By Clare Jim and Umesh Desai

HONG KONG (Reuters) - Building up the second-biggest corporate debt pile in China does come at a cost.

China Evergrande Group <333.HK>, the nation’s No.2 real estate developer reported last week that its borrowings grew to $57 billion by the end of June, including so-called perpetual bonds. Only state-owned Petrochina <0857.HK> owes more.

The crushing impact of that burden became clear in its first-half results as despite reporting a 12.6 percent jump in sales, Evergrande said that income attributable to shareholders slumped 74 percent to 2.46 billion yuan ($368 million). That was mainly because of a 60 percent rise in payments on the perpetual bonds as well as a surge in marketing costs.

The aggressive leveraging of Evergrande’s balance sheet by its founder and major shareholder Hui Ka Yan shows that while investors and economists have been largely focused on the mountains of debt being built up by China’s state-controlled sector, the private sector has also been on a borrowing binge, fueled by the availability of cheap money.

With a stock market value of just $8.5 billion, its critics say that Evergrande, which is a household name in China because of its development of many thousands of apartments for middle class buyers, would be rocked badly if there was a major decline in China’s home prices or a further downturn in an already shaky Chinese economy.

“Evergrande’s stretched balance sheet, due to active land purchases, high dividend payments and expansion into new businesses should keep its net gearing at a very high level,” said Bank of America Merrill Lynch analyst Raymond Ngai “We think the stock should trade at a discount valuation, with its high financing risk.”

Hui and the company declined to comment for this article.

Evergrande’s shares have fallen 7.5 percent since the results were announced late last Tuesday. They ended last week at HK5.33. Hui expects further declines and has a target price of HK$3.90.


For credit analysts, the debt picture appears far from sound.

"We are concerned about Evergrande’s high leverage and liquidity risks," said Moody's analyst Franco Leung.

It is by no means the first time that there have been alarm bells rung, though Evergrande has also been able to have some of its fiercest critics at least partially muzzled.

High-profile short seller Andrew Left, of California-based Citron Research, published a report in 2012 arguing the group was insolvent. Evergrande denied the accusations and Left was recently found culpable of market misconduct by a tribunal in a case brought by the Hong Kong securities regulator.

Left, who declined to comment on Evergrande for this article, says he is considering an appeal.

Moody’s itself was reprimanded by the regulator and fined HK$11 million for alleged failures in producing a critical report on Evergrande. Moody’s is appealing.

Evergrande does have its supporters in the analyst community, who see it taking advantage of the troubles faced by rivals in a weaker economy.

“Evergrande is good at buying land and quickly turning it into cash by selling properties – so this strategy is a good one. In a sector slowdown, there is lot of room to swallow less efficient players,” said David Ng, Macquarie’s Head of China & Hong Kong Research.

Meanwhile, Hui has, if anything, speeded up his debt-fueled purchases in recent years.

In the past eight months, Evergrande has splurged $4 billion on banks, construction companies and stakes in rivals. The company also bought 80 plots of new land spread across 57 cities in the first half of the year.

A lot of the acquisitions are add-ons that the company’s supporters say reinforces its market position, including a supply chain that can stretch from financing to construction and sales.

But Evergrade has also expanded into other areas. It grabbed headlines in 2010 when it bought the main soccer in its home town of Guangzhou. Evergrande also owns a variety of other assets, including an insurance company, a bottled water company, and a New Zealand dairy, and is making a big push into hospitals, tourist projects, movie houses and has become an Internet provider.


Little is known about Hui. Local media reports have said he was born in central China's Henan province in 1958 to a poor family, and he moved south to Shenzhen because he was inspired by then Chinese leader Deng Xiaoping’s visit to the city in 1992 that played a crucial role in accelerating China’s economic reforms. He now has many of the trappings of a top business owner, including a private jet, a yacht and two Rolls-Royce vehicles, according to the reports.

His most controversial recent move has been Evergrande’s $2.2 billion investment in China’s largest real estate developer Vanke <2202.HK>, putting Evergrande in the middle of the country's messiest-ever corporate battle. This has triggered speculation among analysts that it could be considering a costly play for all of Vanke.

"Its purchase of Vanke’s stakes will undermine Evergrande’s efforts to control its debt growth and raises financial and investment risk,” said Moody’s Leung.

Evergrande has characterized the Vanke purchase as an investment and has not elaborated - even to Vanke, whose officials said they were perplexed. "We have been asking them about their intention in buying our shares but they have never replied," Wang Wenjin, executive vice president of Vanke, said last week. L3N1B32HZ]

It has increasingly been using perpetual bonds, which on average pay an interest rate of 9 percent, and are counted as equity rather than debt because they have no maturity date. During the first six months of the year, the amount on issue soared 53 percent to 116 billion yuan.

Yield-hungry investors in China have been happy to amp up the party. Evergrande's bonds due 2020 <XS116514648=TE> were sold last year at a yield of 12 percent but now yields are a mere 3.6 percent despite a CCC-plus rating from ratings agency Standard & Poor's that puts well into junk territory and only five notches above default levels.

Even before the Vanke stake purchase, its net debt to core earnings soared to a ratio of 14.8 at the end of 2015, according to research provider CreditSights, up from 2.1 five years ago. That means it would take nearly 15 years to repay its debt at the current rate of profit generation.

In a group of 40 real estate developers examined by rating agency Standard & Poor's, only three had higher ratios.

In February, the company indicated it was prepared to get even more aggressive when it gained the approval of bondholders to make its covenants more flexible to "pursue additional business opportunities and further business growth." That means leverage will likely rise, says S&P Global analyst Matthew Kong: "We are not confident the company can deleverage, despite the strong sales."

(Additional reporting by Tris Pan in HONG KONG; Editing by Clara Ferreira-Marques and Martin Howell)