Key Takeaways
- Chinese developers were battling margin compression well before the COVID-19 outbreak hit.
- About two-thirds of rated developers reported 2019 revenue below our original forecasts.
- Even as total contracted sales rebounded 136% in March (on month), we assume a 5%-10% drop in contracted sales in 2020.
The release of most Chinese developers' 2019 results show many firms were facing margin compression well before the COVID-19 outbreak hit. The event simply amplified strains underway before this crisis. Tepid sales and tighter margins should drive the ratings on China developers in 2020, particularly as U.S. dollar funding dries up. S&P Global Ratings maintains its baseline view for the sector. We assume a 5%-10% drop in national contracted sales for 2020.
Chinese developers have grown steadily in recent years, with almost all lifted by the rising tide of surging property sales. Most rated entities seemingly built meaningful buffers through this flush period. However, the business disruptions triggered by the COVID-19 pandemic have exposed vulnerabilities in weaker firms that didn't use the good years to bolster their financial strength.
Construction Halts Drag On Deliveries and Revenues
About 67% of rated developers reported 2019 revenue below our original forecasts, resulting in about a 2% gap on an aggregate basis. The worst are 30%-35% below our expectations. The number of joint ventures (JVs) that contribute to the growth in developers' total contracted sales has grown more than we anticipated. This has resulted in a shortfall between revenue booking and contracted sales registration since far fewer of these JV projects were consolidated.
Revenue increased by an average of 28% in 2019, of the Chinese developers we rate. This compares with a 51% increase, year on year, in contracted sales two years ago. Two years is an approximate average life cycle for residential projects in China. We believe a lengthening construction cycle--to stretch out spending--explains this gap. At its essence, this is a case where some firms grew aggressively during the boom times, and have now been caught out by an abrupt slowdown triggered by the outbreak. Firms increased their exposure to joint-venture projects to accelerate expansion, and grappled with challenging delivery execution as the scale of their projects grew ever more ambitious.
Gross margins have declined markedly, (see "Chinese Developers' Margins: What Goes Up Must Come Down," Sept. 5, 2019.) Higher land costs, prolonged price caps, and deeper price cuts--particularly in lower-tier cities--have driven this margin drop. The average gross margin of the 40 developers we rate that had reported results as of April 3, 2020, decreased by about 3 percentage points in 2019 to about 30%.
More than 45% of developers suffered a margin decline of over two percentage points, while a quarter weathered a margin drop of five percentage points or more. We expect this trend to continue.
Chart 1
Developers lost roughly two months of construction in 2020 due to the COVID-19 outbreak, which has involved stringent nationwide containment measures. Revenue recognition in 2020 may face greater slippage as the delivery of projects slated for this year creeps into 2021. The first quarter is typically quieter due to holidays and a seasonal slowdown in construction over winter, but the delays may raise leverage this year.
We estimate that, under our baseline stress test scenario, the median leverage (debt to EBITDA) of rated developers could climb toward 6.5x by the end of 2020, from our original base case of about 5.7x (see "New Virus, Unprecedented Risks For China's Developers," March 1, 2020). This contrasts with the 6.4x leverage registered in 2019 (the median of 40 developers).
Indicatively, our rated developers have set much milder growth targets of 5%-15% for 2020, from an average of about 27% in 2019. This slowdown comes even as some midsize developers still chase scale, pursuing growth in excess of 20% this year.
Demand Is Rebounding, But For How Long?
National sales volume by gross floor area as of March 31, 2020, had caught up with levels seen in 2018 and 2019, after almost all property sales centers reopened by end-March. This comes amid a gradual normalization of business and social activity in China. Despite a 20% year-on-year drop in the first quarter, total contracted sales by value rebounded 136% in March (on month), from a 44% drop the previous month.
The rebound has pulled us back from a more negative outlook for the sector, which we describe as a "more-severe" scenario, which would have involved a 15%-20% drop in contracted sales.
However, we note that an unfolding global recession may continue to depress demand for property in China. We believe most owner-occupier demand has only been deferred and has not disappeared, but the rebound in sales is fragile. Demand remains highly dependent on consumer (and investor-buyer) confidence, which is no sure thing given the global economic downturn. For now, we maintain our base-case view, which is that national contracted sales will drop 5%-10% in 2020.
Chart 2
Offshore Financing Channel May Cause Hiccups
The unaccommodating conditions in the volatile U.S. dollar capital market may linger for months. Many developers managed to issue before the recent turmoil, selling US$23 billion in bonds offshore in the first three months of 2020, thus covering much of the US$27 billion of U.S.-dollar bonds coming due within the year.
Chart 3
Some developers missed this window and may have to rely on other means to repay their upcoming maturities. Rated developers also face a bulky US$44 billion in U.S.-dollar debt due next year.
The solution may lie in domestic markets. Local funding conditions have turned more supportive following government easing initiatives aimed at fostering an economic recovery and boosting funding access. Rated developers have issued Chinese renminbi (RMB) 69 billion (US$ 9.9 billion) into local markets in the first quarter, with another RMB11 billion (US$1.6 billion) in the pipeline for April.
Chart 4
Liquidity management with a focus on cash collection, actionable refinancing plans, and access to onshore financing channels will remain critical, particularly for weaker developers rated 'B' or below.
Chart 5
Restrictive Regulations Stay In Place Despite Downturn
We anticipate some regulatory loosening on home purchasing restrictions such as lowering of "hukou" (official residency) thresholds, and a broadening of the eligibility of other potential homebuyers. We also believe there could be more developer-friendly measures such as extensions on land premium payments, tax breaks, and looser presale conditions.
However, we don't see a high probability of a major change to the current restrictive regulatory framework, which is designed to keep housing prices in check. Although the lower official interest rates may stimulate liquidity and customer demand, rated developers are unlikely to see a much different market even as the outbreak recedes.
Related Research
- New Virus, Unprecedented Risks For China's Developers, March 2, 2020
- China's Illiquid Developers Ask, How Long Will The Coronavirus Crisis Last?, Feb. 2, 2020
- China Property Watch: Growth Confined By Funding Bind, Nov. 5, 2019
- Chinese Developers' Margins: What Goes Up Must Come Down, Sept. 4, 2019
This report does not constitute a rating action.
| Primary Credit Analyst: | Aeon Liang, Hong Kong (852) 2533-3563; aeon.liang@spglobal.com |
| Secondary Contact: | Christopher Yip, Hong Kong (852) 2533-3593; christopher.yip@spglobal.com |
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