cash on hand, we conclude that Evergrande faces an imminent liquidity crisis. in RMB bn Analysis of Evergrande 2012 cashflow cap FY 2012 Estimated 2012 cash outflows Source a Commitments for land expenditure 21.1 page 141, 2011 annual report, note 35 b Commitments for property development 58.4 page 141, 2011 annual report, note 35 c=a+b Subtotal 79.5 d Estimated interest expense 4.8 Citron estimate e Income tax payables 8.8 page 129, 2011 annual report, note 20 f Selling expenses 2.7 Assumes 2012 selling expenses equal to 2011 selling expenses g Administrative expenses 2.2 Assumes 2012 admin expenses equal to 2011 selling expenses h Income tax expenses 8.6 Assumes 2012 income tax expenses equal to 2011 income tax expenses i Working capital - Not available j Other - Not available k = sum(c:j) Subtotal 106.5 Estimated 2012 cash inflows l 2012 YTD contracted sales 16.5 Sum of Jan to April 2012 reported contracted sales m=l×3 Estimated 2012 contract sales 49.4 Assumes annualized trailing four months contracted sales will equal 2012 contracted sales n % Cash collection rate on contracted sales 83% Assumes 2-month delay b/c contract signing & payment. Assumes Evergrande collects cash on sum of Jan-Oct 2012 contracted sales o=m×n Estimated cash collected on 2012 contracted sales 41.1 p 2011 reported contract sales 80.4 Evergrande reported RMB 80.4bn in contracted sales during 2011 n % cash collection rate on contracted sales 83% Assumes 2-month delay b/c contract signing & payment. Assumes Evergrande collects cash on sum of Jan Oct 2011 contracted sales q=p×n Cash collected in 2011 67.0 Cash collected in 2012 on Jan - Oct 2011 contracted sales r=p-q Estimated cash to be collected in 2012 13.4 Cash collected in 2012 on Nov - Dec 2011 contracted sales s Total cash inflows 54.5 Cashflow gap assuming cash is real s Estimated 2012 cash inflows 54.5 k Estimated 2012 cash outflows 106.5 t = s- k Estimated 2012 net cash (outflows) inflows (51.9) u "Real"cash on hand 11.9 Calculated on page 19 v=t+u Cashflow gap (40.0) 1] 2011 cash burn of RMB 14bn refers to Evergrande’s 2011 combined cash used in operaBons and investment acBviBes per Evergrande’s 2011 filings Note: Even assuming Evergrande’s reported total cash balance of RMB 28.2bn at 12/31/2011, Evergrande would sBll have a funding gap in 2012 equal to RMB 23.7bn. Note that RMB 8.1bn of Evergrande’s RMB 28.2bn of cash is restricted cash. Restricted cash is generally unavailable for working capital purposes 12
- 13. SecBon 1: Fraudulent AccounBng Masks Insolvent Balance Sheet Evergrande reports RMB 35bn of equity as of December 31, 2011. We have idenBfied seven cases of accounBng misstatement, where Evergrande is either overstaBng assets or understaBng liabiliBes. AdjusBng for these misstatements, Evergrande’s pro forma equity is nega6ve RMB 36bn. We are not the only analysts who have idenBfied fraud at Evergrande: On October 10, 2011, China’s Ministry of Finance announced that it would be fining Evergrande for reporBng inaccurate financial statements. 13
- 14. Evergrande’s has generated cumulaBve operaBng cash flow before Capex of nega6ve 28bn since 2006. The Company’s growth strategy relies heavily on ever-‐increasing access to debt funding. Evergrande’s financial statements portray an image of prosperity, profitability and stability in order to maintain access to funding from capital markets and banks. Index of Evergrande's Assets and Debt Cum ulative operating cash inflow (outflow ) 10 .0 2006 Levels = 100 -‐ 2 .2 2,500 ( 1. 7 ) 2006 2007 2008 2009 2 0 10 2 0 11 ( 7.5) ( 1. 7 ) 2,000 (10 .0 ) ( 5.2 ) ( 9 .2 ) 1,500 ( 14 . 4 ) ( 11. 7 ) (2 0 .0 ) ( 12 . 2 ) 1,000 ( 2 3 .9 ) ( 3 .7) (3 0 .0 ) ( 2 7.7) 500 (4 0 .0 ) - 2006 2007 2008 2009 2010 2011 C as h inflow(outflow) f or t he p eriod (50 .0 ) C umul a t i v e o p e r a t i ng c a s h i nf l o w ( o ut f l o w ) hi g hl i g ht e d i n y e l l o w Assets Debt Note: Index of debt includes long-‐term borrowings, short-‐term borrowing, customer deposits, deferred tax liabiliBes and current income tax liabiliBes. Data per Evergrande filings. 14
- 15. FRADULENT ACCOUNTING #1: Evergrande’s use of off-‐balance sheet vehicles is as astounding. Evergrande uses JV equity partners to finance individual projects. The JV partnerships are structured with mandatory buyback guarantees. Therefore, Evergrande’s “equity JV partners” are lenders in reality. The JV scheme allows Evergrande to grossly underreport its debt. At large IRR to the off-‐balance sheet investors, these partnerships are quite similar to the ones that Enron infamously employed. • In its January 2010 13% senior notes prospectus, Evergrande disclosed it was required to repurchase interests in 12 JV deals. In one of these mandatory JV buybacks, Evergrande stated that it was required to “repurchased a 49% equity interest” in Hunan Xiongzhen Investment Co., Ltd (湖南雄震投資有限公司). [1] • Yanglee Use-‐Trust, the registry of Chinese trust products, has informaBon about a trust called ”China Financial, Evergrande Palace Real Estate Development Project Investment JV Trust Plan” (中融·∙恒大华府房地产项目投资集合资金信托计划). [2] Translated in English, the trust descripBon indicates that Evergrande hired China Financial Trust to raise capital to purchase a 49% equity in Hunan Xiongzhen Investment Co. Further, the descripBon indicates that trust holders were offered a guaranteed return and the right to Evergrande’s 51% stake, posted as collateral in the event of non-‐payment. • Evergrande’s characterizaBon of the JV buyback as equity is preposterous. Evergrande’s buyback of its JV partner’s “equity stake” in Hunan Xiongzhen is clearly the repayment of a trust loan. Evergrande’s has intenBonally and systemaBcally hidden its trust loans from investors in order to understate debt. Evergrande’s 2010 annual report makes no menBon of trust financing. In 2011 annual report, the only menBon of trust financing was added to a VP’s responsibiliBes. [3] 13% Senior notes prospectus dated January 2010 2011 Annual report dated April 2012 1] page 100, Evergrande 13% Senior Notes Prospectus dated January 2010 2] htp://www.yanglee.com/Shop.aspx?ItemID=282 3] page 201 of 13% senior notes prospectus and page 41 of Evergrande 2011 annual report 15
- 16. FRADULENT ACCOUNTING #1 (conBnued): Evergrande exploits off-‐balance sheet financing as a standard business pracBce. During 2010, Evergrande disclosed RMB 3.9bn in guarantees related to consolidated JV deals, RMB 1.7bn of guarantees related to unconsolidated JV deals and an addiBonal RMB 11.7bn in commitments for unpaid land expenditure. In early 2010, we esBmate that Evergrande underreported its debt related to various JV deals equal to RMB 17bn.[1] • In its January 2010 13% senior notes prospectus, Evergrande admited that it had made more than RMB 3.9bn guarantees against its minority interest and RMB 1.7bn in guarantees to unconsolidated JV partnerships. Evergrande’s off-‐balance sheet guarantees related its minority interests were 16x its reported minority interested of RMB 245mm at June 30, 2009. [2] • Evergrande’s January 2010 senior notes prospectus outlines off-‐balance sheet commitments (aka debt) of RMB 11.6bn for contracted, unpaid land expenditure. The prospectus provides no specifics as to what these commitments could represent. We believe these contractual obligaBons represent debt related to addiBonal unconsolidated off-‐balance sheet JV partnerships that Evergrande employs to underreport its debt. [3] • The company no longer discloses any details about its unconsolidated JV's. Source: page 208, 13% senior notes prospectus dated January 2010 1] Assumes no overlap between RMB 3.9bn in guarantees related to minority interests buybacks, RMB 1.7bn guarantees related to unconsolidated JV buybacks and RMB 11.6 bn in guarantees related land purchases 2] page 208, Evergrande’s 13% Senior Notes Prospectus dated January 2010 3] page F-‐81, Evergrande’s 13% Senior Notes Prospectus dated January 2010 16
- 17. FRADULENT ACCOUNTING #1 (conBnued): Today, Evergrande’s off-‐balance sheet debt related to JV buybacks and unpaid land deals exceeds RMB 23bn and possibly as much as RMB 56bn. Evergrande’s off-‐balance sheet shenanigans conBnues. Evergrande no long discloses guarantee associates with JV buyback guarantees. A review of Evergrande’s 2011 annual report reveals that Evergrande is hiding at least RMB 23bn in off-‐balance sheet debt: reported minority interests were RMB 1.8bn and unpaid land expenditures were RMB 21bn at December 31, 2011. [1] in US$bn Low case Base case High case Debt related to contracted but unpaid land deals $ 21.1 $ 21.1 $ 21.1 Debt related to buyback of minority interests $ 2.2 $ 8.1 $ 34.7 Estimated Evergrande's total off-balance sheet debt $ 23.2 $ 29.1 $ 55.8 • We esBmate that Evergrande is currently exposed to a minimum of RMB 23bn of off-‐sheet balance sheet debt related to interest buybacks – Debt related to contracted, unpaid land deals: In its 2011 annual report, Evergrande disclosed RMB 21bn of commitments related to contracted but unpaid land at December 31, 2011 – Debt related to buyback of minority interests: • Low case: Evergrande reports minority interest of RMB 2.2bn. The Company no longer reports the level of guarantee associated with these minority interests as we presented on page 16. However, we believe that Evergrande has conBnued to enBce JV partner with escalaBng guarantees. • Base case: If we assume that Evergrande guarantees its minority interest a 5-‐year 30% IRR, we esBmate that the off-‐balance sheet debt amounts to RMB 8.1bn • High case: If we apply Evergrande’s historical deals as a guide and apply a 16x mulBple to its reported minority interest, we esBmate that Evergrande now has off-‐balance sheet debt totally RMB 34.7bn 1] page 141, Evergrande’s 2011 annual report 17
- 18. FRADULENT ACCOUNTING #2: Evergrande’s reported cash balances are bogus. Evergrande’s peers earn yields on their cash within the relevant band of deposit rates set by the People’s Bank of China (PBOC), between the PBOC demand deposit rate and the PBOC 3-‐month deposit interest rate. In comparison, Evergrande’s calculated yields on its average cash balance have been below PBOC mandated rates since beginning of 2010. Evergrande’s reported cash balances are either fake or temporary window dressing. Annualized interest income as % of average cash balance 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 1H 2010 2H 2010 1H 2011 2H 2011 Evergrande Country Garden Shimao CR Land Agile PBOC demand deposit interest rate PBOC 3-month time deposit interest rate Source: annualized interest income as % of average cash balance based on public filings. PBOC interest rate data per PBOC website and reflects Bme –weighBng to account for changes in PBOC interest rates 18
- 19. FRADULENT ACCOUNTING #2 (conBnued): Evergrande’s paltry yield on reported cash suggest that Evergrande is overstaBng its cash balance by RMB 17bn (more than 200%). For six months ended December 31, 2011, Evergrande reported average cash balance of RMB 28.4bn. Applying a blend of comparable company cash yields, we calculate that Evergrande’s actual cash balance is as low as 11.9bn. RelaBve to trailing cash used in operaBon and invesBng acBviBes in 2011 of RMB 14bn, Evergrande’s cash posiBon is dangerously low. Benchmark of annualized yield on cash balance 1H 2010 2H 2010 1H 2011 2H 2011 Evergrande 0.33% 0.26% 0.33% 0.45% Country Garden 1.03% 0.58% 0.84% 0.90% Shimao 0.65% 0.67% 0.93% 0.60% CR Land 0.73% 1.46% 1.02% 1.14% Agile 0.86% 1.16% 1.67% 1.62% Average of peers 0.82% 0.97% 1.12% 1.07% Estimate of Evergrande's real cash balance assuming peers' cash yield 1H 2011 2H 2011 Evergrande interest income (RMB mm) 79.6 126.7 EsBmate of Average of peers' cash yield 1.12% 1.07% Evergrande’s real Implied Evergrande average cash balance (RMB bn) 7.1 11.9 cash balance Evergrande reported cash balances 1H 2011 2H 2011 Beginning of period (RMB bn) 20.0 28.7 Ending of period (RMB bn) 28.7 28.2 Overstatement of Average reported cash balance (RMB bn) 24.3 28.4 cash balance by RMB 16.6bn Delta between average reported cash and avg. "Real" cash (RMB bn) 17.2 16.6 1] yield on cash balance is calculated by annualizing reported interest income divided by average cash balance for the period. Average cash balance is the simple mathemaBcal average of beginning of period and end of period reported cash balances including cash and cash equivalents and restricted cash. 19
- 20. FRADULENT ACCOUNTING #3: Evergrande grossly overstates the value of Mr. Hui’s Pet pet projects. We esBmate that a RMB 12bn write-‐down is required. Mr. Hui’s pet projects generate paltry revenues and lose money. If Evergrande were to mark these assets to realized based on reasonable valuaBon methodology, a RMB 12bn write down would be required. • Hui’s pet projects comprise Evergrande’s “other” businesses. On December 31, 2011, Evergrande’s investment in its other businesses equaled RMB 16.2bn. In 2011, Hui’s pet projects generated revenue of RMB 897mm and operaBng loss of RMB 252mm [1] • Even under absurdly generous assumpBons, the value of Mr. Hui’s pet projects are wildly overstated on Evergrande’s balance sheet; a RMB 10bn write down is required. – Method #1 (EBTIDA): Assuming Evergrande’s other businesses had an absurdly high EBITDA margin of 50%, implied is that the other businesses would generate RMB 435mm. Assuming a 10x EBITDA mulBple, the other businesses are worth RMB 2.0bn. Using EBITDA mulBple methodology, Evergrande’s other assets are overstated by RMB 11.9bn – Method #2 (Revenue): Assuming Evergrande’s businesses traded at an absurdly high revenue mulBples 5x, Evergrande’s other businesses would be valued at RMB 4.5bn (RMB 897mm mulBplied by 5 Bmes). Using this revenue mulBple methodology, Evergrande’s other assets are valued overstated by RMB 11.8bn 1] 1] page 106, Evergrande 2011 annual report 20
- 21. FRADULENT ACCOUNTING #4: Evergrande’s investment property porkolio is overstated by at least RMB 10bn, equal to one-‐third of its book value. We triangulate on the amount of overstatement of Evergrande’s investment porkolio by using two separate methods: 1] market valuaBon method (outlined on page 21) and 2] balance sheet method (outlined on page 22 and 23. Both methods support that Evergrande’s investment property porkolio requires at least a RMB 10bn write-‐down. Evergrande earns less than <1.0% gross rental yield on its investment porkolio, which suggests that Evergrande’s “market” appraisal of its investment property is wildly overstated. Assuming a 2% gross rental yield would imply that Evergrande’s investment property is worth 4.2bn, 71% less than its stated value. In other words, Evergrande’s investment porkolio properBes are overstated by at least RMB 10bn. Valuation estimate of Evergrande's investment property in RMB mm 2009 2010 2011 Rental yields on Evergrande's investment property N Reported gross rental income 37.6 51.2 83.9 Value of investment portfolio per balance sheet Beginning balance 1,741 3,131 10,117 Ending balance 3,131 10,117 18,919 O Average value 2,436 6,624 14,518 P = N/O Implied gross rental yield 1.54% 0.77% 0.58% Implied avg. market values of Evergrande's investment property assuming: Q = N / 0.02 @2% gross rental yield [1] 1,880 2,559 4,196 R = Q / O -1 % discount vs. reported book value of investment property -23% -61% -71% A RMB 10bn write Write-down of investment property value required down is required S=O-Q @2% gross rental yield 556 4,065 10,322 assuming 2% annual K Reported book value of shareholders' equity 12,861 20,635 32,687 gross rental yield T=S/K Investment portfolio write down as % of book value 4% 20% 32% Source: company filings Note: HKFRS accounBng standards allow Evergrande to mark its assets to “market”. Note that Evergrande has received massive income instatement benefits by marking its “investment” properBes to fantasy values and then passing those gains through its P&L. Since January 2006, Evergrande has recognized RMB 9.5bn on of phantom accounBng profits on its income statement by marking up its “investment” porkolio. 1] During 2011, CR Land, Shimao generated annual gross rental yields on commercial properBes of 7.1% and 2.7% respecBvely. ConservaBvely, the analysis above assumes a 2% annual gross rental yield. 21
- 22. FRADULENT ACCOUNTING #4 (conBnued):Despite low yielding, the investment property has been marked up significantly since 2006, creaBng RMB 9.5bn phantom accounBng profits on its income statement and RMB 9.5bn phantom book value. To date, Evergrande has recorded RMB 9.5bn of mark-‐to-‐market on its investment property, represenBng 29% of Evergrande’s reported shareholders’ equity as of December 31, 2011. Evergrande simply says that it had an appraiser using a combina6on of valua6on methods to determine the value of the porOolio and no specific details are disclosed regarding how these gains were achieved. Mark-to-market gains on investment property in RMB bn 2008 2009 2010 2011 Balance sheet value of investment property Cumulative cost basis of investment property 0.7 1.3 4.9 9.5 Cumulative mark to market gains on investment property 1.0 1.9 5.2 9.5 Total balance sheet value of investment property 1.7 3.1 10.1 18.9 Cumulative mark to market gains on investment property 1.0 1.9 5.2 9.5 Book value of shareholders' equity at year end 8.3 12.9 20.6 32.7 % of book value of shareholders' equity 13% 15% 25% 29% Mark to market gain during the year 0.1 0.8 3.4 4.2 Reported operating profits 0.8 1.3 13.8 19.9 % of reported operating profits 9% 67% 24% 21% Note cumulative mark to market gains started from 2006 Source: company filings No details were disclosed regarding how those mark-‐to-‐market gains were achieved Page 113, 2011 annual report 22
- 23. FRADULENT ACCOUNTING #4 (conBnued): Our analysis also reveals that Evergrande underreported its development cost of RMB 4bn by capitalizing costs onto its balance sheet as investment property. Our analysis indicates that Evergrande is understaBng the development costs for its property business by capitalizing costs onto its balance sheet as investment property. We esBmate that Evergrande’s investment properBes have a balance sheet cost basis of RMB 7,335 per square meter. In contrast, we esBmate that Evergrande’s development cost for non-‐investment property is RMB 4,260 per square meter. This disparity is highly unlikely. We conclude that Evergrande is allocaBng development costs related to unsold parking spaces of its residenBal projects to its balance sheet and classifying them as investment properBes. In doing so, Evergrande is arBficially inflaBng its balance sheet assets to the tune of RMB 4bn. Underreporting developing costs in RMB bn, unless indicated otherwise 2009 2010 2011 Evergrande's investment property portfolio A Cumulative cost basis of investment property 1.3 4.9 9.5 B Commercial property (in square meters) 95,180 347,141 490,756 C # of parking spaces 10,352 34,242 79,818 D Estimated square meters per parking space [1] 10 10 10 E=C×D Total parking space (in square meters) 103,520 342,420 798,180 F=B+E Total investment property (in square meters) 198,700 689,561 1,288,936 Impact of under-reporting of development costs G = A / F * 1bn Implied cost per sqm for investment property (in RMB) 6,309 7,089 7,335 H Revenue delivered per square meter (RMB per sqm) 5,724 5,572 6,385 I Reported gross margin [2] 34.0% 29.2% 33.3% J = H × (1 - I ) Estimated of delivered cost per sqm for residential projects (in RMB) 3,777 3,946 4,260 K= G- J Cost difference between investment property and residential property ( in RMB) 2,532 3,144 3,075 F Total square meters of investment portfolio 198,700 689,561 1,288,936 J = K × F / 1bn Underreporting of development cost 0.5 2.2 4.0 % of book value of shareholders' equity 4% 11% 12% 1] Assumes 10 square meter per parking space 2] Applies blended gross margin 23
- 24. FRADULENT ACCOUNTING #5: Evergrande is underreporBng the cost of land by capitalizing land expenses onto its balance sheet. We esBmate a RMB 6bn write down is required. Using Evergrande’s reported land reserve data, one can calculate how much land expenses Evergrande is expensing during a given period. In 1H 2011, Evergrande’s land cost data suggested nega6ve RMB 115 per square meter vs. esBmated land cost of RMB 520 per square meter, which implies understatement of RMB 635 per square meter. Evergrande delivered 10mm square meters during 1H 2011. Therefore we esBmate that Evergrande underreported land expenses by RMB 6bn. Evergrande's underreporting of cost of land reserve 1H 2010 2H 2010 1H 2011 2010 Formula Land reserve ( in millions of square meters ) A Beginning (given) 55 72 96 55 B + Addition (given) 22 29 49 51 C=D-B-A - Transferred / Sold Land (5) (5) (10) (10) D Ending (given) 72 96 135 96 Average cost of land reserve per square meter (in RMB) E Beginning (given) 452 519 520 452 F + Addition (given) 738 579 664 648 G = K × 1000 / C - Transferred / Sold Land 764 828 (115) 798 H Ending (given) 519 520 617 520 Total cost of land reserve (in RMB bn) I = A × E / 1000 Beginning (given) 25 38 50 25 J = B × F / 1000 + Addition (given) 16 17 33 33 K=L-I-J - Transferred / Sold Land (4) (4) 1 (8) L = D × H / 1000 Ending (given) 38 50 84 50 Estimation of land cost underreporting during 1H 2011 G Implied average cost of land reserve per square meter for sold land (115) M Per square meter actual cost of land reserve at the beginning of 1H 2011 520 N=M-G Per square meter underreporting of land cost 635 C Square meter delivered (in millions of square meters) (10) O = N × C / 1000 Estimated underreporting of cost of land reserve in 1H 2011 (in RMB bn) (6) Source: Evergrande's 2009 annual report, 2010 annual report, 2010 interim report and 2011 interim report 24
- 25. FRADULENT ACCOUNTING #6: Evergrande’s A/R associated with “other revenue” is materially overstated. In its June 2011 interim report, Evergrande reported an increase in A/R in its other segment that is impossible to explain relaBve to the segment’s reported revenue. We esBmate that other A/R requires a RMB 2.8bn write down. A/R at December 31, 2010 was suspicious and movement at June 30, 2011 is beyond suspicious. Absolutely days is beyond reasonable and the fact that the increase in “other” A/R exceeded “other” revenue is impossible. One possible explanaBon could be that Evergrande lent money to someone (perhaps its Chairman) and booked the loan as a receivable without properly disclosing it. Estimate of A/R write-down in RMB bn 6M ended Increase from Receivables 12/31/2010 6/30/2011 12/31/2011 12/31/10 to 6/30/11 Trade (related to property development) 0.9 1.9 2.8 0.9 Other 1.2 2.2 3.0 1.1 Other A/R exceeded Total 2.1 4.1 5.8 2.0 Other revenue is Revenue impossible! Property development 25.1 31.7 28.8 Other 0.3 0.4 1.1 Total 25.4 32.1 29.9 Receivable days A/ R days Property development 7 11 17 skyrocketed to three Other 624 1,126 509 Total 15 23 35 years! Write-down estimate Other revenue 0.3 0.4 1.1 Assumed A/R days 30 30 30 If A/ R days were a more Implied A/R 0.1 0.1 0.2 reasonable 30 days, Evergrande would need Reported A/R for "Other" segment 1.2 2.2 3.0 to take a write down of Estimated A/R for "Other" segment assuming 30 A/R days 0.1 0.1 0.2 RMB 2.8bn Estimated write-down 1.1 2.2 2.8 25
- 26. China Ministry of Finance has also found evidence of material accounBng fraud at Evergrande. [1] • On October 11, 2011, China Ministry of Finance (MOF) announced that Evergrande would be fined for providing accurate financial statements. [1] • MOF concluded that Evergrande failed to consolidate 57 subsidiaries in its financial statements and provided inaccurate informaBon on RMB 6.4bn of assets in its 2009 financial report, overstated costs and unpaid taxes. It also reported findings that Evergrande under-‐booked allowances related to bad receivables. The “error” accounted for >10% of Evergrande’s reported assets of RMB 63bn and >50% of Evergrande’s reported equity of RMB 13bn at December 31, 2009. • MOF stated ”some property developers have the problem of reporBng inaccurate revenue figures, overstaBng costs and delaying or underpaying taxes”. • As outlined in this presentaBon, out analysis shows that MOF is on the right track, but that has barely scratched the surface. • Meanwhile, Evergrande’s auditor PricewaterhouseCoopers (HK office) has conBnued to provide an unqualified opinion.[2] 1] htp://jdjc.mof.gov.cn/zhengwuxinxi/jianchagonggao/201110/t20111011_598596.html 2] page 78, Evergrande 2011 annual report 26
- 27. SecBon 2: Bribes, Illegally Procured Land Rights and Severe Idle Land LiabiliBes Evergrande acquired its vast land inventory in China at a deep discount to prevailing market prices by paying bribes to local officials. Evergrande’s bribing schemes are coming to light, and precedent indicates that the central government will force Evergrande to return illegally obtained land. In addiBon, the central government is beginning to enforce idle laws. Evergrande risks huge fines and the loss of the vast majority of its land inventory if the government conBnues to enforce these laws. 27
- 28. The growth trajectory of Evergrande’s land bank is shocking, both relaBve to Evergrande’s stated business plan at IPO and relaBve to Evergrande’s peer group. • At the Bme of IPO, Evergrande held 51.2mm square meters of land reserves, the largest among all property developers in China – “We believe the size of our current land reserves can saBsfy our development needs for the next three to five years…” [1] – “…we plan to maintain our land reserves at approximately 50 million square meters on a rolling basis” [2] • Contrary to its statement in the IPO prospectus, Evergrande has conBnued to aggressively accumulate land reserves. The Company now controls 137mm square meters, which is more than that owned by three of China’s largest developers combined. 137mm square meters is almost 3x that amount of land required to support Evergrande’s stated growth strategy at IPO. Land Bank (in millions of square meters) 160 137.0 140 120 96.0 100 80 60 55.0 54.9 48.3 40.4 35.9 34.5 40 30.6 29.9 22.2 22.5 20 0 2009 2010 2011 China Resources Land [3] China Overseas & Land Country Garden Evergrande 1] page 157, IPO prospectus 2] page 162, IPO prospectus 3] As of March 23, 2011 for 2010 land bank and March 7, 2012 for 2011 land bank 28