September 15, 2017 / 9:12 AM / a year ago

Fitch Rates Red Star Macalline's USD Notes Final 'BBB'

(The following statement was released by the rating agency) HONG KONG, September 15 (Fitch) Fitch Ratings has assigned China-based Red Star Macalline Group Corporation Ltd.'s (RSM, BBB/Stable) USD300 million 3.375% senior notes due 2022 a final 'BBB' rating. The notes are issued by Hong Kong Red Star Macalline Universal Home Furnishings Limited, a wholly owned subsidiary of RSM, and are rated at the same level as RSM's senior unsecured rating because they constitute its direct and senior unsecured obligations. The net proceeds of the bond issue will be used for the development of portfolio shopping malls, potential acquisition of properties or related businesses, as well as working capital and general corporate purposes. The final rating is in line with the expected rating assigned on 12 September 2017. The rating is supported by RSM's hybrid business model of owning malls and managing malls it does not own, which enables RSM to expand with a low capex commitment without having to build its own malls. The rating is also supported by a healthy recurring EBITDA interest coverage of 3.0x. The rating is constrained by its rising leverage (as measured by net debt/recurring EBITDA) of close to 5.5x in 2017 due to higher planned capex of CNY7 billion and a large dividend payout. Deleveraging hinges on whether the company will cut its 2018 capex and use its quasi-REIT sales proceeds to repay debt. KEY RATING DRIVERS Limited Rating Headroom: Fitch downgraded RSM's rating in March 2017 from 'BBB+' to reflect its rising leverage due to continued negative free cash flows and a delay in achieving our recurring EBITDA expectation, a view we still hold after reviewing its 1H17 results. We estimate RSM's net leverage will reach 5.4x at end-2017 (1H17: estimated at 5.2x versus 4.9x in 2016) and it has limited deleveraging room in 2018 if it continues to have high capex and pay large dividends. A sustained leverage of above 5.5x may result in further rating downgrades. Capex Exceeds Cash Flows: We estimate RSM's internally generated cash flow from rental income and fees from managed malls of about CNY3 billion to be sufficient to fund the construction of around six new malls a year in 2016-2018. However, RSM's planned 2017 capex of CNY7 billion, which includes land acquisitions, equity investments and a one-off payment for its new office building in Shanghai, is far more than what its operating cash flow can cover. RSM's high dividend payout ratio of 60% of core net profit would also delay deleveraging, if sustained. However, the company does have the flexibility of reducing capex in 2018 onwards as most of the expenditure is not committed. Recurring EBITDA Expectation Delayed: Fitch only expects RSM's recurring EBITDA, the main driver of its rating, to reach CNY4 billion in 2018, compared with 2017 previously. Recurring income, which includes rental income from RSM-owned malls and management fees from malls that it operates, rose 11.2% to CNY6.1 billion in 2016, while the EBIT margin narrowed to 50.7% from 51.6%. The EBIT margin was compressed by higher selling, general and administrative costs related to new malls opened in 2016, and we expect this to persist in the next 12 months, despite the strong occupancy and rental rates for the mature malls (those in operation for at least two years). The margin in 1H17 was flattish compared with 2016. Asset Securitisation Plan Positive: RSM securitised two malls in Tianjin for a quasi-REIT program and received proceeds of CNY2.65 billion in September 2017, which it is planning to use to repay debt. Fitch estimates the two Tianjin malls generate annual recurring EBITDA of CNY140 million on a total leasable area of approximately 97,000 sq m and contributed only 4.3% of RSM's total recurring EBITDA in 2016. Therefore, Fitch does not think the sale of the two malls will diminish RSM's recurring EBITDA materially. However, it shows the company's intention to deleverage and enhance management fees as RSM has a contract to manage the two malls. We also estimate the malls' net rental yield to be as high as 8.3%, limiting the need for RSM to make up for any shortfalls experienced by the quasi-REIT's investors. However, RSM's business profile will be weakened if it continues selling mature malls without using the proceeds to repay debt, and if its capex, including but not limited to venture capital investments, does not generate recurring EBITDA, which would trigger the downgrade guidelines. Healthy Coverage: RSM's coverage ratio (as measured by recurring EBITDA/gross interest expenses) improved to an estimated 3.1x in 1H17 from 3.0x in 2016 and 2.4x in 2015, due to growing rental income and lower funding costs. In addition to the CNY5 billion already raised in 2015, RSM raised an additional CNY3 billion in onshore bonds in 2016 in two tranches at coupon rates of as low as 3.5%, which effectively brought its average funding cost down to 5% in 1H17 from 5.4% in 2016 and 6.9% in 2015. Coverage may temporarily fall below 3.0x in 2017 due to higher debt. However, 56% of RSM's borrowings carried fixed rates as of end-2016, and RSM is consistently optimising its capital structure, so it should be able to manage any reasonable rise in interest rates. Fitch expects RSM's coverage ratio to recover to above 3.0x in 2018 as rental income rises with more investment properties. Market Leader, Strong Profile: RSM's malls are spread across 150 Chinese cities in 28 provinces, accounting for an 11.8% share in the chain home-improvement retail mall sector in 2016. RSM benefits from strong home-refurbishment demand from the rising number of home buyers in both the primary and secondary markets, and from existing property owners - who form more than 60% of total buying demand. Fitch expects RSM to extend its leadership position with its strong pipeline of malls, both owned and managed. The operator expects to increase the number of malls to 300 by end-2019 (1H17: 214), particularly in lower-tier cities that are not currently well-served by home improvement retailers. Parent Not an Immediate Concern: RSM's rating is not linked to its parent, Red Star Macalline Investment Ltd (RSI), which is primarily engaged in property development, other than its 68.44% stake in RSM. RSI accesses RSM's cash mainly through dividends, which we have already accounted for in RSM's high dividend payout. An average dividend of CNY1.2 billion from RSM to RSI is sufficient to cover the annual interest burden. However, Fitch will consider incorporating RSI's impact on RSM's ratings if there are further signs of frequent related-party transactions showing RSI accessing RSM's cash other than dividends. DERIVATION SUMMARY RSM's rating is driven by the resilient rental income from its investment properties, which are mostly in good locations in first- and second-tier cities. RSM's recurring EBITDA of around CNY3 billion from investment properties is lower than that of most of its Hong Kong-based peers, such as Swire Properties Limited (Swire; A/Stable) and Sun Hung Kai Properties Limited (SHKP; A/Stable), whose recurring EBITDA are above USD1 billion (about CNY7 billion). RSM's recurring interest coverage of around 3.0x is also lower than the 5.0x-6.0x for these companies. RSM's business, which is purely as a mall owner and operator, is less volatile than that of Chinese companies like Dalian Wanda Commercial Property Co. Ltd. (BBB/Negative) and China Resources Land Ltd (BBB+/Stable), which are also engaged in the riskier property development business. Both RSM and Dalian Wanda have large, mature retail property portfolios with over 100 assets across China, although RSM's recurring EBITDA is smaller than that of Dalian Wanda - which was above CNY10 billion in 2016. RSM's asset-light model helps it to achieve higher interest coverage than Dalian Wanda and China Resources Land, and it has a lower loan-to-asset value (LTV) ratio than Wanda. RSM's recurring EBITDA is second only to that of Dalian Wanda in China, and is slightly larger than that of China Resources Land. Dalian Wanda and China Resources Land have greater diversity of asset types in their investment-property portfolios, while RSM concentrates on home improvement and furniture retail malls. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Average occupancy for owned and leased malls at above 95% throughout the cycle - 2%-3% rental rate growth - Slight improvement of EBITDA margin of owned and leased portfolios - CNY7 billion capex in 2017 and CNY4.5 billion in 2018 - Dividend payout of 40% of net profit - 4.5%-5% funding cost for new borrowings. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - Net debt/recurring EBITDA sustained below 4.0x - Recurring EBITDA/gross interest expenses sustained above 3.0x Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - Net debt/recurring EBITDA sustained above 5.5x - Recurring EBITDA/gross interest expenses sustained below 2.5x - Any developments that would have a negative impact on RSM's market position, including a sustained decline in rental rates and occupancy at its malls LIQUIDITY Healthy Liquidity, Long Maturity Debt: RSM's available cash of CNY6.2 billion at end-2016 was sufficient to meet its short-term debt repayment of CNY4.7 billion. We expect a cash outflow of about CNY1.4 billion in 2017, after taking into account the budgeted capex of CNY7 billion, finance costs of CNY1.3 billion, tax expenses of CNY0.7 billion and other expenses of CNY4 billion, and the cash collection of CNY10 billion from rental and other income. RSM's overall liquidity position looks comfortable as it has CNY7.8 billion in available but unutilised credit facilities. Contact: Primary Analyst Vicki Shen Director +852 2263 9918 Fitch (Hong Kong) Limited 19/F Man Yee Building 60-68 Des Voeux Road Central, Hong Kong Secondary Analyst Yee Man Chin Director +852 2263 9696 Committee Chairperson Su Aik Lim Senior Director +852 2263 9914 Date of Relevant Rating Committee: 28 March 2017 . 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