The credit quality of Chinese department stores will continue to diverge in the next two to three years as rents rise and competition from Internet retailers and shopping malls increases, Moody's Investors Service said.

According to a Moody's report, retailers that own a large percentage of their stores are better positioned to maintain their profitability, market share and funding access than those that lease their space.

Furthermore, companies' expansion strategies and their ability to generate profits at new stores will also affect their credit quality.

Moody's rates four department stores in China: Golden Eagle Retail Group Ltd, Maoye International Holdings Ltd, Lifestyle International Holdings Limited and Parkson Retail Group Limited.

"Golden Eagle and Maoye are best positioned to withstand the industry's challenges, given their large self-owned store portfolios, commercial-property expertise, young store age, and track record of new store ramp-up," said Alan Gao, a Moody's vice-president and senior analyst.

"The credit quality of Lifestyle will remain stable, but Parkson faces increasing challenges, namely exposure to rent increases and weakening credit metrics," adds Gao, who authored the report.

Gao adds that fast-growing Internet retailers and the shopping mall construction boom are drawing traffic away from department stores, particularly in large cities.

And to stay competitive, department stores are shifting their focus to the mid and high-end market segments and increasing their service offerings and store sizes.

Moody's views store ownership as a strength. For example, it insulates Golden Eagle and Maoye from rising rental costs, which helps them maintain stable profitability.

Moreover, department stores with high store ownership typically have commercial-development expertise. This hybrid model helps department stores compete against shopping malls and is instrumental in securing prime commercial properties in China's low-tier cities, which have become growth drivers for department stores.

Moody's also views fast ramp-up and regional expansion as credit positives, as department stores are also seeking growth through expansion and their credit metrics will depend on how quickly their new stores become profitable.

Finally, the strong liquidity inherent in department stores will likely weaken with acquisitions.

Parkson, for example, in acquiring more physical stores, is likely to use its operating cash flow and debt to fund acquisitions, which will reduce its liquidity buffer.

Changing landscape of China's retail industry