January 4, 2018 / 10:37 AM / a year ago

Fitch Downgrades LVGEM to 'B'; Removes Rating Watch Negative

(The following statement was released by the rating agency) HONG KONG/SHANGHAI, January 04 (Fitch) Fitch Ratings has downgraded China-based LVGEM (China) Real Estate Investment Company Limited's Long-Term Foreign-Currency Issuer Default Rating (IDR), senior unsecured rating and the rating on its outstanding US dollar senior notes to 'B' from 'B+'. Fitch also removed LVGEM's ratings from Rating Watch Negative and assigned a Stable Outlook. The Recovery Rating on its senior unsecured rating is 'RR4'. LVGEM's ratings have been downgraded by one notch following the completion of its HKD9 billion acquisition of a Hong Kong office building on 29 December 2017. LVGEM's leverage, as measured by net debt/adjusted inventory, will increase to above 50% at end-2017 and Fitch expects leverage to remain above 45% in 2018-2019. The acquisition is more aggressive than the business plan the company previously shared with Fitch, and has crowded out the company's financial resources for its property development business. LVGEM's 2017 contracted sales were also affected by Shenzhen's stringent pricing policy in 2017 and Fitch expects LVGEM's project concentration in Shenzhen to continue to expose the company to regulatory uncertainties. KEY RATING DRIVERS Acquisition Raises Leverage: Fitch expects LVGEM's leverage to increase to above 50% at end-2017 and remain above 45% in the next few years, following the completion of its HKD9 billion acquisition of an office building in Hong Kong. The company aims to complete the construction of the office tower, which is located in Kwun Tong district in Kowloon, by mid-2019 and generate revenue by 4Q19. Fitch thinks that it is still too early to assess the possibility of LVGEM executing its option to sell parts of the office building to deleverage, but the option remains and will provide leverage headroom for the company. Sales Below Expectation: LVGEM's contracted sales in January-November 2017 were substantially lower than our expectation of CNY5 billion for the full year. The slower sales were mainly due to a delay in pre-sales in Mangrove Bay No. 1 Phase I, which we previously expected to generate more than CNY1.4 billion sales in 2017. The delay was caused by Shenzhen's restrictive pricing policies that capped the project's average selling price at an unfavourable level. LVGEM is targeting to launch pre-sales no later than 1Q18. Fitch thinks that LVGEM's unique strength in Shenzhen has turned into a double-edged sword as the company has been caught by the stringent home purchase restriction policy in Shenzhen while its higher leverage following its substantial investment has reduced its ability to respond to the restrictions. LVGEM's strategy of slowing sales to achieve the best margin has now resulted in leverage being sustained at higher levels. Quality Investment Properties: LVGEM's investment property portfolio includes the Shenzhen NEO complex, which has office and retail components, and three Zoll community retail centres in Shenzhen, one of which opened in 2017. The Shenzhen NEO complex is located in the city's CBD and is almost fully occupied. Rents that were renewed in 2016 were re-contracted at 15% more on average in 2017 compared with their previous rental rates. The two older Zoll centres had approximately 90% occupancy rates and positive rental reversion of more than 10% in 2016. The contribution from the planned Hong Kong office building will depend on the proportion of the building that is retained for rental. Healthy Recurring Income, Lower Coverage: LVGEM continued to generate strong recurring income in 2017. 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. Fitch expects recurring EBITDA/interest coverage to drop to around 0.4x in 2017 due to the Hong Kong office acquisition, compared with 0.6x in 2014-2016 and our previous expectation of 0.5x in 2017. Fitch expects coverage to trend towards 0.3x by end-2019. DERIVATION SUMMARY LVGEM's rating is supported by its portfolio of quality investment properties, including its centrally located Shenzhen NEO office buildings. Fitch assesses LVGEM's investment properties alone as having a business profile of around 'BB', with more than USD50 million in rental EBITDA per year and more than USD1.5 billion in rental-deriving assets; setting it apart from most Chinese homebuilders that rely on more risky development-property sales to service their debts. This is comparable with Lai Fung Holdings Limited's (BB-/Stable) USD60 million in recurring EBITDA and USD2.0 billion in investment property value. Meanwhile, LVGEM's main business focus is still its urban redevelopment projects in Shenzhen. Its contracted sales are smaller and more volatile than most peers due to the uncertainty about when such projects would be injected from its ultimate shareholder. Fitch also expects LVGEM's leverage to increase to above 45% after 2017, following the acquisition of the Hong Kong office building. This level is similar to that of other 'B' rated peers, such as Yida China Holdings Limited's (B/Positive) 46% and Hong Yang Group Company Limited's (B/Stable) 53%. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - LVGEM successfully raises funds through issuance of new shares in 2018. - An injection of a large Shenzhen urban redevelopment project before the end of 2019, with LVGEM financing the consideration due to the controlling shareholder via equity issuance and shareholder loans. - LVGEM's contracted sales to reach CNY3 billion in 2017 and CNY10 billion in 2018. - Recurring EBITDA to increase to above CNY400 million in 2017-2018, from CNY380 million in 2016. RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action - Attributable contracted sales sustained above CNY10 billion while net debt/adjusted inventory sustained below 45%; and - Recurring EBITDA/cash interest sustained above 0.3x Developments That May, Individually or Collectively, Lead to Negative Rating Action - Net debt/adjusted inventory sustained above 55% - Failing to maintain a project pipeline (including controlling shareholder's land bank) sufficient for two years of development LIQUIDITY Sufficient Liquidity for Acquisition: LVGEM will need to pay around HKD5.5 billion, or CNY4.6 billion, in 2017 out of the total consideration of HKD9 billion. The company's 1H17 available cash of CNY3 billion and its US dollar bond issuance will provide sufficient liquidity to make this payment. LVGEM has also secured offshore loan financing using this new Hong Kong office property as collateral. This, together with the company's other financing plans, will allow LVGEM to replenish liquidity sufficiently to meet the operational needs of its development-property business. FULL LIST OF RATING ACTIONS LVGEM (China) Real Estate Investment Company Limited - Long-Term Foreign-Currency IDR downgraded to 'B' from 'B+', Outlook Stable - Senior unsecured rating downgraded to 'B' from 'B+', with Recovery Rating of 'RR4' Gemstones International Limited - USD225 million 8.5% senior notes due 2020 downgraded to 'B' from 'B+', with Recovery Rating of 'RR4' 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 Media Relations: Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: wailun.wan@fitchratings.com. 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