Fitch Ratings has upgraded China-based toll-road operator Shenzhen Expressway Company Limited's (SZE) Long-Term Issuer Default Rating (IDR) to 'BBB+' from 'BBB'.

The Outlook is Negative. SZE's underlying credit profile remains unchanged at 'bbb'. The ratings have been removed from Under Criteria Observation (UCO).

The upgrade follows the upgrade of the IDR of SZE's parent, Shenzhen International Holdings Limited (SZIH), to 'BBB+' from 'BBB', which reflects the application of Fitch's updated Parent and Subsidiary Linkage Rating Criteria. SZE's Outlook remains Negative, in line with that of SZIH. We expect SZIH's consolidated leverage to remain elevated following several completed and proposed acquisitions. This includes SZE's acquisition of 100% of Shenzhen Investment International Capital Holdings Infrastructure Co. Ltd (SIICH).

RATING RATIONALE

SZIH holds a 51.56% controlling interest in SZE. On a standalone basis, SZE's 'bbb' underlying credit profile is stronger than SZIH's underlying credit profile of 'bbb-'. Still, Fitch believes government support is likely to extend to SZE, which links its IDR to the parent's supported IDR in our assessment of the parent and subsidiary's linkage. SZE's IDR is equalised with SZIH's IDR as Fitch has assessed that SZE has 'High' strategic and 'Medium' operational ties with SZIH.

Fitch assesses SZE's underlying credit profile at 'bbb' based on its robust expressway portfolio, which comprises high-quality assets with a larger commuter base mainly in China's Guangdong province with a focus on Shenzhen.

SZE's toll traffic continued to demonstrate resilience after its swift recovery following the toll-fee exemption period in 2020. SZE's 2021 daily toll traffic, excluding the newly opened Outer Ring Road and newly acquired Longda Expressway, was about 20% above 2019's pre-pandemic level, despite occasional targeted lockdowns imposed during the year.

Several changes in the toll rate policy, including the Differentiated Toll Collection Policy and a change in vehicle classification for toll fees, dampened toll revenue growth in 2021. Nevertheless, we expect the operator to benefit from the new toll system in the long run as this would ease congestion and improve traffic efficiency.

China's 'zero-Covid' policy, with its targeted lockdowns, curtailed SZE's toll traffic, particularly in the Guangdong region. Daily traffic volume of SZE's controlled assets fell by 16% in 1Q22 from a year earlier. SZE expects traffic at its toll-road assets in the Greater Bay Area to recover gradually starting May 2022.

KEY RATING DRIVERS

Criteria Update Leads to Equalisation: Our updated Parent and Subsidiary Linkage Rating Criteria introduced a new prescriptive notching grid to determine rating outcomes. This is based on an assessment of tailored factors that describe the linkage characteristics, depending on whether the stronger entity is the parent or the subsidiary. Caps may apply in certain circumstances.

Unlike the previous criteria, 'top-down minus two', 'top-down minus three' and 'bottom-up plus three' outcomes under the 'stronger parent' path have been removed. SZE is now notched 'top-down minus one' based on 'Weak' legal, 'High' strategic and 'Medium' operational linkages. This allows for SZE's IDR to be equalised with that of the parent as SZE's underlying credit profile is one notch below SZIH's supported IDR, which benefits from the likelihood of state support flowing to SZE.

Strategic, Robust Expressway Network - Revenue Risk (Volume): High Midrange

The majority of SZE's expressways are strategically spread across the wealthy Guangdong province, including Shenzhen city, with some diversification in central China. The operating portfolio mainly includes key arterial roads with a large commuter base and limited competition. The road network has exhibited strong growth and low volatility historically. Toll traffic was robust and toll revenue's recovery was swift amid the pandemic and lockdowns.

Toll rates on the network are generally low due to restrictions, with the government occasionally imposing reductions. Volume risk is constrained to 'High Midrange' due to SZE's rising exposure to non-toll road businesses, which have slightly different risk profiles from its core toll-road business. Fitch does not expect meaningful EBITDA contribution from non-toll road businesses in the near term. However, should there be changes in the EBITDA trend, we will reassess SZE's risk profile.

Opaque Regulatory Framework - Revenue Risk (Price): Weaker

The price risk is a weaker attribute due to lack of transparency and predictability in the regulatory framework. Toll-rate setting and adjustments are highly regulated by the government with limited flexibility for toll-road operators to recover higher costs due to inflation. Most of the prevailing toll rates have been unchanged for a number of years with no visibility of any increases in the future.

The government has imposed adverse policies such as tariff cuts and toll exemptions, resulting in a decline in the average toll rate. That said, we believe these policies will reduce congestion on road networks and boost traffic, which will in turn benefit the company in the long run.

Highly Defined, Flexible Capex Plan - Infrastructure Development and Renewal: Stronger

SZE has considerable experience and expertise in delivering on its network investment. Its planned capex over the next three years is substantial, amounting to about CNY5 billion. SZE's capex plan is highly developed and detailed, and we anticipate more than half will be funded from borrowings and operating cash flows. SZE has demonstrated significant flexibility in delaying its capex plan when necessary. SZE's capex plan for the next one-two years is rather aggressive, which we believe will put a strain on the company's leverage the medium term.

Non-Amortising Uncovenanted Debt - Debt Structure: Midrange

SZE's debt structure is typical of a Chinese corporate borrower as it is funded by non-amortising debt with few of the protective covenants that would be commonly seen in a project finance-type structure. Refinancing risk is mitigated by the company's ample liquidity, comprising cash and significant standby bank facilities, a well-diversified schedule of bullet maturities, a record of prudent debt management and solid access to the capital market.

Interest risk exposure to the country's benchmark lending rate and loan prime rate is manageable because adjustments to the two rates are infrequent and we do not expect them to rise in the near term. Nevertheless, we have considered the risk in our rating case by adding a stress of 200bp on the existing rate.

PEER GROUP

SZE compares well with Yuexiu Transport Infrastructure Limited (YXT, BBB-/Stable). SZE's underlying credit profile is one notch higher than YXT's IDR. The two companies share the same price and infrastructure development and renewal attributes. SZE's key assets have near-monopoly characteristics, but YXT has better geographic diversity and a longer remaining concession life. SZE's net leverage profile is better in Fitch's rating case, which also warrants the one-notch difference in the underlying credit profile.

RATING SENSITIVITIES

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

Downgrade of SZIH's rating, provided our assessment of the linkage between SZE and SZIH remains unchanged

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

Upgrade of SZIH's rating, provided our assessment of the linkage between SZE and SZIH remains unchanged

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure 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 three 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.

CREDIT UPDATE

SZE's total revenue, excluding construction service arrangement revenue, increased by 16% in 2021. Toll revenue accounts for 63% of SZE's revenue, while renewable and solid waste-management segments contribute 8% and 12%, respectively.

Its toll revenue from existing projects, excluding the newly opened Phase I of the Outer Ring Road, increased by 13%. Revenue from the clean-energy business fell 57% due to a delay in the implementation of existing projects and orders of Nanjing Wind Power, SZE's subsidiary, as well as intensified market competition.

Capex was around CNY3.8 billion in 2021, an increase of 53% from 2020, mainly due to the acquisition of a new office building, which made up close to 50% of capex. Most of the consideration for SZE's SIICH acquisition will be paid in 2022 and 2023, which kept leverage low during 2021. SZE has ample liquidity, with cash in hand of CNY6.2 billion and an available credit facility of CNY23.7 billion at end-March 2021.

FINANCIAL ANALYSIS

Fitch's base case (FBC) considers SZE's projected performance for each asset, according to the company's assessment of economic prospects, development of surrounding networks, competing modes of transport as well as the maintenance and expansion plan for the company's assets and those of competing roads.

The FBC forecasts stagnant growth in toll revenue for 2022 in light of continued strict pandemic-related lockdown and control measures in China. Thereafter, Fitch expects modest toll revenue growth as operating rights for the Wuhuang and Shuiguan Expressways expire in December 2022 and 2027, respectively. We forecast EBITDA to remain at 80%-82% of revenue for the next five years and expect a large capex budget due to the expansion of the Jihe Expressway as well as construction of the Outer Ring Project and Coastal Expressway Phase II.

SZE expects its solid-waste management and wind power-related businesses to maintain healthy growth in the medium term before stabilising with more of its newly acquired and developing projects coming online.

The acquisition of SIICH was completed in January 2022. The acquisition cost, including repayment of SIICH's outstanding debt, is payable in two tranches, about 73% in 2022 and the rest in 2023.

The Fitch rating case takes a more conservative view and incorporates a number of stresses, mainly haircuts of 2% on base case revenue and the EBITDA margin, a 200bp increase in floating interest rates, a 5% increase in capex and a 5pp increase in the dividend payout ratio

The base case shows net leverage of 3.9x in 2023, which we expect to decline gradually to 3.0x in 2025. The projected five-year average net leverage ratio is 3.4x.

The rating case shows high net leverage of 4.4x in 2023, which we expect to decline gradually to 3.8x in 2025. The projected five-year average net leverage ratio is 4.1x.

ASSET DESCRIPTION

SZE was incorporated in 1996 and is headquartered in Shenzhen. It engages in the investment, construction, operation and management of toll highways and roads, as well as the general-environmental protection business.

SZE operated and invested in a total of 17 toll highway projects, of which 11 are controlled projects. The attributable mileage of the highways invested in or operated by the company is approximately 633km, of which 5.7km is still under construction. The average concession life is about 11 years. SZE also participates in various regional urban infrastructure development projects, invests in more than 15 environmental protection, clean energy and finance projects. SZE is listed on the Hong Kong Stock Exchange and Shanghai Stock Exchange and is majority-owned by SZIH.

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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