Evergrande: China’s version of Lehman?
The market plunge from late last week into earlier this week certainly has had many investors scrambling to understand how it will impact their portfolios
This pullback was driven by one simple headline issue and a few separate underlying problems that have been building over the past two months.
First, let’s get to the punchline. This is an opportunity to buy the dip. To understand why, read more below.
Investor Essentials Daily:
Powered by Valens Research
The past few months in our Market Phase Cycle newsletter, we have been highlighting issues around overly bullish investor sentiment. Along with concerns about near-term corporate growth rates, we were ripe for a pullback. While it could have been for any number of reasons, it was bound to happen eventually.
Our credit work on both corporate and individual access to credit and debt balance health are the reasons we have been telling our readers one simple mantra for when that pullback happens: Buy the dip.
The headlines aren’t what matters. Instead, savvy investors look to the underlying fundamental data that drives the market over three months to 10 years.
The data, which we look at daily, are based around deep credit research, Uniform Accounting understanding of corporate profitability, earnings growth, valuation, government policy, inflation, and management and investor sentiment, and many smaller signals.
With such a robust pool of data to build an economic picture, it gives us the confidence to say continue to buy the dip.
To understand why, let’s dive into the catalyst for this instability. Evergrande (3333:HKG), the Chinese property development company with $300 billion in debt, is teetering on the edge of bankruptcy.
Additionally, $80 million in interest payments are coming due. Analysts think that without Chinese government assistance, Evergrande won’t be able to survive.
The true Chicken Littles of the market are saying it might be another Lehman Brothers, so it’s no surprise the news has investors panicking.
But this potential issue didn’t creep up on investors… The financial media has been talking about the potential for an Evergrande implosion to occur for months, if not even longer.
Here at Valens, our Uniform Accounting data have been highlighting the ticking time bomb at Evergrande for some time.
Our Credit Cash Flow Prime (“CCFP”) analysis gets to the heart of Evergrande’s true credit risk. In the chart below, the stacked bars represent the company’s obligations each year for the next five years. We compare these obligations against cash flow (blue line) as well as the cash on hand at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
Note that the data in the chart are a year old—this is what Evergrande looked like in 2020! The company has consistently been borrowing money in the short-term markets to finance property development that arguably should be financed with longer-term, stable debt.
This is a classic issue of “maturity mismatching,” when a company or individual invests in an asset that has a long payback period—often many years—but borrows debt that matures very soon in order to finance an investment.
Evergrande was able to get through that massive debt maturity headwall in 2020 not because it had some windfall. Instead, the company had refinanced RMB 412 billion in short-term and long-term debt, rolling debt maturities from 2020 into 2021.
With liquidity flush in the system in the midst of the coronavirus pandemic and with few people believing China would ever let Evergrande fail, the company was able to access the credit markets.
Now the narrative has changed… and with it, Evergrande’s access to credit markets has evaporated. Lenders are no longer confident that Evergrande has China’s backing, or that liquid credit markets mean it can keep on refinancing forever.
And with that backdrop, interest payments coming due this week have brought the issue to a head. As DealBook highlighted earlier this week, Goldman Sachs (GS) strategists think that a collapse could knock $350 billion off of China’s GDP next year. That’s 2% of Chinese GDP.
For folks who remember how interconnected Lehman Brothers was and how the company’s default sent shockwaves through the global financial system, it’s understandable to be worried.
However, one example from 2008 lines up better with Evergrande than Lehman does…
General Growth Properties (GGP) was one of the largest mall real estate investment trusts (“REITs”) in the U.S. and had a number of prestigious high-quality malls in its portfolio. It had built an impressive set of assets from 1954 through 2008.
In the years coming into 2008, GGP had been financing its organic and acquisitive growth with short-term debt. Even though its properties had decades-long lives, the company was borrowing in the short-term money markets, since it could pay lower interest rates using short-term debt.
Then in 2008, much like right now with Evergrande, with credit markets closed, GGP was caught without a seat when the music stopped. It couldn’t refinance its debts that were rapidly maturing. The company went bankrupt, and eventually got picked over by its peers—Brookfield and Simon Property Group.
But this didn’t cause a cataclysmic collapse of the markets like Lehman Brothers did, for a couple of reasons.
- GGP had real hard assets behind its debts, meaning there were tangible assets people could, and wanted to, take possession of. Much like how Evergrande, as a property developer, even in the overheated Chinese real estate market, has backing in at least a portion of its debts.
- More importantly, Lehman Brothers was deeply integrated into the global financial system. These complex relationships helped trigger the deepest mess of 2008. GGP was just a staid property company that had gotten upside down with its debts and had to live with the consequences of its actions.
Now, some might say Evergrande is a far bigger issue for China than GGP was for the U.S. GGP had $24 billion in debt compared to Evergrande’s $300 billion, and many analysts are calling on Evergrande to be the catalyst for a domino of Chinese real estate repricing—much like the housing crash in the U.S. that led to 2008 global meltdown.
But even if we see a Chinese real estate meltdown, outside of those heavily invested in China, investors don’t need to panic…
It’s important to remember the context of the economic growth in the 2000s before drawing such a disturbing analogy.
The U.S. consumer was the fuel of global growth in the early 2000s. U.S. personal consumption, a key component of U.S. GDP, rose from roughly $7 trillion in 2001 to $10 trillion in 2008, and that spending powered economic growth across the globe.
Additionally, the U.S. banking system is at the center of the global economy. German Landesbanks, British and Irish lenders, and Japanese bankers all owned massive amounts of U.S. mortgage debts… and the global economy relies on the piping that runs through Wall Street, which was at the epicenter of the 2008 crash.
On the other hand, while China is the world’s factory, the country has also made it a priority over its “economic miracle” the past several decades to keep as much of its economy off-limits from the world as possible.
China is a net lender to the rest of the world, not a net borrower like the U.S. was in 2008, and still is. China also has strong capital controls that limit investor access to its debt and its equity markets. In fact, it was only less than a month ago that BlackRock (BLK), the largest asset manager in the world, was able to launch the first entirely foreign controlled investment fund in China.
Few asset managers have access to China. And global banks that had thought about venturing into China previously have mostly walked away realizing that this was a futile effort.
Even if there is a reckoning in China from Evergrande, the likelihood that it would be a contagion for the rest of the world—and in particular to the U.S. economy and market—is limited.
All the metrics we monitor for U.S. market health continue to be strong. Unlike the metrics for Evergrande and other Chinese companies, U.S. corporate credit health is impeccable, as is consumer credit… and that alone gives us confidence in the trend in the economy in the market.
So, while others may be panicked about Evergrande, by looking at the real data and taking a step back to look at the big picture, we can again say with confidence to you… Buy the dip.
SUMMARY and China Evergrande Group Tearsheet
As the Uniform Accounting tearsheet for China Evergrande Group (3333:HKG) highlights, the Uniform P/E trades at 31.8x, which is above the global corporate average of 24.3x, but around its historical average of 31.5x.
High P/Es require high EPS growth to sustain them. In the case of Evergrande, the company has recently shown a 99% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Evergrande’s Wall Street analyst-driven forecast is a 21% EPS growth in 2021 and 601% EPS contraction in 2022.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Evergrande’s HKD 2.54 stock price. These are often referred to as market embedded expectations.
The company is currently being valued as if Uniform earnings were to grow by 6% over the next three years. What Wall Street analysts expect for Evergrande’s earnings growth is above what the current stock market valuation requires in 2021, but below that requirement in 2022.
Furthermore, the company’s earning power is below the long-run corporate average. Moreover, cash flows and cash on hand are below its total obligations—including debt maturities, capex maintenance, and dividend. Together, this signals high dividend and credit risk.
To conclude, Evergrande’s Uniform earnings growth is above its peer averages and the company is trading in line with its peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research