The outlook revision reflects Shanshui's increasing debt amid weaker cement industry conditions in Shandong province and the company's still aggressive growth plans. In our view, Shanshui's total debt is unlikely to drop materially over the next 12 months from Chinese renminbi (RMB) 14.6 billion as of June 30, 2012, due to the company's increased working capital requirements and higher capital expenditure. This is a deviation from our original expectation. Shanshui's higher debt is likely to negatively affect its credit ratios. We expect the company's debt-to-EBITDA ratio to approach or even marginally exceed our downgrade trigger of 3.5x, and its ratio of funds from operations (FFO) to debt to fall to slightly less than 20% at the end of 2012.
We affirmed the rating largely to reflect Shanshui's satisfactory operating performance and adequate liquidity amid challenging industry conditions. The rating also reflects the company's cash balance of about RMB4 billion as of June 30, 2012. The company's operating performance in the first half of 2012 was in line with our expectation. Sales contribution from Liaoning province offset weaker sales and lower margins from Shanshui's core market of Shandong.
Both Liaoning and Shandong provinces face oversupply. Liaoning, in China's northeastern region, was one of very few markets in the country where cement prices increased in the first half of 2012. This was mainly because of lower production and not stronger demand. According to data from Digital Cement, total cement production in the northeast declined 9.42% in January-April 2012, over the same period in 2011. However, we believe that going forward, companies may find it difficult to maintain average selling prices at current levels if demand does not pick up.
In the first half of 2012, Shanshui and its main competitor China United, an operating subsidiary of China National Building Material Co. Ltd. (not rated), jointly coordinated three instances of suspended production totaling 50 days. Still, Shanshui's cement prices in Shandong province declined by about RMB20 per ton in the first half of the year. We believe that the operating environment will remain challenging in the second half of 2012 as well given that the company plans to suspend production in September, when demand usually peaks.
In our base-case, we expect Shanshui's total sales to decline about 3% or less in 2012, from about RMB16.8 billion in 2011. Our expectation does not factor in any government stimulus program that would affect supply or demand in a short time.
The rating on Shanshui reflects oversupply in the cement industry and uncertain demand. The company's strong market position in Shandong and Liaoning provinces tempers these weaknesses.
Shanshui has "adequate" liquidity, as our criteria define the term. We expect the company's liquidity sources, including cash and equivalents, to cover more than 1.2x of its liquidity use in the next 12 months. Our liquidity assessment incorporates the following factors and assumption:
-- Liquidity sources in the next 12 months include cash and equivalents of about RMB4 billion as of June 30, 2012, our projection of FFO of about RMB3 billion, other available funding sources of about RMB600 million.
-- Liquidity uses include short-term debt of RMB3.5 billion maturing in the next 12 months, working capital requirements of RMB700 million, and capital expenditure of about RMB3.3 billion, and dividend payout of about RMB550 million. We believe that Shanshui has some flexibility to defer its capital expenditure, which is not committed.
-- We expect liquidity sources to exceed its uses even if EBITDA drops by 15%.
The negative rating outlook reflects our expectation that Shanshui's high debt burden is unlikely to ease over the next six to 12 months given challenging industry conditions.
We may lower the rating if Shanshui's financial leverage, as defined by a ratio of debt to EBITDA, increases to more than 3.5x and the FFO-to-debt ratio is less than 20% over a prolonged period. This could happen if the company's operating environment deteriorates further or its debt-funded expansion is more aggressive than we expect.
We may revise the outlook to stable if Shanshui's total debt falls or an improvement in the operating environment leads to higher-than-expected EBITDA in the next 12 months.
Related Criteria And Research
-- Methodology And Assumptions: Standard & Poor's Standardized Liquidity Descriptors For Global Corporate Issuers, July 2, 2010
-- Key Credit Factors: Business And Financial Risks In The Global Building Products And Materials Industry, Nov. 19, 2008
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
Ratings Affirmed; CreditWatch/Outlook Action
China Shanshui Cement Group Ltd.
Corporate Credit Rating BB/Negative/-- BB/Stable/--
Greater China Regional Scale cnBB+/-- cnBBB-/--