Country Garden Deconstructed By Slumping Sales, Heavy Debt

Key Takeaways:

• Country Garden warned it expects to report a loss of up to 55 billion yuan for the first half of this year
• The leading property developer’s sales fell 35% in the first seven months of this year, reaching 140.8 billion yuan

By Yi Xi

The launch of China’s “Three Red Lines” policy in 2020 abruptly ended a high-leverage era for the nation’s freewheeling property developers, making them deal with mountains of debt incurred over two decades of breakneck building. When Beijing called on the state-owned China Bond Insurance Co. to assist a select group of private developers last year by guaranteeing their bonds, Country Garden Holdings Co. Ltd.’s (2007.HK) inclusion on the list provided a shot of confidence for investors.

Its performance has declined since then as China’s property market sags, even as its relatively healthy finances allowed it to raise more funds with new share issues. While many of its peers struggled, investors believed that Country Garden was one of the best bets among China’s increasingly troubled field of private developers.

But all that ended last week when the company failed to pay $22.5 million in interest due on two bonds, in a rude awakening for investors. It seems even a leader like Country Garden wasn’t immune to China’s growing property downturn.

The first signs of trouble came two weeks ago on July 31, when Country Garden unexpectedly warned it would report a loss for the first half of this year. That same day, the company reportedly prepared to raise new funds by selling stock at HK$1.30 per share, or nearly 18% below its closing price of HK$1.58 that day. The amount being raised was a relatively modest HK$2.34 billion ($300 million), but even so, the share sale was called off.

Four days later, the company’s property management arm, Country Garden Services (6098.HK), announced that its 2022 dividend and special dividend originally scheduled for payment on Aug. 30 would be paid ahead of schedule on Aug. 11, leaving investors scratching their heads. When media reported last Tuesday that Country Garden missed the interest payments, many guessed that its major stakeholder, billionaire Yang Huiyan, urgently needed the dividend cash to support the company.

A company announcement last Thursday shed more light on things, as Country Garden disclosed it would report a massive loss of 45 billion yuan ($6.2 billion) to 55 billion yuan for the first six months of this year, reversing a 1.91 billion yuan profit a year earlier. The company also admitted to experiencing the most difficult period since its founding. The announcement sent investors scurrying, trimming nearly 6% off the company’ stock the next day as it fell below HK$1 mark into penny territory, shrinking the company’s market value to just HK$27 billion.

Hidden Debt?

While Country Garden has yet to announce its full interim results, its 2022 annual report showed it had 128.2 billion yuan in cash at the end of last year, with 271.3 billion yuan in liabilities and a low net gearing ratio of 40%. Based on that, its financial situation certainly looked safe. So, how, in just over half a year, could its finances deteriorate so dramatically to prevent it from making an interest payment of just over $20 million?

The latest revelations have investors worried about Country Garden’s debt. People who follow the sector know that many developers often have far more debt than what’s disclosed in their financial statements, thanks to aggressive use of off-balance-sheet obligations.

To hide their debt, developers often use separate entities or joint ventures to take out loans, while letting the listed company or its major shareholders act as guarantors. Such loans don’t appear on a company’s balance sheet, but still need to be included in the notes section of their financial reports. To avoid such disclosures, developers often negotiate with lenders to release their guarantees on June 30 and December 31 every year. The guarantees are then restored the next day.

Such sleights of hand let companies avoid disclosing such loans, since technically they aren’t guaranteeing those obligations on the official closing date of their two reporting periods each year. And like magic, those obligations disappear from the final reports.

We don’t know whether Country Garden has such hidden debts. If it does, then how large are they? And how serious is its situation? We should add that once such debts default, they can stay hidden no longer and must be shown in the company’s financial statements.

Plunging Sales

Even if Country Garden has no such hidden debt, repaying the huge debts it does disclose relies mostly on generating cash from property sales. Strong property sales can help to keep debt problems in check. But that’s increasingly difficult in the current market, where property sales have gone from bad to worse this year.

Country Garden’s sales in January totaled 22 billion yuan, and rose to 24.8 billion yuan in February. But we should note that January this year was slow due to the Lunar New Year, so the February rebound is often a cyclical occurrence. In fact, the company’s sales have sagged since peaking at 25 billion yuan in March, falling by half over the four-month period to 12.1 billion yuan in July. Country Garden’s property sales in the first seven months of the year totaled 140.8 billion yuan, down 35% year-on-year, and off by more than 60% from the same period in 2021.

So, what are the chances the situation might reverse in the rest of the year? Beijing’s “Three Red Lines” policy clearly prioritizes debt reduction for China’s property developers. The problem is, the only way to pay down debt is by selling properties. And to do that quickly, developers must offer promotions, often by lowering prices. But other developers also want to sell their properties, and offer their own discounts. The vicious cycle has produced a sharply rising property supply even as aggressive promotions further undercut prices.

The reality is that homes aren’t just for living, but are also a popular investment tool. When property prices rise, people rush to buy even if they don’t need a place to live. And when prices fall, nobody wants to buy no matter how cheap it is.

Interestingly, when prices first began falling, many people who waited years to enter the market saw an opportunity and rushed to buy. But they quickly found that today’s bargain was tomorrow’s overpriced property. Others saw what was happening and grew cautious, casting a growing chill on property sales. Worse still, many would-be buyers have been scared off as a growing number of cash-strapped developers are unable to complete their projects, leaving people who pre-paid for such homes empty handed.

Four Strategies

Faced with a deteriorating market, Country Garden hasn’t simply stood still. In addition to issuing an open letter of apology, the company announced four strategies that it hopes can reverse its situation.

The first is to fully guarantee delivery of its properties, while the second is to tackle its debt by communicating with its creditors and consider other debt management measures.

The third is ensuring its continued orderly operations. The company emphasized that its current net assets are sufficient at about 310 billion yuan at the end of last year. Its total salable resources were worth about 1.2 trillion yuan. Country Garden also said it would streamline its organization and reduce expenses.

Its fourth and final step is to strengthen its organizational leadership during “the special period.”

So, can Country Garden’s sudden slide be reversed? So far no “unfinished buildings” have been delivered in accordance with its “guaranteed delivery” pledge. Resolution of its liquidity pressure could largely depend on whether it can provide a plan to service its debt and get creditors to sign on.

Its emphasis of sufficient assets doesn’t mean too much, since real estate assets are nothing more than buildings and land. Everything depends on future trends in the market. If property prices continue to fall, Country Garden’s properties and land reserves will also lose value. Falling asset prices will also drive up the company’s debt ratios. And reducing expenses, as Country Garden has promised, may be little more than a drop in the bucket for companies with hundreds of billions of dollars in debt.

Obviously, a sudden turn for the better in China’s property market would be enough to rescue Country Garden. But more deterioration could put the company’s future at risk. The current situation certainly doesn’t look good, since things are unlikely to bounce back in just a year. Accordingly, Country Garden’s plan to regain its footing may be easier said than done.