August 10, 2017 / 2:49 AM / a year ago

Fitch Rates LVGEM's USD Notes Final 'B+'

(The following statement was released by the rating agency) HONG KONG/SHANGHAI, August 09 (Fitch) Fitch Ratings has assigned China-based LVGEM (China) Real Estate Investment Company Limited's (B+/Stable) USD225 million 8.5% senior notes due 2020 a final rating of 'B+' with a Recovery Rating of 'RR4'. The notes were issued by its wholly owned subsidiary, Gemstones International Limited, and are guaranteed by LVGEM. The notes are rated at the same level as LVGEM's senior unsecured rating because they constitute its direct and senior unsecured obligations. The final rating is in line with the expected rating assigned on 2 August 2017. LVGEM's ratings are supported by its strong pipeline of property-development projects, which Fitch expects to significantly increase the company's scale to above CNY5 billion and widen EBITDA margin to more than 50% from 2017. The rating is also supported by LVGEM's good-quality investment property (IP) portfolio that generates recurring EBITDA to provide the company a healthy debt service buffer. The rating is constrained by LVGEM's small scale compared with other Chinese homebuilders rated 'B+' by Fitch, and its rising leverage due to expansion in the property-development segment. Fitch expects LVGEM's net debt/adjusted inventory to trend towards 45% from 41% at end-2016. KEY RATING DRIVERS Small Regional Player, Growing Sales: We expect LVGEM's contracted sales to steadily expand to CNY10 billion over 2017-2018, from less than CNY4 billion before 2016. LVGEM, whose inventory is mainly made up of completed development properties in Shenzhen, had volatile contracted sales in 2014-2016, ranging from CNY830 million in 2016 to CNY3.4 billion in 2015. However, its Shenzhen projects LVGEM Hongwan Garden and Mangrove Bay No. 1 Phase 1 will start sales in 2017-2018, and will be followed by the Liguang and Meijing urban redevelopment projects. LVGEM also expects several project injections from controlling shareholder Mr. Wong Hong King to help the company further raise contracted sales. Urban Redevelopment Focus; Asset Injections: LVGEM has developed 13 projects in Shenzhen as of end-2016, of which 10 involved urban redevelopment. Fitch expects LVGEM to obtain more urban redevelopment projects through asset injections in 2017-2019 from Mr. Wong, who has secured about 12 million square metres (sqm) of land, mainly in Shenzhen, Dongguan and Zhuhai (three major cities in Guangdong province). One of the projects is a large Shenzhen project, which Fitch expects will have about 4 million sqm of gross floor area (GFA) and will be injected in 2018-2019. Fitch expects this Shenzhen project to become LVGEM's flagship urban redevelopment project. Quality Investment Properties: LVGEM's IP portfolio includes the Shenzhen NEO complex that has office and retail components, and three Zoll community retail centres, one of which opened earlier this year. The Shenzhen NEO complex is located in the city's CBD and is almost fully occupied. Rents that were up for renewal in 2016 were re-contracted at 15% more on average. The two older Zoll centres had approximately 90% occupancy rates and positive rental reversion of more than 10% in 2016. Recurring Income Coverage to Decline: Fitch expects LVGEM to generate recurring cash inflow of CNY700 million in 2017 from rentals from the Shenzhen NEO towers, hotel and carpark rentals, and its property-management business. Recurring EBITDA/interest coverage was around 0.6x in 2014-2016 but we expect the ratio to gradually decline to 0.5x in 2017 and trend towards 0.3x by end-2019 due to its expansion in the property-development segment. High Margin, Moderate Leverage: Fitch expects the property-development segment to have a gross profit margin of above 60% in 2017-2018 due to sales from the high-margin LVGEM Hongwan Garden and Mangrove Bay No. 1 projects. This will support the company's overall EBITDA margin at above 55%. LVGEM's gross profit margin averaged 42% in 2014-2016, higher than the industry average of around 20% due to its advantages in obtaining lower-cost urban redevelopment projects. Its average cost of land was below 20% of the average selling price for all its Shenzhen projects. Fitch expects LVGEM's net debt/adjusted inventory of 41% in 2016 to rise in 2018-2019, but remain below the 45% threshold where Fitch may consider negative rating action, mainly due to the substantial construction cost and land cost cash outflow associated with the large Shenzhen urban redevelopment project before its presales start after 2021. DERIVATION SUMMARY LVGEM has a good-quality IP portfolio that includes the centrally located Shenzhen NEO towers, which enjoyed near full occupancy and double-digit positive rental reversion on renewal. Fitch thinks that LVGEM's high-quality IP alone has a business profile consistent with a 'BB' rating as it has rental EBITDA of more than USD50 million and above USD1.5 billion of rental assets. These metrics are comparable with Lai Fung Holdings Limited's (BB-/Stable) USD60 million in recurring EBITDA and USD2 billion in IP value. Its recurring EBITDA /gross interest cover was around 0.6x in 2014-2016; higher than that of most Chinese homebuilders, which rely on more-risky development properties sales to service their debt. However, Fitch expects recurring EBITDA/gross interest cover to deteriorate due to its expansion in the property-development segment. LVGEM's small scale and volatile contracted sales constrain the rating to the 'B' category. Its net debt/adjusted inventory of 41% in 2016 is lower than that of most 'B' rated peers, such as Yida China Holdings Limited's (B/Positive) 46% and Hong Yang Group Company Limited's (B/Stable) 53%, and hence in line with a higher 'B+' financial profile. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - A large Shenzhen urban redevelopment project to be injected in 2018-2019, with LVGEM financing the consideration due to the controlling shareholder mainly via equity issuance and shareholder loans. - LVGEM's contracted sales to reach CNY5 billion in 2017, and CNY10 billion in 2018. - Property-development segment's gross profit margin to rise to 68% in 2017 and 65% in 2018, from 47% in 2016. - Recurring EBITDA to increase to above CNY400 million in 2017-2018 from CNY380 million in 2016. Recovery rating assumptions - The recovery analysis assumes LVGEM would be liquidated in a bankruptcy because it is an asset trading company. - We have assumed a 10% administrative claim. - The liquidation estimate reflects Fitch's view of the value of inventory and other assets that can be realised and distributed to creditors. - We applied a haircut of 20% on its adjusted inventory, lower than the norm used for its peers, because of its higher-than-industry profit margin, which implies its inventory is valued higher than that of peers. - We applied a 50% haircut to its net property, plant and equipment. - We also assumed LVGEM will be able to use 100% of the CNY1.7 billion in restricted cash to pay debt. - Based on our calculation of the adjusted liquidation value, after administrative claims, we estimate the recovery rate of the offshore senior unsecured debt to be 67%, which corresponds to a Recovery Rating of 'RR3'. However, LVGEM's Recovery Rating is capped at 'RR4' because debt of offshore Chinese holding companies face structural issues as the onshore operating companies do not provide upstream guarantees. RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action - Attributable contracted sales sustained above CNY20 billion while net debt/adjusted inventory sustained below 35% - Recurring EBITDA/cash interest sustained above 1.0x Developments That May, Individually or Collectively, Lead to Negative Rating Action - Net debt/adjusted inventory sustained above 45% - Failing to maintain a project pipeline (including controlling shareholder's land bank) sufficient for two years of development LIQUIDITY Satisfactory Liquidity: LVGEM's CNY4.7 billion in cash (including restricted cash) at end-2016 is sufficient to cover CNY3.6 billion in short-term debt. LVGEM has CNY550 million in undrawn credit facilities, as well as continued support from its controlling shareholder via asset injections and shareholder loans. We believe that LVGEM has flexibility in its projects to easily adjust the pace of development to alleviate its debt interest burden. Fitch also expects LVGEM to be able to issue more equity, based on its quality project pipeline, to support its expansion. Contact: Primary Analyst Vicki Shen Director +852 2263 9918 Fitch (Hong Kong) Limited 19/F Man Yee Building 68 Des Voeux Road Central Hong Kong Secondary Analyst Chloe He Associate Director +86 21 5097 3015 Committee Chairperson Su Aik Lim Senior Director +852 2263 9914 Date of Relevant Rating Committee: 7 July 2017 Media Relations: Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: Additional information is available on Applicable Criteria Country-Specific Treatment of Recovery Ratings (pub. 18 Oct 2016) here Criteria for Rating Non-Financial Corporates - Effective from 10 March 2017 to 7 August 2017 (pub. 10 Mar 2017) here Non-Financial Corporates Hybrids Treatment and Notching Criteria (pub. 27 Apr 2017) here Non-Financial Corporates Notching and Recovery Ratings Criteria (pub. 16 Jun 2017) here Related Research LVGEM (China) Real Estate Investment Company Limited here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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