China's Runaway M&A Trains


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Prudence dictates that a compulsive shopper who runs up a hazardous amount of debt should think about cutting the credit card in half and staying home for a while. Try telling that to China's acquisition-hungry companies.

Two prime examples were on show this week when China Evergrande Group, one of the nation's biggest developers, and Fosun International, an expanding Shanghai-based conglomerate, reported first-half earnings. The results show just how hard it is to kick the buying habit in an environment where compliant lenders stand ready to advance seemingly unlimited sums.

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Total borrowings at junk-rated Evergrande jumped by 28 percent from the end of December to 381 billion yuan ($57 billion). That pushed the Guangzhou-based company's ratio of net debt to shareholders' equity to 142 percent, above the average 108 percent for China's overleveraged property developers, according to data compiled by Bloomberg.

Count Evergrande's perpetual bonds as debt rather than equity and even that ratio starts to look benign. The total debt to common equity ratio rose to 809 percent at the end of June, from 582 percent six months earlier. The developer added about 40 billion yuan more perpetual notes during the period.

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So, time to rein things in somewhat? Not a bit of it. Evergrande wants to acquire brokerage and trust companies as well as smaller rivals, Chief Executive Officer Xia Haijun told reporters in Hong Kong Tuesday. That would be on top of more than $5 billion of purchases so far this year, including building a stake in larger developer China Vanke and acquiring a chunk of Shenyang-based Shengjing Bank. First-half profit, meanwhile, fell 23 percent excluding property revaluations and foreign-exchange losses.

The debt buildup wouldn't be so striking if Evergrande were acquiring cash-generating assets that can help pay down borrowings. If anything, things seem to be moving in the opposite direction. The developer, whose B3 rating for senior unsecured debt with Moody's denotes a "high risk," has reported six consecutive years of negative cash flow from operations. Cash from financing activities is keeping the game going, with a net inflow of more than 290 billion yuan since 2008.

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Over at Fosun, things are starting to look a little more restrained. The owner of Club Med reported a 21 percent increase in net income, driven by gains in its investment and industrial businesses. The company said it will "accelerate the optimization of its debt structure" and enhance the liquidity of assets with the aim of raising its credit rating above junk.

It still has some way to go. Fosun is ranked three levels below investment grade at Moody’s Investors Service and two under the threshold at S&P Global Ratings. The company's net debt to equity ratio nudged up to 43.2 percent at the end of June, from 41.8 percent six months earlier, Bloomberg data show. Total debt climbed to about 119 billion yuan from 115 billion yuan.

Some progress is being made. The group, whose co-founder Guo Guangchang disappeared mysteriously for four days late last year, has scrapped deals such as the purchase of Israeli insurer Phoenix and sold some assets, while planned IPOs of its health-care businesses and U.S. insurer Ironshore will raise further funds to reduce debt.

Still, whatever its protestations, Fosun is far from shedding the acquisition bug. In July, its health unit announced a $1.3 billion deal to buy Indian drugmaker Gland Pharma; other purchases since the end of June include the U.K.'s Wolverhampton Wanderers Football Club and Brazilian asset manager Rio Bravo Investimentos. It's now in the running to buy British handbag maker Aspinal and was looking to buy ING's Korean life unit, until that deal was aborted.

Fosun remains committed, it said, to an "insurance+investment model" (modeled on Warren Buffett's Berkshire Hathaway) in which policy premiums enable the leverage to fund purchases. The group says its focus is on a "wealth, health and happiness ecosystem," a group of categories broad enough to encompass just about anything. Indeed, Fosun has acquired a ragbag of assets spanning advertising, property, gold mining, fashion retailing, dairy products, baby strollers, film and TV production and Canada's Cirque du Soleil.

The bigger mystery for China's serial acquirers is why lenders and investors remain so willing to keep providing them with firepower. As with Evergrande, financing has accounted for most of the cash inflows to Fosun in recent years -- more than 86 billion yuan since 2013, while cash from operations contributed a negative 21 billion yuan.

Markets appear remarkably sanguine. Evergrande's 8.75 percent notes due 2018 have returned 7.9 percent this year and are trading close to a record high reached in August. Fosun's 6.875 percent 2020 bonds have returned 10 percent and are trading at 104 cents on the dollar. While shares of both have dropped this year, they remain well above the levels of three or four years ago.

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At some point, these acquisitions will need to start throwing off a lot more cash. In the meantime, if financing conditions become less accommodating, things could start to look ugly. Riding China's M&A train isn't for the faint of heart.

  1. The bonds, which have no maturity date, are usually booked as equity on company balance sheets.

Source: China's Runaway M&A Trains

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