Red Star Macalline Group Outlook Revised To Negative On COVID-19-Induced Income Volatility; 'BB+' Rating Affirmed

  • The COVID-19 outbreak's dampening effect on consumer demand presents an unprecedented shock for China's furnishing and home improvement mall operators.
  • We expect Red Star's income volatility to rise and its financial buffer to drop during this disruption.
  • On March 24, 2020, S&P Global Ratings revised its outlook on Red Star to negative from stable and affirmed our 'BB+' long-term issuer credit rating on the company. We also affirmed our 'BB' long-term issue rating on the company's guaranteed senior unsecured notes.
  • The negative outlook reflects our expectation that the outbreak is testing the stability of Red Star's recurring income. The issuer's strong market position may see its income rebound quickly if consumer confidence is swiftly restored.
HONG KONG (S&P Global Ratings) March 24, 2020—S&P Global Ratings today took the rating actions listed above.
We revised the outlook on Red Star Macalline Group Corp. Ltd. to negative from stable on the view that the COVID-19 outbreak and resulting economic downturn will hit Red Star's operating results in the next 12 months. In January and February 2020, national retail sales fell by 21% year on year. Furniture sales dropped by one-third, compared with the same period in 2019.
We affirmed the rating as we expect Red Star to maintain its position as the largest retail chain operator in China's home improvement and furnishing industry, underpinning its ability to recover from this slump.
The key question is whether the issuer can manage the demand shock and maintain income stability. Recent signs that the COVID-19 outbreak is contained in China suggest that its operating performance may rebound.
We are still uncertain about the effect of the outbreak on consumer spending in China in the long run, given the containment is at a nascent stage.
Red Star owns a large portfolio of furniture malls from which it had previously derived highly steady recurring rental income. The outbreak is now testing this income stability. Red Star is more vulnerable than other landlords because its tenancy agreements are short, at one year. This makes the company more exposed to industry cycles than a typical landlord in the retail and office arena.
Red Star has high exposure to franchise management fee income, where its managed shopping malls use the Red Star brand and part of the Red Star chain. We expect such franchise income accounted for 28% of the company's revenue in 2019. This exposure adds to its cash flow uncertainties.
We estimate that EBITDA may decline by 8%-9% in 2020. This assumes a revenue decline of 9%-10% (assuming 5%-10% negative rental reversion and a one-month voluntary rent-free period). This implies an increase in the debt-to-EBITDA ratio to 6.5x-7.0x.
Nonetheless, Red Star's business model gives it flexibility to defer capital expenditure, given most such spending is uncommitted and expansion related. This could support current cash flows, albeit at the expense of growth. Moreover, tenants prepay rent to Red Star, and put cash on deposit to Red Star, providing a cushion against an immediate drop in rental income from tenants.
We view Red Star's liquidity as less than adequate given its persistently high short-term maturities, especially bonds due within a year. The loss of operating cash inflow will also strain the company's liquidity profile. About half of its short-term maturities are corporate bonds and commercial mortgage-backed securities of Chinese renminbi (RMB) 5.4 billion. These debts are due in September and November 2020. Bank loans comprise the rest of its short-term debt.
That said, we don't expect the company to have significant refinancing risks given its large holdings of unencumbered assets, which represent nearly 70% of its investment properties. Red Star issued RMB1 billion in bonds and medium-term notes of in January and March 2020--a time of market stress--confirming its sound market access.
The negative outlook reflects our view that the COVID-19 outbreak has severely dented consumption in China, and will erode Red Star's recurring income. However, we expect that this shock will be short-term. Red Star's cash flows and EBITDA from its home improvement and furnishing retail malls should rebound once consumer confidence returns.
We could downgrade the company if this rebound is weaker or the downturn lasts longer than we expected. Some indications of this could include:
  • Red Star's debt-to-EBITDA ratio rises above 7.5x and its ratio of funds from operations (FFO) to debt drops below 9% on a sustained basis, or
  • Its liquidity profile deteriorates further from levels that we currently view as less than adequate.
We may also downgrade Red Star if we believe that the volatile property development business of its parent, Red Star Macalline Holding Group Co. Ltd., becomes the key driver of the risk profile of the group. This would happen if recurring rental income no longer contributed a substantial majority of group EBITDA. We may also downgrade Red Star if the parent's ability to service debt weakens substantially. A sign of this would be if its EBITDA interest coverage dropped below 1.5x on a sustained basis.
We may revise the outlook to stable if Red Star improves its leverage and cash flow adequacy measures such that its debt-to-EBITDA ratio stays at below 7.5x or its FFO-to-debt ratio increases to above 9%. This may happen if the company quickly rebounds from the disruption to its business operations and achieves solid rental income growth, while controlling its financial leverage.
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