OREANDA-NEWS. Fitch Ratings has affirmed China-based home improvement mall operator Red Star Macalline Group Corporation Ltd's (RSM) Long-Term Issuer Default Rating at 'BBB+' with a Stable Outlook. Fitch has also affirmed the operator's foreign-currency senior unsecured ratings at 'BBB+'.

The affirmation reflects RSM's stable financial profile, driven by the steady performance of its malls, even though the operator's managed-mall expansion is progressing slower than Fitch had expected. The ratings continue to be supported by RSM's hybrid business model of owning malls and managing malls it does not own - which enables RSM to expand quickly while keeping capex low.

KEY RATING DRIVERS

Stable Recurring Rental Income: The malls that RSM owns have maintained strong rental rates, with high occupancy rates of above 95%, in the past year. The rental of mature malls (in operation for two years) increased by 5.3% to CNY159 per square metre (sq m) per month in 1H16, which compares favourably with other Chinese mall operators. RSM's investment property portfolio generated a stable rental income of CNY2.3bn in 1H16 and Fitch expects full year income to reach CNY5bn, with an estimated rental yield on market value at 7%.

Improving Coverage: The coverage ratio, as measured by recurring EBITDA/gross-interest expenses, improved to 3.1x in 1H16, from 2.4x in 2015, due to stronger rental income and lower funding costs. Fitch expects coverage to improve above 3.5x in 2017, as RSM's investment properties scale increases and it is consistently optimising the capital structure and` lowering funding costs by tapping into the onshore short-term bond market. Its average funding cost decreased to 5.8% in 1H16, from 7.6% in 1H15.

Slower Managed Mall Expansion: RSM's managed-malls are progressing slower than Fitch expected due to its exposure to third - and four-tier cities. RSM only opened three managed malls in 1H16, a slower pace from its revised full-year target of 30. Capital-related difficulties of property developers in lower-tier cities delayed construction and constrained their ability to honour contract payments to RSM on time.

The slower expansion from managed-malls will lower RSM's operating cash flow generation only related to one-off income from the initiation, entrance and consultation fees collected from developers. However, recurring EBITDA, which includes rental income from RSM-owned malls and management fees from its managed-malls, will continue increasing and improving the operator's credit metrics. RSM had a large pipeline of 488 managed malls at end-June 2016 (1H15: 392), among which 279 had secured land parcels (1H15: 205). This supports 30 to 40 new mall additions per annum.

Temporary Higher Leverage: Fitch expects RSM's net-leverage, as measured by net debt/recurring EBITDA, to temporarily edge above 4.0x by end-2016, due to higher capex from building new malls. However, Fitch expects this to reverse by end-2017, as the majority of the 25 new malls under construction will be completed and will start generating income. Net leverage was flat in 1H16, at 4.0x, compared with 3.9x at end-2015.

Market Leader, Strong Profile: RSM's malls are spread across 129 Chinese cities in 27 provinces, accounting for an 11.1% share in the chain home-improvement retail mall sector in 2015. RSM benefits from strong home-refurbishment demand from increasing primary and secondary market home buyers, and more importantly, 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-2018 (1H16: 181), particularly in lower-tier cities that are not currently well-served by home improvement retailers.

KEY ASSUMPTIONS

- Average occupancy for owned and leased malls at 95% throughout the cycle

- Flat rental rate

- Slight improvement of EBITDA margin of owned and leased portfolio

- Capex outlay up to CNY12bn for the next three years

- 30% dividend payout

RATING SENSITIVITIES

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

- Recurring EBITDA/gross-interest sustained below 3.0x

- Net debt /recurring-EBITDA sustained above 4.0x

- Any developments that negatively affect RSM's market position, including a sustained decline in mall rental rates and occupancy ratios

Positive: Fitch does not expect positive rating action in the next 12-18 months.