October 15 (SeeNews) - Fitch Ratings said it has affirmed Turkish residential developer Emlak Konut Gayrimenkul Yatirim Ortakligi A.S.'s long-term foreign- and local-currency issuer default ratings (IDRs) at 'BB-', with negative outlooks.
The ratings reflect the Emlak Konut's distinct business model, underpinned by the revenue-sharing model (RSM), which gives the company a significant competitive advantage, the ratings agency said in a statement on Wednesday.
The negative outlooks reflect that on the Turkish sovereign (BB-/Negative), Fitch added.
The global ratings agency also said in the statement:
"KEY RATING DRIVERS
Volatile Operating Environment Continues: On 21 August Fitch revised the Outlook on Turkey's IDRs to Negative from Stable and affirmed the IDRs at 'BB-'. The Turkish economy and the lira remain volatile, with Fitch forecasting GDP to contract 3.9% in 2020, although growing more than 5.0% in 2021. The lira has depreciated more than 30% since the beginning of the year and shows little sign of stabilising. Turkey also remains vulnerable to geopolitical risks.
Low Interest Rates Fueling Sales: The Central Bank of Turkey has made multiple interest rate cuts, which has resulted in real interest rates falling from 8.3% in June 2019 to minus 3.5% in August 2020. These measures, along with company incentive programmes, have accelerated housing sales. In the first half of the year, sales and pre-sales exceeded TRY10.2 billion, double the company's 2020 target. On 24 September, the government increased the interest rates by 200bp, which may slow sales. Nevertheless, with a young, growing and increasingly urban population and a housing shortage, demand for housing remains strong.
Low-risk RSM Anchors Business: Emlak Konut generates most of its revenue and EBITDA through the RSM, which provides revenue visibility and protects the company from short-term market volatility. Under the RSM, the company passes nearly all project development risk to contractors, including design, build, finance and sales. Contractors must guarantee Emlak Konut a minimum revenue, which must be paid even if project revenue falls short, and share any upside gains with the company under an agreed ratio. Emlak Konut only provides land to the project.
Total project returns have historically exceeded the minimum revenue by more than 2.5x. In some cases, the company will develop its own projects under the turnkey model, only passing building risk to contractors, but the RSM will be the dominant model over the medium term.
Project Control Retained: Once a project is underway, the company retains strong control over the project, supervising the building process and collecting and distributing project cash flows, including the contractor's revenue share at defined milestones. This control also provides the flexibility to alter projects if necessary. For example, the company delayed the latter stages of three projects in 2019, which will resume once it feels demand is sufficient. The company can also cancel tenders for any reason, including if bids fall short.
TOKI Relationship Fundamental: Emlak Konut's largest shareholder is TOKI with a 49.4% holding, including all A shares. The exclusive priority agreement with TOKI allows the company buy land from TOKI at independently appraised values with no tendering process. Having ready access to significant and attractive land parcels is a significant competitive advantage. TOKI benefits from Emlak Konut's dividend and land payments, which helps TOKI fund its own, mainly low-income developments. A deterioration in relations with TOKI would materially impair Emlak Konut's business, but this risk appears low given the arrangement is mutually beneficial.
Substantial Land Bank: Emlak Konut holds land of more than 2.9 million square metres with a value of more than TRY3.9 billion (1H20), nearly all in or around Istanbul. The strength of the land bank is crucial to the company's ability to continue to attract strong contractors to its tenders and sustain sales to consumers. Emlak Konut is under no obligation to buy land from TOKI and can only return parcels to TOKI for an updated independent valuation, given legitimate reasons are met.
Exposure to Contractor Performance: As the RSM passes nearly all development risk to contractors, contractor failure is a risk. Emlak Konut mitigates this through several means. Firstly, a two-stage bidding process largely ensures only financially viable contractors win tenders. The preferred bidder must provide a down payment of around 10% of the minimum revenue amount, as well as a letter of credit equating to around 6% of the total estimated project revenue. The company can step in if it has concerns about a contractor's ability to complete a project and carry out the rest of the project under the turn-key model. There have been no project defaults to date.
Higher Debt: Emlak Konut significantly increased debt in 2020 with Fitch funds from operations (FFO) leverage forecast to reach 5.7x by year end, taking advantage of low interest rates. Debt has been steadily increasing -FFO leverage was only 1.1x at end-2017 - reflecting difficult markets and company growth. With strong housing sales in 1H20, we expect this level to steadily fall, although this will take time given the difference between when sales are booked and accounted for.
The weighted average interest rate is now 10.6% (end-2019: 17.7%). The company used the proceeds to refinance some debt, but will also use it buy land, recently acquiring a significant plot near the Istanbul end of the planned Istanbul Canal. Liquidity remains a risk due to significant swings in working capital, the short-term nature of debt, as well as dividend payments, which were TRY118 million in 2019, down from TRY644 million in 2018.
DERIVATION SUMMARY
Emlak Konut does not have a direct peer. While the company's turn-key model is akin to most home builders, the RSM is unique, ensuring a minimum guaranteed revenue amount and share of upside, but also passing nearly all development risks to private contractors. In addition, the priority agreement with TOKI -- unique among rated home builders - provides the company with access to significant and desirable parcels of land that other local developers do not have.
Emlak Konut is of similar size to UK-based Miller Homes (BB-/Stable) and Germany-based Consus Real Estate AG (B-/Stable), but smaller than Russia's PJSC LSR Group (B+/Stable) and PJSC PIK Group (BB-/Stable). Emlak Konut operates with higher FFO margins that have historically exceeded 50%, while most other rated peers tend to be less than 20%. This reflects the effect of the RSM.
Emlak Konut historically had FFO leverage of under 1.0x, but 2020 projected FFO leverage is 5.7x, which is similar to Consus. Dubai-based Azizi (B/Stable) has mainly been funded by equity, but management is now using debt to finance projects and negative working capital. FFO leverage is therefore forecast to average 3.3x between 2020 and 2023.
Emlak Konut operates in a much more volatile operating environment than rated peers, such as Consus in Germany and Miller Homes in the UK. Azizi is in a challenging sector, but mainly because of an excessive housing supply over demand. While Turkey has a material housing deficit and a growing population, the economy remains highly volatile.
KEY ASSUMPTIONS
- Sustainable EBITDA margin above 30% despite double digit decrease in turnover in 2020
- FFO gross leverage averaging 5.5x on the back of land acquisitions
- Negative working capital assumptions for 2020 and 2021
- Continued negative free cash flow
- Stable dividend policy averaging 50% of net income
- Relationship with Toki unchanged
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to positive rating action/upgrade:
- Business and geographical diversification reducing the inherent risk of the Turkish housing market.
- Consistently strong GDP growth, along with political stabilisation.
- Unless the above developments take place, Fitch does not expect to upgrade the rating, as Emlak Konut's operations are exclusively in Turkey and the Turkish sovereign rating and domestic operating environment will constrain the rating.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
-Deterioration of the operating environment and downgrade of the sovereign rating.
- Sustained erosion of profit due either to weak housing activity, meaningful and continued loss of market share, and/or land, resulting in margin contraction and weakened credit metrics, including net debt to capitalisation above 50% on a sustained basis
- FFO adjusted gross leverage above 4.5x on a sustained basis
- Gross debt-to-work-in-progress (WIP) ratio consistently above 50%
- Any material change in the relationship with TOKI causing deterioration in Emlak Konut's financial profile and financial flexibility.
- Deterioration in liquidity profile over a sustained period.
- Order backlog to WIP below 150% over a sustained period
- EBITDA margin below 30% for a sustained period
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 [...].
LIQUIDITY AND DEBT STRUCTURE
Emlak Konut increased debt in 1H20, taking advantage of low interest rates. This extended the weighted average debt maturity profile to just over 2.5 years (H12020) from 1.4 years at end-2019. The weighted average interest rate fell to 10.6% from 17.7% during the same period. Although improved, the debt maturity profile remains relatively short-term in nature, reflecting the limited availability of long-term funding from domestic banks. This is common among Turkish corporates but exposes the company to systemic liquidity risk.
The debt issuances improved the company's cash position at 1H20, with around TRY1.5 billion of available cash, but we expect the company to use the cash to acquire land and it bought a significant land parcel valued at TRY1.4 billion in July. Liquidity will come under pressure as we forecast negative free cash flow in 2020 and dividends of around TRY235 million.
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 [...]"