China Railway Group Ltd. #BBB+# Ratings Affirmed On Improving Outlook Positive

Stocks and Financial Services Press Releases Wednesday October 25, 2017 16:08
HONG KONG--25 Oct--S&P Global Ratings

HONG KONG (S&P Global Ratings) Oct. 25, 2017--S&P Global Ratings said today it affirmed its 'BBB+' long-term corporate credit rating on China Railway Group Ltd. (CREC). The outlook is positive. At the same time, we affirmed our 'BBB+' long-term issue rating on the US$500 million senior unsecured notes issued by China Railway Resources Huitung Ltd., and guaranteed by CREC.

We anticipate CREC will continue to pursue a conservative approach to capital expenditure (capex) and investment projects. In 2016, CREC spent about Chinese renminbi (RMB) 13 billion for equipment and investment projects. These investments included build-operate-transfer (BOT) projects in which CREC has a majority control. We expect the company's annual capex and commitment to investment projects in 2017 and 2018 to be similar to 2016 levels. This level is low compared with CREC's revenue and operating cash flow, and is notably lower than that of some Chinese peers (in terms of percentage to revenue). In our view, the appetite for investment projects that require funding is the most sensitive driver of the financial metrics of Chinese engineering and construction (E&C) companies.

CREC is likely to maintain its working capital close to break-even over the next one to two years, in our view. By delaying payables to suppliers and increasing advance receipts in 2016, CREC more than offset increases in receivables and inventory, and recorded a material net working capital inflow of around RMB27 billion, a record high for the company. We believe such working capital inflows reflect CREC's good bargaining power with suppliers, supported by its very large size. Although we expect CREC to register a potential net working capital outflow going forward, because of increasing public-private-partnership (PPP) exposure, we believe CREC will largely pass on its receivables pressure to suppliers, hence containing the size of working capital outflow.

As a result of the above, we expect CREC to generate positive free operating cash flows (FOCF) over the next two to three years, which caps the company's borrowing needs. Such flows, together with sustained revenue and EBITDA growth, will gradually improve CREC's credit metrics under our base-case scenario. CREC notably reduced its leverage during 2016 as a result of material FOCF generation, while its total debt balance further reduced during first half of 2017, against its level at year-end 2016.

Meanwhile, we expect CREC to register robust revenue growth with stable profitability over the next 12-24 months. This is mainly driven by the very rapid infrastructure spending growth in China, which increased 20% during the first eight months of 2017. CREC, in particular, has been benefiting materially from Chinese local governments' rush for railway infrastructure (including metro, inter-city rail, etc.). The company recorded 79% and 44% growth in urban rail E&C new contracts signed in 2016 and first-half 2017 respectively (on a year-on-year basis).

We anticipate Chinese infrastructure spending growth will expand in line with GDP growth over the next two to three years, given its importance in generating demand and employment. This will in turn benefit E&C companies such as CREC in terms of further revenue and project growth. Also, rapid expansion in new infrastructure projects, especially from local government, also provide some marginal support to CREC, given these local governments tend to mainly work with large reputable central state-owned enterprise (SOE) E&C companies.

The positive outlook reflects our expectation that CREC will continue to grow its revenue and profit over the next 12- 24 months, with moderate capex and limited working capital outflow. The company will therefore generate positive free operating cash flows and is expected to utilize this FOCF to lower its debt leverage. We also expect CREC to maintain its strong market position and stable profitability, supported by sustained growth in infrastructure spending in China.

We may raise the rating if CREC can maintain its steady revenue growth without a material increase in capex or material working capital outflow, such that its ratio of FFO to debt approaches close to 30%. An upgrade also assumes CREC will maintain its profitability. We could also raise the rating if we believe the likelihood of extraordinary support from the Chinese government to the company is stronger than our expectation, although we expect such scenario to be less likely.

We may revise the outlook to stable if CREC's leverage ratios fail to improve from 2016 levels. This could happen if: (1) the company aggressively bids for new E&C projects, especially investment-linked projects, such that its working capital requirements and capex are much greater than we expect; or (2) the company faces materially higher execution risk in overseas projects than we expect due to aggressive expansion, leading to sustained large scale loss on projects.

Meanwhile, we could lower the rating on CREC if we believe the likelihood of government extraordinary support is weaker than our expectation, although such a scenario is less likely, in our view.

We maintain our 'BBB+' issue rating on the US$500 million senior unsecured notes issued by China Railway Resources Huitung Ltd., and guaranteed by CREC. Although this U.S. dollar debt is structurally subordinated to other debt issued by operating subsidiaries of CREC (which contributes materially to more than 50% of CREC's total debt), we believe there is no material subordination risk. This is because we expect the government to be willing and able to intervene, if necessary, so that holders of the U.S. dollar notes would not have worse recovery prospects than structurally senior lenders. This is supported by the importance of CREC as a Chinese central SOE, and the significant reputational risk and economic penalty if foreign lenders were materially disadvantaged in a post-default scenario.

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