Will Country Garden be the next Chinese developer to fail?

Picture of Mark Jolley
Posted by Mark Jolley

Views presented in this blog are the author’s own opinion and do not constitute financial research or advice.

  • Country Garden in focus after missed payments
  • Chinese developer has displayed risky accounting signals for years

Back in May, we looked at Chinese property developers and concluded that, large Chinese developers have a manipulation risk score three times higher than equivalently sized global companies.” 

Even if real-estate conditions improved, we said the underlying cash position of developers could further deteriorate due to the delayed impact of account manipulation. 

Recovery in China’s real estate market remains elusive and the plight of the developers has worsened, recently punctuated by the bankruptcy of China Evergrande Group (3333 HK) and the technical default of Country Garden (2007 HK).

Evergrande was always seen as a risk due to the enormity of its debt pile. Certainly, anyone following Transparently.AI’s accounting manipulation risk system would have steered well clear of the company. The system flagged Evergrande in the worst 10% of Asia ex Japan stocks (and often the worst 5%) as far back as 2010.

The market is now looking for the next Evergrande. In fact, our system identifies 175 Hong Kong and China-listed real estate companies with high accounting manipulation risk scores. Twenty-one of those are among the largest 20% of stocks globally. 

Country Garden

Is Country Garden at risk? It has certainly contributed to the jitters since it missed two interest payments on its bonds earlier this month. 

This is a company that was always more highly regarded by analysts than Evergrande. More importantly, Chinese property buyers once saw Country Garden as one of China’s most dependable developers. 

Should it fail, the knock-on effects will be less than for Evergrande, because 40% of the sector is already in technical default. Still, the knock-on effect on Chinese property market sentiment could surprise. Every privately owned developer is already regarded with suspicion.

Country Garden Chairman Yang Huiyan was once well regarded as China’s richest woman. Having sold her shares repeatedly late last year, in July she transferred most of her remaining stake to a charity founded by her sister. 

This sale occurred when the company was attempting to raise US$300 million in a primary share placement. Unsurprisingly, the share placement failed.

Accounting risk

In spite of its standing among investors and customers, it’s worth noting that Country Garden has always ranked poorly on the Transparently.AI Manipulation Risk Analyzer. This is the tool that establishes the probability that a company is manipulating its accounts and is at risk of collapse.

Figure 1 shows a snapshot from Country Garden’s full risk report prior to the impact of Covid in 2019. The manipulation risk score rose steadily from 56% in 2008 when it was first rated to 72% in 2019. 

Figure I. Excerpt from Country Garden full risk report for 2019

Source: transparently.AI

The company’s risk score of 72% put it in the 91st percentile for all Asia ex-Japan stocks and at the 86th percentile for all real-estate stocks. 

The system indicated that a dartboard would have chosen a less risky stock than Country Garden nine times out of 10 and a better real-estate stock more than eight times out of 10. The risk score has deteriorated further since 2019. 

In 2019, the account manipulation risk system gave Country Garden red flags for gearing, growth signals, credit, investing activity, working capital signals, valuation signals, business manipulation and margin signals. The confluence of so many red flags indicated a high risk of potential failure.

Country Garden red flags

From a manipulation perspective, Country Garden was not the riskiest real estate company in 2019 but it was very far from the type of company that investors and customers imagined it to be.

The problems at Country Garden did not emerge from thin air, they were always present from the company’s inception. In 2010, for example, the risk score was already high at 61%. Red flags were issued for gearing, smoothing activity, investing activity, accruals management, asset quality, growth signals, credit, and working capital signals.

From a governance perspective, the only things that changed at Country Garden over time were the rising debt level and slowing sales growth which, by 2019, made it virtually impossible to undertake further manipulation via accruals and capitalization of expense. 

The jig, as they say, was up.

The system doesn't tell you when a company is likely to collapse as a result of manipulation (or alongside manipulation), but history tells us it's usually within 5 years. 

In the case of Evergrande, it took substantially longer as the market refused to give up on the company. Nonetheless, it has now gone into bankruptcy. Which domino will fall next?

Disclaimer: Both the author and Transparently Pte Ltd do not have trading positions in the companies it expresses a view of. In no event should the author or Transparently Pte Ltd be liable for any direct or indirect trading losses caused by any information contained in these views. All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any of the information contained herein.