OREANDA-NEWS. January 26, 2016. Fitch Ratings has downgraded the Long-Term Issuer Default Rating (IDR) of China South City Holdings Limited (CSC) to 'B' from 'B+'. The Outlook is Stable. The company's senior unsecured rating and the rating on its outstanding US dollar senior notes have also been downgraded to 'B' from 'B+' with Recovery Rating of 'RR4'.

Fitch downgraded CSC's rating due to its deteriorating credit profile amid weak industry demand. The Stable Outlook reflects that CSC has the intention and flexibility to slow its pace of development and reduce selling, general and administrative (SG&A) expenses gradually, while increasing its non-property development income. We expect its leverage to stabilise around 45%-50% if it can maintain contracted sales at the January-December 2015 level of CNY5bn-6bn (HKD6bn-7bn). The ratings of China South City are supported by its unique business model, close collaboration with local governments, a long track record in integrated trade-centre development supported by an experienced management team, and sufficient liquidity.

KEY RATING DRIVERS
Weak Industry Demand: Demand in the trade and logistics centre sector has been weak since the end of 2014 due to SMEs' poor sentiment towards investment amid weaker economic growth, slower relocation demand, delays in the completion of transportation networks by local governments, and lower investor appetite. CSC's contracted sales for the nine months to December 2015 fell 42.5% yoy to CNY4.4bn (HKD5.2bn). Demand from SME buyers and investors is likely to continue to be lacklustre if the weak economic environment persists and local governments' continue to rein in infrastructure spending. Fitch expects CSC's contracted sales to shrink to CNY5bn-6bn in the financial year ended March 2016 (FY16), from about CNY10bn in FY14 and FY15.

Higher Leverage: CSC's leverage, measured by net debt / adjusted inventory, rose to 44.5% at end-September 2015 from 37.3% at end-March 2015, because of slower sales and increased construction FY15 to grow its business scale. Construction slowed down in 1HFY16, with CSC's properties under development and unsold completed properties (including investment properties) declining to 13.3 million square metres (sqm) as at end-September 2015 from 13.9 million sqm at end-March 2015.

Fitch expects leverage to hover between 45% and 50% over the next two years due to CSC's plan to reduce inventory by slowing development and selling more completed stocks in 2016 while continuing investment property development. CSC's extensive land resources of 17 million sqm available for future development also give it flexibility to refrain from land purchases.

Fragmented and Competitive Market: CSC's average selling price (ASP) may come under pressure because the industry is fragmented with many small players, and its trade centres face competition from nearby 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 this risk.

Collaboration with Government Supports Sustainability: CSC's continued cooperation with local governments gives it the benefits of low land costs (1HFY16: CNY296/sqm), infrastructure support, government grants and favourable policies that minimise project execution risks. In the recent market downturn, government grants increased to HKD870m in FY15 and HKD686m in 1HFY16 from HKD28m in FY14. This allowed the company to maintain EBITDA margin at 33% in 1HFY16 even though SG&A rose 30% to HKD1.02bn and revenue dropped 58% to HKD2.15bn. Fitch expects CSC's EBITDA margin to be above 30% in the next one to two years, which gives the company buffer to absorb volatility in ASPs.

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

Growing Non-development Income: CSC targets to increase its non-development income - stemming from rental, property management, logistic and warehouse, outlets and e-commerce related to its trade centre projects - from HKD1.1bn in FY15 to HKD1.5bn in FY16 and HKD2bn in FY17. CSC's non-development income rose 63% yoy to HKD603m in 1HFY16, and the non-development income coverage of interest reached 0.6x. The diversification into non-development business smoothed sales volatility, reduced operational risk, and provided stronger cash flow quality compared to peers. However, adjusted non-development EBITDA margin remains low at around 20-30% in 1HFY16 after taking into account estimated SG&A and other costs. Fitch expects SG&A costs to decrease and EBITDA coverage from non-development businesses to increase as the trade centre projects mature.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for CSC include:
- Contracted sales to remain weak at HKD6bn-7bn in FY16-FY17.
- Non-development income to increase to HKD1.5bn in FY16 and HKD2bn in FY17.
- Capital expenditure to decline to HKD8bn-9bn per year in FY16-FY017.
- Government grants to reach HKD1.3bn in FY16 and 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 at 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 at above CNY10bn a year
- EBITDA margin sustained at above 30% (1HFY16: 33.1%)
- Net debt/adjusted inventory sustained at below 40% (with investment property valued at cost) (1HFY16: 44.5%)
- Contracted sales/total debt sustained at above 0.5x (1HFY16: 0.3x)

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 HKD6bn end-September 2015 to meet the repayment of its short-term borrowings (HKD12.1bn) and land acquisitions.

CSC's issuance in the onshore bond market has also alleviated its refinancing pressure and lowered its average borrowing cost to 6.5% at end-September 2015 from 6.8% at end-March 2015. The group also issued an additional CNY3bn of onshore corporate bonds due 2019 at 5.98% coupon on 15 January 2016.

FULL LIST OF RATING ACTIONS

China South City Holdings Limited
Long-Term Foreign-Currency Issuer Default Rating downgraded to 'B' from 'B+'; Outlook Stable
Foreign-currency senior unsecured rating downgraded to 'B' from 'B+'; Recovery Rating of 'RR4'
Rating on USD125m 13.50% senior unsecured bond due 2017 downgraded to 'B' from 'B+'
Rating on USD400m 8.25% senior unsecured bond due 2019 downgraded to 'B' from 'B+'