In Part 1 of our Hengda (Evergrande) series, we introduced the Hengda (China Evergrande) conglomerate, while in Parts 2 to 4 we explored each of Hengda's publicly listed subsidiaries (Evergrande Property Services in Part 2, Evergrande Auto and Healthcare Segment in Part 3, and the now divested HengTen Networks in Part 4).
In this article, we conduct a financial analysis of Hengda Group by examining its revenue structure, profitability, and cash flow pattern, in addition to gauging the company's liquidity standing by analyzing Hengda's leverage level, trade balance with third-party suppliers, and borrowings breakdown. A more qualitative assessment of Hengda is available in Part 6.
Note: we only include financial results up to and including 1H2021 as Hengda does not have a published 2021 annual report as of the date of writing.
Hengda (Evergrande) Conglomerate Series
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A Prelude On Off-Balance-Sheet Financing
Hengda has been noted to engage significantly in off-balance-sheet financing with development projects funded by what are known as trust companies. A trust company in the Chinese context is a special purpose vehicle/entity (SPV/SPE) set up by a company to raise funding for specific projects (e.g. a real estate development project) with a limited timespan. Multiple sources claim that Hengda has a track record of using trust companies to obtain off-balance-sheet funding for real estate development projects (at least in part to circumvent regulatory restrictions on leverage), where the trust companies raise funding to purchase plots of land that are acquired by Hengda as land-use rights, while Hengda pays back the trust company investees using the initial sales proceeds obtained from property buyers. Indeed, Hengda's annual reports mention the acquisition of certain property development companies that only "held parcels of land and did not conduct any substantial operation", which the Group treats as acquisitions of land-use rights rather than as traditional business acquisitions. At its peak, Hengda paid a consideration of RMB96 billion in 2017 to acquire such land-use rights.
In addition to trust companies, Hengda has also been shown to employ personal wealth management products as a way to garner additional off-balance-sheet funding (we discuss these issues further in Part 6).
Since reporting for the various forms of off-balance-sheet financing is not consolidated with reporting for the mother company, the numbers presented on Hengda's balance sheet may not and probably do not paint a complete picture of the size and scale of its business. However, as there are no available approximations for the entirety of Hengda's business, we continue our analysis with the company's officially published data, albeit with the above warning in mind.
Revenue and Profit
We now proceed to examine Hengda's revenue structure and profitability.
#1: Hengda Has Growing Revenues But Declining Gross Profit and Operating Income
Hengda's total revenue increased from 2017 to 2020, although the company's annual gross profit, operating income, and net income showed a steady decline since 2019. The continual drop in gross profit is due to lower property selling prices as a result of inventory clearance in 2019 and price concession campaigns in 2020 and 1H2021, while operating income decreased due to higher selling and marketing expenses intended to boost the Group's stagnating sales, as well as administrative costs associated with Evergrande Auto (see Part 3). The substantial drops in gross profit and operating income resulted in a threefold reduction in gross profit margin, while Hengda's operating profit margin also decreased by 2.5 times from 2018 to 1H2021.
Hengda issued a profit warning prior to releasing its 1H2021 results.
We next break down Hengda's revenue by segment. Hengda defines itself as having four main operating segments for financial reporting purposes: (1) property development, which refers to the sales of properties, (2) property investment, which generates rental income, (3) property management services, which primarily refers to the property management activities carried out by Evergrande Property Services (see Part 2), and (4) other businesses, which refers to all of Hengda's other businesses including the new energy vehicle and healthcare business (Evergrande Auto - see Part 3), internet-related businesses (HengTen Networks - see Part 4), and Hengda's other smaller initiatives.
#2: Property Development Comprises Almost All of Hengda's Revenues and Profit
Although Hengda markets itself as a diversified conglomerate, the company's financials suggest otherwise with property development accounting for almost all of the Group's revenues each year.
The Role of Rent Financing
Like many Chinese real estate companies, Hengda was able to expand with the use of rent financing schemes (see our Danke series for a more thorough explanation). Essentially, such schemes represent a three-way contract between a property buyer, the real estate developer, and a financial intermediary (typically a bank), where the developer enables the property buyer to obtain a lower mortgage rate by pledging itself as a guarantor to the bank. The specific terms of each rent financing scheme can differ depending on the parties involved and regulations in place. However, the key takeaway is that Hengda is obligated to repay a property buyer's mortgage if the buyer defaults, an obligation which can become problematic (as in the case of Danke) should correlated buyer defaults arise. This can happen if a developer faces a severe liquidity crisis and is unable to pay for the completion of property construction, causing a cascade of buyers to intentionally default.
As of June 2021, Hengda has RMB519 billion worth of rent financing guarantees outstanding, down from a peak of RMB550 billion at the end of 2020. The Group also has RMB38 billion of financial guarantees outstanding for the borrowings of its joint ventures, associates, and third-party construction companies, in 1H2021.
We next examine Hengda's cash flow pattern.
#1: Hengda's Year-To-Year Cash Flow Pattern Is Very Erratic
For a relatively mature company, Hengda's cash flow pattern is extremely erratic. In some years, the company generates strong, positive cash flows from its operating activities (not to be confused with net operating cash flows shown below, which deducts income taxes and interest expenses paid from cash flows generated from operations), while in other years the Group's operations generate very little cash flows which are further offset by high interest expenses to result in very negative net operating cash flows (shown below).
The direction and magnitude of Hengda's financing cash flows also vary significantly from year to year depending on the amount of financing proceeds the Group is able to obtain in that year relative to the amount of borrowings and cash advances it is repaying. Hengda's financing proceeds primarily come from bank borrowings and funding through trust companies ("Bank and Other Borrowings" in the diagram below), although the Group became increasingly reliant on cash advances from its joint ventures, associates, and non-controlling interests, as its creditworthiness declined. We note that these trust companies are in addition to the development project trust companies discussed in the prelude.
Hengda also has significant capital injections ("Capital Injections From Non-Controlling Interests") each year. With the exception of equity proceeds from the listing of Evergrande Property Services (see Part 2) in 2020 and an RMB22 billion capital injection to assist the more or less insolvent Evergrande Auto (see Part 3) in 1H2021, the rest of Hengda's capital injections went to fueling the Group's property development initiatives. Management does not provide particularly specific details, but we presume that these capital injections were utilized at least in part to avoid taking on too much debt, similarly to Hengda's use of trust companies and wealth management products as a source of additional, off-balance-sheet funding.
Note: we exclude non-core financing items such as proceeds from share disposals or the issuance of shares pursuant to the company's share option scheme. Percentages are calculated based on only the items shown in the graph.
Lastly, unlike its operating and financing cash flows, Hengda's net investing cash flows are consistent but very negative. The net investing cash outflows can be attributed to investments in joint ventures and associates, the acquisition of subsidiaries, and capital expenditure. In 2020 and 1H2021, Hengda also had substantial investing outflows classified as cash advances to joint ventures, associates, and non-controlling interests, although the reasons for and details regarding these cash advances were not disclosed.
Borrowings and Leverage
Next, we focus specifically on analyzing Hengda's borrowings and utilization of leverage.
#1: Hengda Had RMB800 Billion Of Borrowings Outstanding And A Leverage Ratio Of 41.6% At The Peak Of Its Indebtedness
Hengda is a very leveraged company, with a highest recorded leverage ratio (defined as total borrowings as a percentage of total assets) of 41.6% in 2017. Although the Group gradually lowered its leverage level over time, there was no substantial reduction in the raw amount of debt Hengda took on until the the first half of 2021, during which the company lowered its debt level to RMB572 billion from a lofty peak of RMB800 billion in 2019.
#2: Current Borrowings Comprise Almost Half of Hengda's Total Borrowings Outstanding
Examining a breakdown of Hengda's borrowings by maturity, we see that the Group relied heavily on short-term debt to fuel its expansion. Indeed, short-term debt (defined as debt with maturities due within one year) accounted for nearly half of Hengda's outstanding borrowings in each year, while borrowings with a maturity between one to two years comprised approximately a quarter of total borrowings, and borrowings with a maturity between two to five years constituted another 20% to 30% of the total. Clearly, there is a maturity mismatch in Hengda's heavy reliance on short-term debt to fund long term development projects that can lead to significant liquidity problems if not well-managed.
#3: Hengda Has Almost RMB1 Trillion of Accounts Payable Outstanding in 1H2021
We also consider Hengda's accounts payable to determine its trade balance with suppliers. Similarly to Evergrande Auto (see Part 3), although Hengda has been paying off some of its borrowings, the Group's accounts payable have been ballooning year over year to reach an outstanding balance of RMB951 billion in 1H2021. Of these payables, approximately 70% are trade payables due to third-party contractors, while the remaining 30% include balances outstanding to joint ventures, associates, and non-controllling interests, payables for the acquisition of subsidiaries and land-use rights, lease liabilities, accrued expenses, as well as payroll and taxes payable.
Lastly, we conclude this article by assessing Hengda's liquidity position.
#1: Hengda's Liquid Current Assets Cover Less Than 30% Of Its Current Financial Liabilities
On the surface, Hengda has positive working capital and an acceptable (albeit declining) current ratio that does not seem indicative of potential liquidity problems. However, a closer look shows that the Group's current assets are predominantly illiquid with properties under development comprising 66% and completed properties held-for-sale comprising 7.4% of current assets respectively. Consequently, we compute two additional liquidity ratios that capture Hengda's liquid current assets as a percentage of (1) its total borrowings due within one year ("Current Borrowings"), and (2) its total borrowings and accounts payable due within one year ("Current Borrowings and Accounts Payable").
*Liquid current assets are defined as the sum of cash and cash equivalents (excluding restricted cash), accounts receivable, and financial assets at fair value through profit/loss.
Considering only Hengda's relatively more liquid assets, we see a rather different story. The Group's liquid current assets covered only 70% to 80% of its current borrowings (which we refer to as "debt coverage") until Hengda reduced its debt level in 2020 and 1H2021, and less than 30% of Hengda's current borrowings and accounts payable (which we refer to as "financial liability coverage") over the time period under consideration. Although Hengda was able to increase its debt coverage ratio substantially in 2020 and 1H2021, the Group's financial liability coverage ratio continued to decline as a result of its ballooning accounts payable balance. Among other reasons, we believe Hengda gave less priority to reducing its accounts payable since high leverage and defaults on debt generate far more severe consequences. Given the Group's liquidity crisis that unfolded in the latter half of 2021, it is clear that Hengda's debt coverage reduction tactics were insufficient to secure a stable future for the conglomerate.
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Hengda (Evergrande) Conglomerate Series