Chinese Property Stocks Leap But Red Flags Abound

Mainland Chinese stocks shot higher on Wednesday, driven by a rally in financials and the beleaguered property sector. The broad-market CSI 300 closed up 2.9%, by far the strongest gains in Asia on a generally positive day for the continent's markets.

Country Garden Holdings (HK:2007), the largest developer in China by sales for 2021, saw its shares jump 6.3% in Hong Kong. Its property-management spinoff Country Garden Services Holdings (HK:6098) was the top gainer in Hong Kong's benchmark Hang Seng Index, climbing 9.7%.

At least for today, investors appeared to move past the "red flags" raised by close to a dozen mainland developers that are struggling to prepare their annual results. Most have a deadline that is tomorrow, or has already lapsed. Many have also seen auditors resign, hinting at behind-the-scenes chaos in making sense of the numbers. Although most companies cite Covid staff shortages as one of the reasons, they typically have also run into massive liquidity problems, and sharply slowing sales.

Many of the largest Chinese developers are listed in Hong Kong, where the CSI Hong Kong-Listed Tradable Mainland Real Estate Index climbed 6.5% on Wednesday, avenging its 2.1% fall of the day before, and then some. The broad Hang Seng Index in Hong Kong advanced 1.4%.

But the stock moves of the last couple of days are prosaic by recent standards, with the volatility of Chinese stocks in general and property stocks in particular exceptionally high. That CSI index of the mainland developers listed in Hong Kong plummeted 25.0% between March 10-15, then summited 34.2% by March 17. After this week's movements, it's approaching where it started March, down "only" 8.1% since the beginning of the month.

The fact remains that these are terrible times for Chinese property developers. The sector is struggling under forced deleveraging from the Chinese government that has called into question the business model of many homebuilders: to sell apartments off-plan before they're built, rush through development using that funding, finish the project as quickly as possible, and move on. Chinese property prices have moved into reverse in many Chinese cities, sapping the enthusiasm of the home-buying public.

Slowing sales have led to financial distress at many developers, which causes doubts among apartment buyers, leading to slowing sales... it becomes a vicious cycle involving a loss of confidence.

One of the biggest share-price movements today might have come from the company that started the speculation over the financial health of developers. China Evergrande Group (HK:3333) and (EGRNF) , which lost its title of China's largest developer to Country Garden as it ran aground, today announced it would raise C¥3.66 billion (US$576 million) by selling a property project in the city of Hangzhou, near Shanghai. But Evergrande shares have been suspended since March 18.

So far, nine developers have declared they can't file their annual accounts on time, including Evergrande. The others are: Agile Group Holdings (HK:3383) and (AGPYF) ; Fantasia Holdings Group (HK:1777); Kaisa Group Holdings (HK:1638); Logan Group (HK:3380); Ronshine China Holdings (HK:3301); Shimao Group Holdings (HK:0813) and (SIOPF) ; Sinic Holdings (HK:2103); and Sunac China Holdings (HK:1918).

Ronshine, for instance, saw PricewaterhouseCoopers resign as its auditor on March 21, just 10 days before the company is supposed to release its financials, tomorrow.

There's more going on than a bit of trouble tabulating the taxi receipts. Auditors normally only quit when they don't want their name attached to some creative/questionable number crunching. The results are sure to be weak; even the accountants that stay on board may offer "qualified opinions" that they're only basing their signoff on what they've been told.

Nomura's China property analysts, Jizhou Dong and Stella Guo, note that "when developers change auditors ahead of full-year results season, it typically raises red flags regarding potential auditing issues, and should lead to serious market concerns about the trustworthiness of their financial numbers."

Evergrande was also supposed to file its annual report by tomorrow, and will miss that deadline. Instead, it tells us today about a deal it has just struck - after delivering a bombshell about a US$2 billion financial hole it is investigating over in accounts.

Evergrande is selling the Crystal City Project, a mixed commercial-and-residential development currently under construction in Hangzhou, a city known for its entrepreneurs and headquarters to Alibaba Group Holding (HK:9988) and (BABA) . Evergrande says it doesn't have the cash to complete the construction, which has been delayed by its liquidity problems, and is disposing of the project to the state-owned company working on its construction, as well as the local state-owned developer.

The contractor, Zhejiang Construction Engineering Group, is an operating arm of Zhejiang Construction Investment Group (SZ:002761), which is state-owned but listed on the Shenzhen Stock Exchange. The developer is Zhejiang Zhejian Real Estate Group, which is ultimately owned by the government of Zhejiang Province. Hangzhou is the capital of the province.

The Evergrande group will only net a profit of C¥216 million (US$34 million) that it is putting toward working capital, because much of the money will go to pay back the contractor for the construction it has already carried out.

This kind of disposal is increasingly common in China, where developers that are short on working capital are having to sell projects, or even sell out entirely, typically to government-controlled entities. It's a form of government bailout without being a government bailout. Interestingly, while the Beijing government may be talking tough on whipping developers into shape, the property companies often have very warm relations with local governments. Selling land to developers is one of the primary sources of revenue for city and provincial governments.

Evergrande remains deeply troubled. It has also announced this week that it is setting up an independent investigation committee comprised of its independent directors to look into just how its property-management spinoff, Evergrande Property Services (HK:6666), has come to have a C¥13.4 billion (US$2.1 billion) hole in its balance sheet. It, too, has had its shares halted since the close on March 18.

Only in preparing its financial figures for last year did Evergrande Property Services realize that banks have seized the billions in cash, because it was used as security on pledges by an unidentified third party. Both Evergrande companies requested that their shares be suspended at the start of last week so they can try to find out what has happened.

The missing US$2.1 billion accounts for the bulk of cash that the property-management company had on hand. The company says preliminary findings show it was used as collateral as the company slipped into financial distress.

The rival developer Hopson Development Holdings (HK:0754) will be feeling like it dodged a bullet. Hopson agreed to buy 50.1% of Evergrande Property Services for HK$20.0 billion (US$2.6 billion), part of what I explained is a salvage effort by its parent. But the deal fell apart, as I also outlined, due to doubts over the accounts.

Hopson, which insisted it still wanted to go ahead, said it was supposed to pay the money into the bank account of Evergrande Property Services, so the property-services unit could settle its accounts payable and receivable with its parent. But Hopson said China Evergrande Group tried to change the terms so that it would be paid the cash instead. Hopson refused to do that, saying it wouldn't know whether the target subsidiary would get what it was owed by the parent.

That's one deal-specific story representing plenty of behind-the-scenes scurrying to get developer finances into shape. There's no way investors can touch the Chinese property sector with any security in the near term. Bold speculators might make massive one-day gains, or suffer severe losses.

The Chinese government, at a committee meeting led by Vice-Premier Liu He, promised to supply some stability to the sector, as I explained mid-month. But Beijing has baulked at helping individual developers that have run into trouble. As a result, the paper gains today from this troubled sector remain just that, paper, and far from anything as safe as houses.

At the time of publication, Alex Frew McMillan had no position in the securities mentioned.