1 December, 2023


Never profitable

Fredrik Oeqvist

Evergrande’s much delayed and recently published 2021 annual report makes clear that it significantly overstated revenue and earnings – most likely for many years. Contrary to what some people think, Evergrande was not so much a victim of tightened liquidity or a COVID-induced property market downturn; its problems were far more fundamental – there were never any profits.

Join our Newsletter

Evergrande inflated revenue and profits for years

In 2021, Evergrande made significant changes to how it recognised revenue from property sales[1]. Previously, Evergrande said it recognised revenue when the customer “obtains the physical possession or the legal title of the completed property”. This seems reasonably clear. The wording is identical to that of other Chinese property developers, including Country Garden. However, under its new auditor, Evergrande changed the description of its past practice: it seems revenue had been recognised on the “earlier of the acceptance of the property by the customer or according to the sales contract, the property was deemed to have been accepted by the customer”. This appears much more aggressive. Significantly, there is no reference to the property being delivered or completed; deemed acceptance was sufficient.

On top of this, Evergrande added an extra condition for revenue recognition: the “requirement for obtaining construction completion certificates or delivery of property inventory to property owners for use”. The completion certificate is required before properties can be delivered to buyers. It appears that, before 2021, Evergrande had, in some instances, booked the full amount of revenue before properties had been delivered and even before they had been completed. The reason given for this extra requirement was Evergrande’s “liquidity difficulties”. This suggests Evergrande may not have the money to complete properties on which it has already booked revenue and profits.

This change in accounting policy should have been applied retrospectively with the financials for prior periods restated to see the impact over time. However, Evergrande claimed it was unable to do so because of the large number of staff that had left the group. The company, therefore, applied the changes just from 2021, adjusting the year’s opening balances.

The change to revenue recognition had a substantial impact on Evergrande’s financials. It resulted in the reversal of previously recorded revenue of RMB664bn and net profits of RMB102bn. The amounts were equal to 27% of Evergrande’s entire revenue since 2004, the earliest year for which we have financial information, and 38% of cumulative net profits.

The change to revenue recognition resulted in the reversal of previously recorded revenue equal to 27% of Evergrande’s entire revenue since 2004, the earliest year for which we have financial information, and 38% of cumulative net profits

These sales can be booked a second time when the new conditions for recognition are met. Most of Evergrande’s current revenue is likely to be sales that have been re-recognised. Contract liabilities (primarily deferred revenue from pre-sold properties), which increased from RMB186bn at YE20 to RMB908bn on restatement at the beginning of 2021, had fallen to RMB604bn by end-1H23. In theory, the profits on these sales can also be re-recognised, although there is little evidence to suggest this has happened: Evergrande has recorded gross profits of just RMB16bn over the last two-and-a-half years. The suspicion is these profits never existed and have not just been deferred.

Evergrande has recorded total losses of nearly a trillion renminbi since the start of 2021, equal to 41% of total assets at end-2020

In addition to the RMB102bn profit reversal at the start of 2021, Evergrande recorded net losses of RMB686bn for the year, with further deficits of RMB126bn in 2022 and RMB39bn in the first half of 2023. These were primarily the result of asset write-downs, especially to development properties. Including the impact of the change in revenue recognition, Evergrande has recorded total losses of nearly a trillion renminbi since the start of 2021: a staggering RMB954bn, equal to 41% of total assets at end-2020 and nearly four times cumulative net profits up to that date of RMB268bn. Evergrande’s aggregate net losses have been RMB686bn since 2004, as Figure 1 shows and, by end-1H23, it had negative net assets of RMB644bn. The prediction in our original report on Evergrande in 2016[2] for write-downs of RMB150bn was too optimistic although, at that time, its balance sheet was less than half the size.

Other Chinese property developers have also incurred substantial losses in recent years. However, none have been on a similar scale. Evergrande’s total losses in the last two-and-a-half years, have been 272% of its equity at end-2020. China Aoyuan had the next highest losses, equal to 86% of equity, as Figure 2 shows.

It is unclear how long Evergrande has been artificially inflating its revenue. However, a longstanding puzzle had been why its contract liabilities were so low relative to peers. At end-2020, Country Garden reported contract liabilities equal to 61% of total properties under development, compared to just 15% for Evergrande; in 2010, both were around 50%. However, on restatement after the change in revenue recognition, Evergrande’s contract liabilities jumped to 57% of properties under development at start-2021, similar to Country Garden, as Figure 3 shows. It suggests Evergrande’s may have been pulling forward revenue for up to a decade.

At some point, it appears Evergrande’s primary purpose became raising finance to fund its inflating balance sheet and keep the party going. While, correctly measured, the property business may not have been profitable, Evergrande’s ability to find new sources of financing was exceptional, including wealth management products, insurance funds, new business ventures (bottled water, healthcare, electric vehicles etc.) and RMB130bn from strategic investors with the promise of an onshore listing.

In general, we think the conclusions from our 2016 report hold up reasonably well, even if it took longer than expected for the financing taps to be turned off:

“In our view, Evergrande is insolvent, in that the value of its assets is less than its liabilities. The company’s offshore bonds, which are structurally subordinate to its onshore liabilities, are also at risk of being wiped out... The company can stay afloat only by borrowing ever increasing amounts. There are already signs that some sources of finance have dried up. Predicting exactly when creditors will turn off the taps is impossible but, at some point, it will become too big to finance.”

[1] See Evergrande FY21 annual report, note 2, p52
[2] GMT Research: CHINA EVERGRANDE (3333 HK): Auditors Asleep, 30 Nov 2016