Fitch Ratings has revised China-based Zhongyu Energy Holdings Limited's Outlook to Stable from Positive and affirmed its 'B+' Long-Term Issuer Default Rating.

Fitch has simultaneously withdrawn the rating.

The Outlook revision reflects our expectation that Zhongyu's Fitch-defined EBITDA net leverage may be sustained above 5.5x, a positive rating sensitivity, over the next four years, driven by slower profit growth from the value-added service (VAS) and smart-energy business segment. We have lowered our forecasts materially for the non-gas business segment's profit growth over the next four years, as the company's top-line and profitability underperformance in 1H22 suggests it faces challenges in achieving the targets it previously set.

Fitch has chosen to withdraw the rating for commercial reasons.

Key Rating Drivers

Non-Gas Business Growth Below Expectation: The gross profit of Zhongyu's non-gas smart-energy and VAS business declined by 2% yoy in 1H22, worse than Fitch's expectation of a 10% rise. The gross profit margin (GPM) for the smart-energy business was 32% in 1H22, much lower than our estimate of 70% due to slow ramp-up of solar power projects. VAS revenue dropped by 31% yoy in 1H22 as new connections remained weak.

We now expect the company to miss its smart-energy GPM target of 70%-90%, its previous guidance to Fitch, in 2022-2025 as the ramp-up of solar power plants has been much slower than expected, while other non-gas businesses such as the provision of integrated energy, heating and cooling services have lower margins. We have also lowered our forecast for VAS revenue growth due to uncertainties in the domestic property market.

Difficulty in Deleveraging: We expect Zhongyu's Fitch-defined EBITDA net leverage to reach 5.5x-5.8x in 2022-2025 from 4.8x in 2021 after incorporating our revised assumptions for the smart-energy and VAS business. We expect capex to gradually decline on lower investment in rural coal-to-gas projects, although this will depend on the pace of capacity addition for smart energy.

Slide in New Connection Revenue: We estimate a decline of 28% and 7% in new connections during 2022 and 2023, respectively, as China's property market remains weak. The decline in connections will be a drag on Zhongyu's EBITDA, and the segment contribution will drop to below 20% by 2025 from 40% in 2021. On the other hand, Zhongyu's earnings visibility will improve over the medium term on the lower profit contribution from one-off connections.

Improved Dollar Margin: Zhongyu's dollar margin improved by CNY0.015 yoy to CNY0.55/cubic metre in 1H22, while most rated peers suffered a margin decline due to high gas costs. Zhongyu has set up a centralised gas procurement centre and the completion of its gas pipeline network has allowed it to increase the procurement of lower-cost piped gas from Chinese oil majors and other sources. The gas is cheaper than the spot price of liquefied natural gas (LNG).

We estimate Zhongyu's yoy dollar margin improvement continued in 2H22. Soft natural gas sales consumption in China during 2022 alleviated gas supply tightness and enabled city-gas distributors to procure a higher proportion of lower-cost contracted gas from oil majors. Spot LNG prices during November and December 2022 fell 11.5% yoy, and the peak season city-gate prices charged by oil majors only increased by 10% yoy. As a result, we expect Chinese city-gas distributors' cost pass-through to be smoother in the 2022/2023 winter season.

Slower Gas Sales Volume Growth: We estimate Zhongyu's retail gas sales volume growth moderated to 4% in 2022, from 16% in 2021. China's gas sales growth slowed in 2022 due to weaker economic growth and higher gas costs. However, we expect gas sales growth to recover in 2023 on the removal of pandemic control measures. We expect Zhongyu's gas sales volume to achieve a CAGR of 8% in 2022-2025.

Rising Interest Rates: Zhongyu's offshore loan proportion reached 76% by end-June 2022, mostly in floating-rate borrowings. We believe rising global interest rates will weaken the company's interest coverage ratio, reducing financial flexibility to some extent. We expect Fitch-defined EBITDA interest coverage to weaken during 2022-2025 from 4.4x in 2021, but remain commensurate with the 'B+' rating level. We believe Zhongyu remained compliant with its loan covenants in 2022. Zhongyu plans to refinance some maturing offshore debt with onshore debt over the next 12 months, which may improve its funding cost and financial flexibility.

Derivation Summary

Zhongyu's 'B+' rating reflects its elevated leverage against a relatively stable and resilient business profile as a city-gas distributor in China. We compare Zhongyu with Concord New Energy Group Limited (CNE, BB-/Stable) and ReNew Power Private Limited (BB-/Stable). Concord's renewable business faces lower price and volume risk with minimum guaranteed grid off-take. It also has no fuel cost exposure. Both Concord and Zhongyu used to have receivable collection issues, which pressured operating cash flow generation. However, the collection risk has dropped for both as Concord rebalanced its portfolio with more subsidy-free projects and Zhongyu cut back on its rural coal-to-gas project expansion.

ReNew Power is much larger than Zhongyu as a leading renewable-power producer in India. ReNew, like Concord, has higher earnings visibility, but it faces much higher counterparty risks than Zhongyu from weak state power-distribution companies, leading to higher risks in receivable collection.

Key Assumptions

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

Retail gas sales volume CAGR of 8% during 2021-2025, supported by increasing sales volume from rural projects and higher gas sales penetration in China.

Steady retail dollar margin in 2022, despite higher gas costs as the company continued to optimise its gas supply mix through its gas procurement management centre. Dollar margin to increase slightly in 2023-2025 on lower gas costs.

New connections dropping by 28% in 2022 due to the property market turmoil, and decline by another 7% during 2023-2025.

Smart-energy business' installed capacity to reach 550MW by 2025 with average utilisation hours of 1,350.

Capex to decline to about HKD1.08 billion-1.47 billion a year in 2022-2025 from HKD1.54 billion in 2021, as lower gas-related capex is offset by rising investments in the smart-energy business.

RATING SENSITIVITIES

Not applicable as the rating has been withdrawn.

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.

Liquidity and Debt Structure

Manageable Refinancing Risks: Zhongyu reported available cash of HKD1.8 billion at end-June 2022 and unused credit facilities of HKD3.7 billion against short-term debt of about HKD6.1 billion. We expect the working-capital loan portion of the short-term debt, roughly HKD2.4 billion, to be rolled over due to the company's solid refinancing record and the stable nature of the city-gas business.

Its sound banking relationships and record of refinancing will also help in obtaining additional working-capital loan facilities, if needed. The company also has large encumbered assets, which can be used to secure bank financing.

Issuer Profile

Zhongyu was established in 2002 with dual headquarters in Shenzhen and Zhengzhou. The company is mainly engaged in the development and operation of city-gas projects in China.

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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