China Property:Uptrend in net gearing more serious than reported
Reported net gearing numbers likely understate actual leverage 。
A key theme in 1H14 results of Chinese developers is the rise in net gearing, which was not a surprise given strong growth in land sales and debt issuances by developers in 2013 and early 2014. Average reported net gearing for 22 listed developers was 70.4% at end-1H14, up from 59.8% at end-2013. What is surprising, however, is that after adjusting for differences in management's calculations and IP valuation, accounting treatment for project-level perpetual loans (PCSs), and some full-year FY13 dividends that were still unpaid by end- 1H14, average effective net gearing at end-1H14 was much higher than reported - 103% (excluding Evergrande) and 2,385% (including Evergrande).
First level of adjustment: reclassifying project-level PCSs from equity to debts 。
Looking at the net gearing numbers reported by developers, we found that developers used different calculations and classifications, and after adjusting for the differences, their effective net gearings were generally higher than the reported numbers. First, after reclassifying project-level PCSs from equity to debt, accounting for the FY13 dividends that remained unpaid at end-1H14 for certain developers, and calculating net gearing by dividing net debt by shareholders’ equity (the method that COLI uses), the average net gearing was 98.9% at end-1H14, up from 73.4% at end-2013. Excluding state-owned developers, the average rose from 78% at end-13 to 106% at end-1H14 - already high, but we still need to make one more adjustment.
Second level of adjustment: applying more reasonable gross yield to value IPs 。
Adopting a more reasonable gross rental yield of 5% to reflect a more realistic market value for investment properties (IP), we found that effective net gearing of some developers is significantly higher than reported numbers. For the 22 developers, average effective net gearing at end-1H14 rose to 2,385% (vs. 70% reported). Excluding Evergrande, effective average net gearing at end-1H14 was still meaningfully higher at 103%, up from 78% at end-13. COLI, CRL, COGO, CCRE, Vanke are more conservative in terms of reporting Our analyses show COLI, CR Land, COGO, CCRE, Vanke, Poly A, Gemdale and Country Garden were meaningfully more conservative in calculating their reported net gearing. Conversely, among bigger developers, we see more significant differences in our est. effective net gearing vs. reported net gearing for Evergrande, Shimao, R&F. Overall, COLI, CR Land, Vanke and CCRE have lowest effective new gearing of below 50%. Conversely, the 5 big and mid-caps with very high effective net gearing at end-1H14 are: Evergrande (48,000%), Shimao (133%), R&F (195%), Poly-A (174%) and Agile (136%).
We expect another round of inventory clearance and price cuts in Sep-Nov 。
Given the latest gearing situations, we expect another round of major inventory clearance in Sep-Nov with more price cuts, which should stimulate sales and present positive news flow for the sector. However, for developers with high effective gearing, we see the need for more aggressive price cuts, which would hurt margins. In addition, there could be more capital-raising activities (like the latest rights issue by Country Garden) which would result in dilution. Our Top Sells are Shimao, Evergrande and Country. Our Top Picks are COLI, CR Land, Vanke-A and Kaisa. We also like R&F, CCRE, Poly-A, KWG for their attractive valuations. Key risks: unexpected economic and policy volatility.