Fitch Ratings has downgraded LVGEM (China) Real Estate Investment Company Limited's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'CCC', from 'B-'.

Fitch has also downgraded LVGEM's senior unsecured rating and the rating on its outstanding US dollar senior notes, issued by Gemstones International Limited, to 'CCC', from 'B-', with a Recovery Rating of 'RR4'.

The downgrade primarily reflects LVGEM's tight liquidity and uncertainty over its ability to refinance upcoming capital-market debt maturities, including the USD470 million bond maturing on 10 March 2023. The company is in the process of seeking refinancing for the debt, but any delay may put pressure on its repayment ability.

Key Rating Drivers

High Refinancing Risk: We believe LVGEM will have to rely on external funding to address the USD470 million bond due in March 2023, given its tight liquidity and limited internal cash flow generation before pre-sales of the Baishizhou project begin in 2023.

LVGEM is in negotiations to obtain CNY1.5 billion-2 billion in additional bank borrowings secured against its investment properties in Shenzhen. It is also negotiating with offshore fund investors to secure USD300 million-500 million of loans with a share pledge on the Baishizhou project company. Such arrangements would cover the March 2023 maturity, but are subject to high execution risk in the current market environment.

Tight Liquidity: LVGEM's available cash of CNY2.7 billion at end-1H22 (end-2021: CNY3.9 billion) was insufficient to cover its CNY5.6 billion of short-term capital-market debt maturities, including CNY1.4 billion of onshore bonds puttable in August 2022, of which CNY891 million was extended to August 2023, USD470 million (CNY3.3 billion) of bonds due in March 2023, and CNY911 million of convertible bonds due in May 2023.

Operating Cash Outflows: LVGEM's net debt increased to CNY27.4 billion by end-1H22 (end-2021: CNY24.2 billion) as the company incurred significant development costs, including settling around CNY450 million in land premium for the Baishizhou project, and CNY1.0 billion in interest costs. In addition, it repaid CNY599 million of the CNY1.46 billion of convertible bonds puttable in May 2022, with the remainder now due in May 2023.

We expect operating cash flows to remain negative in 2H22, as we forecast contracted sales to be similar to 1H22, while the company continues to incur significant project development costs, including another CNY450 million in land premium due for the Baishizhou project, as well as continued large interest costs. The company also repaid CNY509 million of onshore bonds in August.

Sale of Project Stake to Vanke: In June, the company entered into an agreement to sell 20% of the economic rights in phases 3 and 4 of the Baishizhou project to China Vanke Co., Ltd. (BBB+/Stable) for CNY2.3 billion. It received CNY1.1 billion in August, and the remaining CNY1.2 billion is expected in 1Q23. The proceeds will help to offset LVGEM's negative operating cash flows, but the company's liquidity is expected to remain tight.

Derivation Summary

LVGEM's ratings are driven by its tight liquidity and risks to the refinancing of its upcoming capital-market maturities.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Attributable contracted sales of CNY5 billion and CNY7.6 billion in 2022 and 2023, respectively

Annual development costs, including land and construction costs, of CNY7 billion in 2022 and 2023

KEY RECOVERY RATING ASSUMPTIONS

The recovery analysis assumes that LVGEM would be liquidated in bankruptcy.

We have assumed a 10% administrative claim.

We use a multiple assumption tool to derive a 4x EBITDA multiple to estimate the going-concern value. Given the nature of homebuilding, the liquidation value approach always results in a much higher value than if the company continues as a going concern.

Liquidation Approach

The liquidation estimate reflects Fitch's view of the value of balance sheet assets that can be realised in sale or liquidation processes conducted during a bankruptcy or insolvency proceeding and distributed to creditors.

54% advance rate applied to net inventory. LVGEM's inventory mainly consists of completed properties held for sale, properties under development (PUD) and deposits or prepayments for land acquisitions. Different advance rates were applied to these different inventory categories to derive the blended advance rates for net inventory.

50% advance rate to PUD. Unlike completed projects, PUDs are more difficult to sell. These assets are also in various stages of completion. A 50% advance rate was applied. The PUD balance - prior to applying the advance rate - is net of margin adjusted customer deposits and other non-current liabilities mainly related to the Baishizhou project.

90% advance rate to completed properties held for sale. Completed commodity housing units are closer to readily marketable inventory, and LVGEM has historically recorded strong gross margin of over 40%. As such, a higher advance rate (versus the typical 50% mentioned in the criteria) was applied.

90% advance rate to deposits or prepayments for land acquisitions. Similar to completed commodity housing units, land held for development are closer to readily marketable inventory given that LVGEM's land is well located. As such, a higher advance rate than the typical 50% mentioned in the criteria was considered.

50% advance rate to investment properties. LVGEM's investment properties mainly consist of commercial buildings in higher tier cities, such as Shenzhen and Hong Kong, and the portfolio had an average rental yield of 2.6% on completed investment properties in 2021. Fitch considers a 50% advance rate to be appropriate as the implied rental yield on the liquidation value would be 5.2%, which is acceptable in secondary market transactions through the cycle.

80% advance rate applied to trade receivables. As typical in the China homebuilding industry, account receivables constitute a very small portion of total assets for LVGEM. We have adopted a 80% advance rate in line with the advance rate for accounts receivable in the criteria.

60% advance rate applied to property, plant and equipment (PP&E). LVGEM's PP&E mainly consists of land and buildings, the value of which is insignificant.

0% advance rate to excess cash. The regulatory framework for China's homebuilding sector means that available cash, including pre-sales regulated cash, are typically prioritised for project completion, which includes payment for trade payables. Net payables (trade payables - available cash) are included in the debt waterfall ahead of secured debt, however we do not assume available cash in excess of outstanding trade payables would be available for other debt servicing purposes and therefore the advance rate for excess cash is 0%.

The allocation of value in the liability waterfall corresponds to a Recovery Rating of 'RR1' for the offshore senior unsecured debt. However, the Recovery Rating for senior unsecured debt is capped at 'RR4' because under Fitch's Country-Specific Treatment of Recovery Ratings Criteria, China falls into Group D of creditor friendliness, and instrument ratings of issuers with assets in this group are subject to a soft cap at the issuer's IDR and Recovery Ratings of 'RR4'.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Sustained improvement in liquidity and funding access, with the company addressing upcoming capital-debt maturities in a timely manner

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Failure to obtain new financing to address upcoming capital market-debt maturities in a timely manner

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Issuer Profile

LVGEM is a small property developer specialising in urban-renewal projects in the Greater Bay Area, primarily in Shenzhen and Zhuhai. It recorded contracted sales of CNY3.7 billion in 2021 and it owns investment properties in Shenzhen and Hong Kong. It is listed on the Hong Kong Stock Exchange.

Summary of Financial Adjustments

We exclude funds under regulation by banks for specific purposes and performance deposits required by government from cash and include them as inventory in our leverage calculation. Restricted bank deposits are included in cash to calculate net debt, as these are mainly pledged for obtaining bank loans.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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