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Fitch Downgrades Red Star Macalline to 'BBB'; Outlook Stable
March 28, 2017 / 9:12 AM / in 9 months

Fitch Downgrades Red Star Macalline to 'BBB'; Outlook Stable

(The following statement was released by the rating agency) HONG KONG, March 28 (Fitch) Fitch Ratings has downgraded China-based Red Star Macalline Group Corporation Ltd's (RSM) Long-Term Foreign-Currency Issuer Default Rating (IDR) and senior unsecured rating to 'BBB' from 'BBB+'. The Outlook for the IDR is Stable. The downgrade reflects our expectation that the mall operator's leverage will increase in 2017 instead of decreasing as previously expected. The sustained increase in its leverage, as measured by net debt/recurring EBITDA, to above 4.0x,is likely to result from its slower-than-expected recurring EBITDA growth and higher capex and dividends payout. Leverage of this level is above that of other Fitch-rated Chinese investment-property companies and RSM's 'BBB+' rating can longer be justified. RSM's Stable Outlook reflects our belief the company's financial profile is not likely to deteriorate from 2017, due to a growing recurring EBITDA and slower capex in 2018. Furthermore, the recurring EBITDA interest coverage is still healthy at 3.0x. KEY RATING DRIVERS Rising Leverage: Fitch expects RSM's free cash flow to continue to be negative because of high capex and dividend payments. 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 each year in 2016-2018. However, RSM's planned capex of CNY7 billion in 2017, 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. Furthermore, RSM has a high dividend payout ratio of 60% core net profit that would also delay deleveraging, if sustained. We expect RSM's leverage to reach 5.4x at end-2017 (end-2016: 4.9x). However, the company does have the flexibility of reducing capex 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 exceed 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 by 11.2% to CNY3.3 billion in 2016, while EBIT margin narrowed to 50.7% from 51.6%. 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 2017, despite the strong occupancy and rental rates for the mature malls (those in operation for at least two years). RSM's EBITDA fell 6.1% to CNY4.2 billion in 2016, with EBITDA margin narrowing to 44.9% from 50.7% in 2015, due to lower one-off income from the initiation, entrance and consultation fees that it collects from managed mall developers. Healthy Coverage: RSM's coverage ratio, as measured by recurring EBITDA/gross interest expenses, improved to 3.0x in 2016, from 2.4x in 2015, due to growing rental income and lower funding costs. RSM successfully raised CNY8 billion by issuing three tranches of onshore corporate bonds at coupon rates as low as 3.5%, which effectively brought its average funding cost down to 5.4% in 2016 from 6.9% a year ago. Coverage may temporarily trend down below 3.0x in 2017 due to higher debt. However, 56% of RSM's borrowing carry fixed rates as of end-2016, and RSM is consistently optimising the 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 142 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 (2016: 200), particularly in lower-tier cities that are not currently well-served by home improvement retailers. 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 CNY7bn). 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 compared with 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 portfolioa with over 100 assets across China, although RSM's recurring EBITDA is smaller than Dalian Wanda's, which was above CNY10bn 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 Dalian Wanda's 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 Red Star 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 portfolio - 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 negatively impact RSM's market position, including 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 Media Relations: Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: wailun.wan@fitchratings.com. 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