Guangxi Dongcheng Investment & Development Assigned 'BB' Rating With Stable Outlook; Proposed Notes Rated 'BB-'

 22-Nov-2018 21:31 EST

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 We see an extremely high likelihood that LZDC will receive timely and sufficient extraordinary support from the Liuzhou municipal government if the company comes under financial distress.  LZDC has very high financial leverage, weak operating flow and interest coverage, a small scale, high geographic concentration, and business dependence on the local government. The company's exclusive rights in developing Liudong New and ongoing government support partly moderate these weaknesses.  We are assigning our 'BB' long-term issuer credit rating to LZDC and our 'BB-' long-term issue rating to the proposed U.S. dollar-denominated senior unsecured notes that the company proposes to issue.  The stable rating outlook on LZDC reflects our stable credit outlook on the Liuzhou municipal government over the next 12-24 months.

HONG KONG (S&P Global Ratings) Nov. 23, 2018--S&P Global Ratings today said it has assigned its 'BB' long-term issuer credit rating to Liuzhou Dongcheng Investment & Development Co. Ltd. (LZDC). The outlook is stable.

We also assigned our 'BB-' long-term issue rating to the proposed U.S. dollar-denominated senior unsecured notes that LZDC proposes to issue. The issue rating is subject to our review of the final issuance documentation.

LZDC is the largest local government investment and financing platform (LGFV) and state-owned enterprises (SOE) in Liuzhou city, Guangxi province. LZDC is wholly owned by Liuzhou State-Owned Assets Supervision and Administration Commission (SASAC), on behalf of the Liuzhou municipal government.

The rating on LZDC mainly reflects the creditworthiness of the company's sole owner and ultimate controller, the Liuzhou municipal government. In our view, there is an extremely high likelihood that LZDC will receive timely and sufficient extraordinary government support if the company comes under financial distress. The rating on LZDC is therefore three notches above the company's stand-alone credit profile (SACP), which we assess as 'b'.

Our view of an extremely high likelihood of extraordinary government support is based on the following factors:

 Very important role to the government. LZDC is the sole platform of the municipal government for primary land development, and infrastructure construction and operation in Liudong New District, which was established in 2006 and mainly focuses on the automobile industry. LZDC is responsible for the Motor Town development, which will be a key driver of the city's tax income. The company's core business of infrastructure development is non-commercial driven. We believe the unique role and strategic position of LZDC cannot be easily replaced by the private sector or other SOE entities in the city.  Integral link with the government. The Liuzhou municipal government has full control over LZDC. The Liuzhou SASAC has direct supervision over company's investment and financing activities, appointment of senior management, and performance review. LZDC has a record of receiving support from the Liuzhou government in various forms, such as capital injection, continuous financial subsidy, state-owned operating income refund, special funding support, and low interest loans.

We expect LZDC to remain the most important participant in primary land development and infrastructure project construction in Liudong New District on behalf of the local government. We believe the likelihood of extraordinary government support will remain the most important credit factor for LZDC in the next 12 months. Therefore, the credit strength of the Liuzhou city government is a key driver of the rating on LZDC.

Liuzhou is the second-largest city in Guangxi province and is a major industrial hub within the province as well as in southwestern . The city's creditworthiness is constrained by its fast-growing but concentrated automotive-dominated economic base, combined with very high debt due to the government's investment-driven growth model. The city continues to benefit from exceptional liquidity. Over the past year, risks emanating from the city's high leverage remain despite better budgetary outturns than we expected.

Liuzhou is one of the country's major automobile production bases and is home to one of the world's top 10 construction equipment manufacturers, LiuGong Machinery Co. Ltd. This industrial base and real economic activity boosts revenues and helps the government to have sizable operating surpluses. The city's strong internal cash generating capability keeps its deficit after capital accounts below 10% of budget revenues, despite the government's sizable investment-driven growth program. Various government-related entities (GREs) have accumulated high levels of debt as a way to bypass institutional features that prohibit city governments in China from directly borrowing. At present, Liuzhou and its GREs are able to sustain their borrowings in part due to the central government's debt-swap program, which allows low-cost refinancing of such borrowings. Moreover, the financial system is readily willing to lend to GREs with close association to the government.

Our assessment of LZDC's SACP reflects the company's very high financial leverage, weak operating cash flow and interest coverage, and significant refinancing risk. In addition, LZDC's small scale, geographic concentration, and material exposure to land-sale and property-market conditions result in high volatility in revenues. The company's exclusive development rights in Liudong New District, continued development opportunity secured by long-term contracts with the government, and ongoing government support moderate the above weaknesses.

LZDC's competitive position is mainly driven by its exclusive undertaking of primary land development and infrastructure construction in Liudong New District. The company's operations are highly capital-intensive and essentially policy-driven. In the three years ended December 2017, the government transferred 42.5 million square meters of land for development to LZDC, and the company holds much more of transferred land. According to the government planning, the pace of land sales is likely to accelerate in Liudong New Area in the next two years to accommodate development needs. Such commercial land transfers are more profitable for LZDC than sale of industrial land, and will likely support the company's revenue and cash flow. Under the government mandate, LZDC is also responsible for infrastructure construction and public service projects.

We believe the government shares LZDC's operational risk, but the company lacks control over contract acquisitions, working capital management, and leverage control. LZDC signed a 30-year service agreement with Liu Dong New District SASAC earlier this year. According to the agreement, Liu Dong New District SASAC will have to pay back LZDC the development cost plus 15% as the investment return within 60 days after project delivery.

Government refund of land sale income dominates the revenue and profit of LZDC, exposing the company to market and policy risks related to the property market in Liuzhou and to potential changes in the financing model of the local government for primary land development. The government's payment could be delayed, given the volatility of the land and property market in China. The company also develops industrial and public-welfare facilities in Liudong New District. We expect this business segment to contribute 10%-20% of LZDC's total revenue and gross margin over the next two years. The company's remaining business segments such as gas supply and gas stations, in joint ventures with national players, account for minimal assets, revenue, and profit.

LZDC's low profitability, substantial interest expenses, and increasing debt to finance significant capital expenditure constrain its cash flow adequacy. The company's primary land development, infrastructure, and property leasing businesses are to fulfill the government's development goal and are not primarily profit-driven. But the businesses require heavy capital expenditure. Hence the company is exposed to significant refinancing risks, and its ability to access banking facilities and capital market is essential for it to service its debt. We therefore assess the company's financial risk profile as highly leveraged. LZDC's highly leveraged balance sheet together with its fragile cash flow generation is a key risk constraining the company's SACP.

In our view, LZDC is exposed to significant refinancing risks due to tightening credit market conditions since the second half of 2017. The company's overall funding cost has increased to 5.8% in the first half of 2018, from 5.4% in the first half of 2017, mainly driven by a higher interest rate for trust loans and financial leases. LZDC's banking facilities are mainly from China Development Bank, which is the Chinese policy bank specifically supporting such local government mandates.

The stable outlook on LZDC reflects our view that Liuzhou's economy and budgetary revenues will continue to grow at a strong pace, ensuring that its after-capital-account deficit will average less than 10% of total revenues, and the pace of borrowing by the government and its LGFVs will remain moderate over the next 12 months. We also expect the Liuzhou government to be able to maintain its exceptional liquidity profile over the period.

The stable outlook on LZDC also reflects our expectation that the company will continue to have an extremely high likelihood of receiving extraordinary support from the municipal government if needed over the next 12 months. We expect the Liuzhou government to provide LZDC with ongoing financial and operational support. We also expect LZDC's leverage to remain high owing to its capital expenditures and investments in multiple government projects.

We could lower the rating on LZDC if:

 The credit profile of the Liuzhou government weakens. This could happen if: (1) Liuzhou's revenue growth is weaker than we expect and management fails to adjust spending, leading to an operating surplus below 5% and the deficit after capital accounts exceeding 10% of adjusted total revenues; or (2) the government and its LGFVs increase their pace of borrowing more rapidly than we expect.  The likelihood of extraordinary government support is lower than we currently assess. This could happen if: (1) the local government reduces its shareholding in the company; (2) we assess that there is no clear and robust process that enables effective governance, monitoring, and control over the company; or (3) the government's strategies and priorities change. Weakened management control from the government, or the company engaging in more businesses on a commercial basis could indicate declining government support and commitment. Another indicator could be the opening up of the company's core businesses under the government procurement agreement to other state-owned or private companies.  The company's liquidity weakens but the government does not have timely and sufficient measures to provide timely support.

We believe the rating upside is limited for LZDC in the next 12 months. However, we could raise the rating if the credit profile of the Liuzhou government improves significantly. This could happen if Liuzhou's tax-supported debt ratio falls below 270% of total revenues, reflective of operating revenue growth significantly outstripping the pace of borrowing, or if the government and its LGFVs begin to actively pay down its debt.

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