Inventory days regularly exceeded 4 years, while Payable days consistently hovered at around 2-3 years.
Evergrande used aggressive funding methods, such as avoiding settlement of payables with suppliers and exchanging payments owed to suppliers for equity in JVs. This effectively amounts to borrowing loans from their suppliers.
OCF/FCF was consistently negative from FY13-20 despite blockbuster revenue growth, except for a few years.
Evergrande’s “look-through” owner’s earnings can be derived from an adjusted normalized OCF metric, Operating Cash Flow less Capitalized Interest. This metric shows improved performance but only by a little.
AI-Generated Summary of this Podcast (477 words)
Aaron from Value Investing Subsatck revisits his September 2021 article on the Evergrande crisis in light of the company's official windup in January 2024. He reflects on past analyses, reiterating that Evergrande's downfall was not due to being a Ponzi scheme but rather due to over-leverage and risky overbuilding. Aaron highlights that Evergrande would presell houses and use the cash as collateral for further borrowing to fund continuous construction, a practice that relies on perpetual growth. The financial red flags, such as long inventory days, indicating slow turnover of unsold properties, were clear indicators of the company's unsustainable practices. The article serves as a retrospective diary entry, emphasizing the importance of scrutinizing cash flow and inventory metrics when evaluating a company's financial health.
Aaron discusses Evergrande's financial intricacies, comparing them with the infamous Wealth Management Products (WMPs) prevalent in China, likened to high-risk, high-yield government-controlled unit trusts. WMPs are used as a standardized borrowing vehicle by the Chinese government and large corporates due to their appealing yields, despite potentially low ROI.
Evergrande's practice of treating suppliers as an unofficial funding source is highlighted, where unpaid suppliers are often compensated with equity in joint ventures instead of settlement of cash payments. This is akin to an informal debt-to-equity swap, commonplace in China despite being less feasible in countries with stricter accounting regulations.
Aaron emphasizes that while these practices may resemble corporate shenanigans, and involve forming joint ventures where suppliers fund the capital expenditures (CAPEX), they do not constitute a Ponzi scheme. He recommends reading a detailed Nikkei article on the subject for further insight and concludes by reminding readers that the financial maneuvers of Evergrande, while complex, should not be mislabeled as a Ponzi scheme.
In discussing Evergrande, he notes the company's cash flows were virtually non-existent, with only two years of positive cash flow from 2013 to 2020, despite increasing revenue and profits. The positive cash flow years were marked by an increase in trade payables and contract liabilities, hinting at supplier funding as a key factor. The primary culprit for negative cash flows was identified as high interest payments, with interest paid significantly outweighing interest expenses, suggesting a discrepancy driven by capitalized interest related to property development.
Aaron introduces his own metric, Operating Cash Flow minus Capitalized Interest, to better reflect Evergrande's normalized cash flow situation, which adjusts the negative cash flow picture slightly. He acknowledges that while Evergrande's aggressive growth and borrowing practices resemble a Ponzi scheme in terms of unsustainable cash flow, he stops short of labeling it a scam, suggesting instead that it was a case of overly aggressive business expansion. Aaron points out that borrowing growth outpaced revenue growth, indicating the need for continual financing to sustain operations.
In conclusion, the Evergrande debacle is characterized by aggressive risk-taking and borrowing to fund growth rather than a deliberate Ponzi scheme to defraud investors.
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Full Transcript (WhisperAI + editing)
Hi guys, this is Aaron from Value Investing Substack. So the news that's been making headlines today is of course the Evergrande windup. This was something that has been going on for the past two years and it just never really got anywhere until today. So now that the windup is official, I thought it was worth a revisit. When the news first broke out that Evergrande was in trouble because I did write an article around that time.
So my article is dated September 25th 2021. Today is more or less 29 January 2024. And if you recall, the end financial IPO was pulled slightly prior to November 10th 2021. Which is when my article was written. So I just thought that it'd be fun for all of us to just take a stroll down memory lane and revisit what happened to these two. Alright, to Evergrande, right? It's not going to be anything serious. We're just going to do it stream of consciousness style. So forgive me if I'm jumping around a bit. But without further ado, let's get into it.
So now the great thing about writing or having your own newsletter is that it's like a diary. It keeps trying off the stuff you've been writing about in the past. And yeah, this is like my Evergrande diary. Because if you actually click in the article in the link below, you'll see that I actually did a pretty decent screening level research, let's just say. And very quickly found out the red flags which were highlighted by other analysts as well. So if you recall, at the time, a big part of the news was around the possibility that Evergrande was a Ponzi scheme. Partly because the end financial IPO kind of saw that review that it was a Ponzi scheme. We could do another article about that, but for now, let's just stick to Evergrande.
Evergrande Is Not A Ponzi
So in contrast, Evergrande is not a Ponzi scheme, right? Evergrande is just a very plain over-leverage, hyper-aggressive risk-taking, over-building story. And we can see this very plainly in the numbers. I won't spoil the surprise, let's just go through it one by one. So the idea behind Evergrande being a Ponzi scheme starts with Evergrande borrowing a certain amount to build a house. Then in China, they tend to have collections for the household up front. So before the house has been completely built before the house has been completely built, Evergrande would then sell the house to a home buyer in a presale. And because it's a presale, they can use the cash inflow from that presale.
Remember, Chinese citizens tend to be very big savers. And with real estate in China being such a high-stater symbol, it's not unheard of for entire families to pull together their savings to join the own house, which is just not something you find in most other parts of the world. So in China, they do that. And because of that, Evergrande gets the entire amount of cash sale upfront as a collateral for the presale. (Sorry, sorry, not as a collateral) for the presale. And then they will use that as collateral to borrow even more money, even before the first house is completed.
Then you can rinse and repeat this process. Use the new money, the new money borrowed to build a new house, get people to invest more, take the presale proceeds. You get the story, right? And let's be fair, this is not an exclusively China scenario. It happens in the US as well. But technically, this would qualify as a Ponzi scheme, because you're basically relying on ever-growing scale to find your next stage. And once that growth stops, everything, the whole house of cards falls.
Extended Inventory Days: 3-4 Years
So in my article, I actually looked at the cash flow stats, the typical stuff I look at when screening a company. And a few things stand out. So we can see that, so I'm actually going through my article right now. This is like a trip down memory lane. So we can see that actually receivable days are okay, which is good, right? As evidence, or perhaps evidence of the presale of the homes that they are building. But inventory days are incredibly bad.
So inventory days of Evergrande have regularly hovered at around 4 year mark. So 4 years, what's that? That's about 1,000, 3,000 days. Okay? Sorry. So I'll just list the numbers out to you since I have them here. In financial year 08, it was 3... I'm not sure what the denomination is, but it's 3425. I think this is in trillions of UN or something, okay? But regardless, right? Oh no, sorry, this is actual inventory days. So that's 3,425 days, okay? Inventory days. In 2009, it was 3,720 inventory days. I improved substantially in 2010 to 2011 because there was more or less, I guess, the impact of the subprime crisis. Then in 2012, it actually rebounded back to over 1,000 days, inventory days.
So you can see, right, how... I don't care what business you are in. If you have inventory days exceeding 4 figures, there's something wrong, alright? And payable days aren't much better. They're consistently in a 2 to 3 year mark. So as context, inventory days was regularly in a 4 year mark, right? Oh wait, those were just, you know, 2008 to 2013. So if you look at 2014 to 2020, inventory days was regularly around 1,500 days, which is bad, right? The latest figures as of 2020, which was, you know, prior to when I was doing this research, was 1,335 days, inventory days, 963 payable days and 102 receivable days, right? So receivable days, I think that's fair. The other two, not very good.
Inventory Days Breakdown
So what's the reasons behind them? In inventory days, they are pretty easily addressed, right? There are likely all the infamous unsold properties, you know, that CalVest has been making a lot of noise and news for, you know, the gold cities and stuff. But actually, if you dig a little bit deeper into the components of these, they include inventories, properties under development and completed properties held for sale.
So without getting too much into real estate jargon, properties under development as well as completed properties held for sale are also counted as inventories in the real estate or in the property construction. Property developer sector, right? Because properties under development are those who are still holding on a milestone basis, right? Those whose revenues are still recognized under the cost of percentage of completion method. And completed properties held for sale is more about overhang properties, right? So, yeah, I know they're the main culprits behind the high inventory days as opposed to the actual net inventories of other stuff. All right.
So next, we'll look at the payable days. So, you know, as we noted, payable days were just roughly 60% as bad as inventory days, which is also terrible. And what we notice is that payable days of Evergrande were also quite unique. So I'll go into it. There's a lot of more story here. As you can imagine, payables represent paying your suppliers, right? And if you can delay paying your suppliers, that's good for your working capital. So it seems that Evergrande is a primary culprit of being able to strong arm their suppliers into very onerous supplier payment terms.
And the proof is really in the annual reports, right? So we can actually see as we dig deeper and deeper, a very large portion of the trade payables is represented. So, okay, in mind, I'm looking at FY 2020 annual report. Yes, financial year 2020 annual report. You can see that they have trade payables of about 620 million, other payables of 163 million. And there's a pretty large funding component called just third parties note B. And that's 51 million, right? So that's about 8% of the total payables.
And if you look at the notes 26A of the annual report 2020, you see that the cash advances, these third parties are actually cash advances from non-controlling interest amounting to Renminbi 2.6 trillion, which bear average interest terms of 15% per annum. So, okay, I mean, this is a bit unusual, right? And because I had actually looked at the end financial IPO prospectus, I really knew what to look for. It was very reminiscent of Ant Financial of balance sheets liabilities under the are heading called unconsolidated structured entities.
And to make a long story short, these are basically the infamous WMP investments, wealth management products, which is where it's basically a government controlled unit trust. You can sort of think about it that way where instead of borrowing from the markets like developed economy governments do Chinese government, the way they borrow, you know, a very universal standardized borrowing vehicle is these WMP wealth management products. They're basically securities where they're like very high fixed income deposits with higher risk, right? Fixed deposits or certificate of deposits. So you can sort of think of them as bank deposits or bonds, right? The way the average Chinese thinks about it, at least as far as I understand, sorry if I'm wrong, is that these are like they think of them as a bank deposits, high risk bank deposits because it's a very fixed income yield.
And, you know, as we saw with the notes in Evergrande's Annual Report, they pay upwards of 15%. And because of their very attractive yield, they become a very standardized funding vehicle, both for governments as well as large corporates in China. In a way, okay, I don't want to go too much in the macro, but it's a little bit of financial repression here because it's government encouraging savings and allocating those savings towards investments, which are presumably not very high ROI, not very productive. I mean, you've all heard the China micro story before, so I'm not going to reinvent the wheel here.
But let's get back to Evergrande, right? So there's a good, I think it's a Bloomberg article, no, it's a Nikkei article, right? So there's a Nikkei article which actually goes into it, the WMP and their structures. I won't do that here, but it can be summed up. All right, so these are just your very typical corporate shenanigans where Evergrande would, but it's quite unique because you can't really do this in the US today due to very stringent rule-based accounting regimes and stuff, right? Where it's just bad, right? It's bad for your optics. But in China, they do this, right? Or at least apparently, China, Evergrande did. So what they would do is they actually treat suppliers as a source of funding, right? Because if you think about it, right? What are Evergrande suppliers supplying them? It's things like steel, cement, you know, very expensive stuff, not on a unit basis, but on a gross basis, right? You shell a lot for steel or bricks or cement, right? And then basically just not paying them.
And then when you can't pay them, so when you don't pay them, that's a loan from the supplier, right? Then when you can't pay them, you give them equity in one of your subsidiaries related to the project. So that's kind of like a debt equity conversion without the conversion, right? The supplier typically is a small guy, doesn't have to have to challenge Evergrande in court, so he has no choice and takes your subsidiaries' equity. And you know, that's effectively a loan from the supplier, right? So you get all these kind of things. At least that's what the case says here. It's a very good article I encourage you to read.
So basically, they will form a JV. Okay, so it actually goes into a bit more here. They will form a JV with the supplier, where the supplier will effectively fund the KPACs of the JV and Evergrande only takes a small stake. But right, and the KPACs will actually be accounted for as a cash advance. Okay. Yeah, this is like annual level stuff, right? But let me be clear, this is not a Ponzi scheme, okay? We will tie everything up at the end of this. So, yeah, there's a really good article here. I don't want to pause too long and go into it, but it's just your typical cow-bask rant, right? How they're doing this and that and constructed says that there's not enough reconciliation between assets and liabilities and stuff and all that. Okay, so just go read the article, if my article from 2021, if you want the details.
Consistently Negative Operating Cash Flow/FCF
So cash is king in business, right? And if you look at Evergrande's, at least the annual report 2020, operating cash flows and free cash flows, you see that there's none. Okay, so they are operating cash flow/free cash flow. Yeah, I'm treating them in this article as equal because their depreciation amounts are quite negligible. So we can see that from 2013-2017, they've been consistently negative operating cash flow, right? And despite revenue growing very significantly and also profits. Then, 2018, they had a slight reprieve with 54, I think this is billion, running B, right? And then 2019, they went back into the red at 67, negative billion. And then 2020, it was positive 110 billion. So, you know, over 1, 2, 3, 4, 5, 6, 7, 8 years, they only had 2 years of positive free cash flow, which just, you know, obviously does not net off as positive.
And if you dive deeper into the operating cash flows, you know, you can... I'm actually reading the article here. Okay, so the trade payables show up again. The two positive operating cash flows were contributed by large positive trade other payables and contract liabilities. You know, so this could be because of the supplier funding component I was discussing earlier. But, right, that's not good news for your operating cash flow if it's being funded by your suppliers, right? O
kay, then digging deeper, we actually find out what is the actual operating culprit for their consistently negative operating cash flows. And it's actually interest paid. So it's interest paid that's causing operating cash flows to drop significantly, to go into the red. And I actually noted at the time that this is weird because the ratio between your interest expense and your interest paid is huge, right? So interest paid, interest expense. So paying way more.
Okay, so you know, typically in a healthy large company, your interest paid and interest expense more or less nets off over time as they should, right? It's a 1:1 ratio. Okay, so let me just go through what Evergrande's interest paid to interest expense ratio. Okay, keep in mind this is interest paid being more than interest expense. In 2013, it was negative 22.2x. 2014 was 13.9x. 2015 was 6.5x. 2016 was 2.7x. 2017 was 6.8x. 2018, 3.8. 2019, 2.9x. And 2020, 34.8x.
So the interest paid, right, which is supposed to over the long term basically be one to one with your interest expense, is regularly and growingly so, 3 to 6 times more than your interest expense. So this is obviously not status quo, right? So what makes up this difference? Well, note the two shows us it's mainly interest capitalized. Capitalized interest.
And where do capitalized interests show up? When do they show up as an accounting like item? They happen typically, okay, if let's say you're building a factory and you borrow money to build a factory, right? Obviously, CAPEX you can capitalize and then depreciate later. But you're also allowed to capitalize the interest incurred to borrow that loan to build a factory because, strictly speaking, it's part of the construction costs, right? They're normally very small.
In Evergrande’s case, I'm not sure, but I'm 100% sure, but I think that because they are building homes real estate, they're doing the same thing. And I'm going to assume that this is fair, okay? This is above bond. I'm not 100% sure. Just to keep things simple, okay? If you look at the capitalized interest, yes, it's definitely so because the note 12 that I'm looking at here, the capitalized interest amount falls under the properties under development amount, which as we saw earlier was under Inventories, right?
So these are definitely capitalized interests to build homes, to build real estate, right? And it shows, it says the notes here, capitalized rate of borrowing costs for the year ended 2020 is 9.46%. I don't know if that's good or bad for, you know, 2020 China, keeping in mind that they probably have high interest rates, highest policy rates at the time. But yeah, you know, it's just full for thought. So that explains, right? A lot of why they've been so free cash flow negative.
And the long and short of it is that if you, so the metric, I made up my own metric. I call it operating cash flow less capitalized interest. What this represents in real life is basically, let me think about it. Right. So this is basically just, you know, supposedly true operating cash flows because, you know, as we saw capitalized interest were the actual, the actual culprit behind negative, the consistently negative operating cash flow. Right. If you back out, sorry, it's not plus it's negative. If you back out capitalized interest from operating cash flows, the picture changes a little bit better. OK, so it's it's instead of two years of positive operating cash flow (over the past 7 years), you get four years of positive operating cash flow less capitalized interest.
Summary: Not A Ponzi, But Overbuilding
And and, you know, basically the long and short of it is that we can see just very consistently deteriorating fundamentals over time. It's just bad. Right. But no evidence of Ponzi scheme. I guess you could technically call it a Ponzi scheme if you wanted to be really cynical because technically they're, you know, kicking the can down the road by building ever bigger and bigger ever grand. No pun intended.
OK, so but but, you know, this is not like Ponzi in the scam context, right? I mean, I think Valeant Pharmaceuticals did it for a while before they blew up in 2016. Yeah, you know, this is something that many American companies do as well. So I don't I don't I wouldn't go so far as to accuse them of scamming people. It's just way too aggressive. It's taking and, you know, yeah, just your typical Shark Tank business kind of situation. Right.
The last thing, I actually noted here that. So this is actually what I was saying earlier. You can actually tell this kind of quasi Ponzi scheme behavior going on because the borrowing growth is actually higher than the revenue growth. So the one main characteristic of Ponzi scheme is the lack of sustainable cash flow. You need that revolving door to keep things going.
And the way the Evergrande has done that was by borrowing more than what they could actually sell.. You know, just very cursor really by looking at how they're borrowing growth have exceeded their revenue growth. Quite a bit. Actually, you can look at the stats in my article. So if you really want to be cynical, you could say it's a Ponzi scheme. But but a Ponzi scheme tends to imply malicious intent to scam somebody. Which doesn't really exist here. This is just a guy who who really wants to build a real business and it's just way too aggressive.
So, yeah, this was fun. This was fun going through evergrand all over again. And I invite you to read my article. If you want more than just this, please. You know, I love doing this kind of research. I identify as a value investor, but I love just doing, you know, a very standard fund management kind of CFA kind of analytical accounting research. And if you want me to look at something, you know, especially if you're a paid subscriber (support me, by the way) I could look into it. Time permitting. I love doing this stuff. And, you know, yeah, when I do this stuff, I share the value with you. So please sign up, become a free subscriber. If you can support this channel, this newsletter. I look forward to the next podcast review. Thanks!
Evergrande Revisited: A Deep Dive