Kaisa default forensics yield clues in accounting footnotes

[HONG KONG] Investors still wondering how Kaisa Group Holdings Ltd doubled its debt in six months and triggered China's first property bond default may want to read page 63 of its 2014 interim report.

There, in footnote No. 15 of the Shenzhen-based company's balance sheet, is a reference to 11 billion yuan (S$2.36 billion) in advance deposits for property projects from third parties and for 1.15 billion yuan that needed to be refunded.

At issue is whether these deposits were initially classified properly as current liabilities on Kaisa's books. Analysts at Lucror Analytics Pte, Mitsubishi UFJ Securities HK Ltd and BDO Ltd say the payments have characteristics of interest-bearing debt, and booking them the way Kaisa did may have made metrics that investors use to assess a company's riskiness appear stronger than they actually were.

"We view anything where the holder can demand repayment as being debt-like," said Charles Macgregor, head of Asia high- yield research in Singapore at Lucror and a former senior credit officer at Moody's Investors Service. "The advance deposits in Kaisa's balance sheet are akin to a convertible bond where the holder has the option to take land or take cash."

Questions over Kaisa's accounts are now delaying both the restructuring of its US$10.5 billion of debt and a takeover worth as much as US$1.2 billion by rival Sunac China Holdings Ltd. Asian junk dollar bond yields began climbing in the second half of last year and peaked in January as falling property prices and the slowest economic growth in more than two decades make it harder for companies to pay record debts.

DEBT DOUBLES

Kaisa declined to discuss its accounts, according to its public relations firm IPR Ogilvy & Mather. PricewaterhouseCoopers LLP, the company's auditor, said it couldn't comment due to client confidentiality. Ernest Kong, a spokesman for Hong Kong's Securities and Futures Commission, declined to comment.

On Feb 16, Kaisa surprised investors with a stock-exchange filing that disclosed its total debt more than doubled to 65 billion yuan on Dec 31 from 29.8 billion yuan on June 30. The stock slumped 12 per cent in four days. It lost 47 per cent over six months before being suspended pending the release of delayed 2014 accounts.

In a March 8 statement, Kaisa gave as the first reason for the jump in debt requests from independent third parties for a "refund of their deposits with interest." It said trust financing and other borrowings also contributed.

ASSETS FROZEN

"Interest-bearing debts came in larger than what we expected, and the significant increase wasn't well explained by the company," said Franco Leung, a senior analyst at Moody's, which rates Kaisa's debt Ca, just one step from the lowest grade typically signaling default.

Kaisa's troubles started unfolding on Oct 17 when it denied speculation that Chairman Kwok Ying Shing was missing amid a corruption crackdown in Shenzhen. The founder resigned on Dec 31 citing health reasons and agreed to sell his family's controlling stake to Sunac in January.

Financial constraints tightened as Shenzhen authorities blocked sales of some developments amid the corruption probe and local creditors obtained court orders to freeze Kaisa's assets. After examining the books, Sunac Chairman Sun Hongbin said in March overseas creditors don't understand how serious the situation is. Kwok returned to the helm on April 13, and seven days later the company defaulted on dollar bonds.

'UNANSWERED QUESTIONS'

The deposits outlined in the Sept 21 interim report differ from proceeds builders get from selling properties ahead of completion, a common item that's booked under liabilities until developers deliver the projects. Builders in China have to obtain approval from local authorities before they're allowed to start pre-sales.

Leung of Moody's said Kaisa's use of advance deposits for projects without pre-sale certificates was "not common" among Chinese developers. The item started appearing in 2012, when it was 3.37 billion yuan, and almost quadrupled to 13.27 billion yuan by 2013, stock exchange filings show.

"This does look like short-term loans to fund Kaisa's operations and has probably been reclassified to debt," said Rui Guo, a credit analyst at Mitsubishi UFJ in Hong Kong. "There are still quite a few unanswered questions." Robert Fong, an analyst at Bloomberg Intelligence in Hong Kong, said the advances could have been a form of funding structured as a property sale with conditions.

"The net effect of the arrangements would have made the debt situation look less severe than it actually was," he said.

DEBT RATIO

China's builders were forced to resort to less transparent forms of financing as the government sought to prevent a property bubble by limiting access to bank loans.

Moody's estimated in a January report that shadow banking assets including trust funding reached a record 45 trillion yuan by Dec 31, 71 per cent of gross domestic product. It is unclear to what extent Kaisa tapped the industry, which is now being more heavily regulated by the government. Two calls and a fax to the China Securities Regulatory Commission press office went unanswered.

Kaisa's net debt to equity ratio of 72.5 per cent on June 30 treated deposits from independent third parties as liabilities along with pre-sale proceeds, and not as interest-bearing debt. The metric includes short-term borrowings of 6 billion yuan and long-term debt of 23.8 billion yuan. The median reading of the financial-health benchmark for 197 Chinese property companies was 68.1 per cent in their latest filings, data compiled by Bloomberg show.

Including the 11 billion yuan of advance deposits as debt would have pushed Kaisa's ratio up to 115.4 per cent, Mitsubishi UFJ's Guo estimated.

LESSON LEARNED

"This kind of method - you could call it gray market borrowing - is actually quite common in China," said Andrew Lam, a director at accounting firm BDO. Developers that take advance deposits may lump them under their payable accounts and pay interest as high as 30 per cent, he said.

While bondholders have become more optimistic about Kaisa's prospects amid the pending Sunac acquisition - its March 2018 dollar bonds have rallied to 58.2 cents on the dollar from 29.6 on Jan 7 - the Kaisa episode reinforces one key lesson, according to Mr Guo: Read the fine print.

"The takeaway is for analysts to exercise more scrutiny on such line items of other developers, as there could be hidden debt as well," he said.

BLOOMBERG