OREANDA-NEWS. Fitch Ratings has assigned China South City Holdings Limited's (CSC; B/Stable) proposed US dollar senior notes a 'B(EXP)' expected rating and Recovery Rating of 'RR4'.

The notes are rated at the same level as CSC's senior unsecured rating because they constitute the company's direct and senior unsecured obligations. The final rating is subject to the receipt of final documentation conforming to information already received.

CSC's ratings are constrained by its deteriorating credit profile amid weak industry demand. The ratings are supported by the company's unique business model, close collaboration with local governments, a long record in integrated trade-centre development and sufficient liquidity.

KEY RATING DRIVERS

Trade Centre Sales Further Weakens: Sales from CSC's trade and logistics sector further weakened due to SMEs scaling down new investments, slower relocation demand, local government delays in completing transport networks and lower investor appetite for commercial properties. Contracted sales of HKD6.6bn in the financial year to end-March 2016 (FY16) were in line with Fitch's expectations and represented a 41% fall from FY15, after falling 20% from FY14. Residential property sales were flat at HKD2.3bn, while trade centre sales tumbled to HKD3.7bn, from HKD8.5bn. Fitch expects flat contracted-sales of HKD6-7bn in FY17, despite there being no sign of a recovery in trade centre sales, as the company is aggressively adding to its residential saleable resources.

Higher Leverage: CSC's leverage, measured by net-debt/adjusted-inventory, rose to 48.3% in FY16, from 37.8% in FY15, due to slower sales and increased construction to build-up saleable residential resources. Construction picked up in 2HFY16, with CSC's properties-under-development and unsold completed properties (including investment properties) rising to 14.1 million square metres (sq m) as end-FY16, from 13.9 million sq m at end-FY15.

Fitch expects leverage to hover around 50% over the next two years due to CSC's plan to cut its capital expenditure to HKD7bn, from HKD9bn in FY16, and destock by churning out more residential while continuing its investment property development. The company's extensive land resources of 15.8 million sq m ground floor area available for future development also provide the flexibility to refrain from land purchases.

Fragmented and Competitive Market: CSC's average selling price (ASP) declined 6% yoy in FY16 due to product-mix changes. ASPs may come under further pressure as the industry is fragmented, with many small players, and CSC's trade centres face competition from wholesale/trade centre projects within the same city and government-supported projects in nearby cities. CSC's brand name and low land costs give it a stronger competitive position and mitigate these risks.

Government Collaboration Supports Sustainability: CSC's continued cooperation with local government provides the benefits of low land-costs (FY16: CNY295/sq m), infrastructure support, government grants and favourable policies that minimise project execution risks. CSC received government grants of HKD2bn during the FY16 market downturn. This allowed the company to maintain its EBITDA margin at 32.5%, even though its selling, general and administrative costs rose 13%, to HKD2.0bn, and revenue dropped 37% to HKD6.1bn. Fitch expects CSC's EBITDA margin to remain above 30% in the next year or two years, providing a buffer to absorb ASP volatility.

Competitive Business Model: CSC's business profile is supported by the fundamental strength of its trade centres, which offer physical, online and logistics elements. The company's business model of providing a full-range of integrated value-added services and facilities strategically positioned in provincial capitals and large economic centres, along with the proven success of the business model of its flagship property, CSC Shenzhen, provides it with a strong competitive position in a fragmented market.

Rising Non-development Income: CSC's non-development income in FY16 - stemming from rentals, property management, logistics and warehousing, outlets and e-commerce related to its trade centre projects - increased steadily, but was lower than Fitch expected due to stagnant e-commerce income. Currently, e-commerce has mainly launched in Zhengzhou and is offered to new buyers. Although CSC has gradually extended e-commerce to other CSC projects, we do not expect strong growth in light of the current slow market in trade centre sales. Property investment income slowed to 19% in FY16, from 88% in FY15, while logistics and warehousing and outlet operations retained strong growth momentum of around 50%.

CSC's non-development income-coverage of interest reached 0.9x in FY16. Diversification into non-development business smoothed sales volatility, reduced operational risk and provided stronger cash flow quality compared with peers. However, the company's adjusted non-development EBITDA margin remained low, at around 20%-30% in FY16, after taking into account estimated selling, general, administrative and other costs. Fitch expects costs to decrease following management's administration cost-cutting efforts and for EBITDA coverage from the non-development businesses to increase as trade centre projects mature.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for CSC include:

- contracted sales remaining weak at HKD6-7bn in FY17-FY18

- non-development income to increase to HKD1.8bn in FY17

- capital expenditure to decline to HKD7-8bn per year in FY17-FY18

- government grants received to be around HKD0.8bn in FY17.

RATING SENSITIVITIES

Future developments that may, individually or collectively, lead to negative rating action include:

- substantial decrease in contracted sales

- EBITDA margin sustained below 20%

- net-debt/adjusted-inventory sustained above 50%, with investment property valued at cost.

Future developments that may, individually or collectively, lead to positive rating action include:

- total contracted-sales sustained above CNY10bn per year

- EBITDA margin sustained above 30% (FY16: 32.5%)

- net-debt/adjusted-inventory sustained at below 40%, with investment property valued at cost (FY16: 48.3%)

- contracted-sales/total-debt sustained above 0.5x (FY16: 0.2x)

LIQUIDITY

Sufficient Liquidity: CSC has the flexibility to rein-in its rapid development should sales come in below the company's expectations. Fitch expects CSC to maintain sufficient liquidity, with available cash of HKD10.8bn and unutilised credit facilities of HKD6.0bn at end-FY16 to meet the repayment of its short-term borrowings of HKD10.2bn and land acquisitions.

CSC's issuance in the onshore bond market has also alleviated its refinancing pressure and lowered its average borrowing cost to 6.3% at end-FY16, from 6.8% at end-FY15.