Fitch affirms Hemas Holdings at AA-(lka); outlook stable

Fitch Ratings has affirmed Sri Lanka-based conglomerate Hemas Holdings PLC's (Hemas) National Long-Term Rating at 'AA-(lka)' with a Stable Outlook. Fitch has also affirmed the National rating on Hemas's outstanding senior unsecured debentures at 'AA-(lka)'. Hemas's rating reflects Fitch's view that the group's business risk profile has improved from the acquisition of Atlas Axillia (Private) Limited (Atlas), the largest domestic manufacturer and distributor of exercise books, pens, colour products and other school stationery, early this year. However, the benefits are offset to an extent by the operational pressures in its fast moving consumer goods (FMCG) segment that accounted for 40% of EBITDA in the financial year ended March 2017 (FY17) and its leisure business (12%), which we expect to persist in the next 12-18 months. The affirmation takes into account Fitch's view that significant expansion plans in the next couple of years could limit further improvements in Hemas's leverage, defined as adjusted debt/operating EBITDAR (FY17: 1.3x), as internally generated funds may not be sufficient to fully fund planned capex and shareholder returns. KEY RATING DRIVERS Atlas Boosts Defensive Cash Flows: We expect Hemas's LKR5.7 billion Atlas acquisition to improve cash flow stability as the latter's business is defensive across economic cycles. Fitch expects demand for school stationery to grow over the medium term, supported by government and private-sector investments in the education sector and rising per capita income in the country. We believe this acquisition is in line with Hemas's strategy of using its significant cash balance to expand its core businesses through M&A. Atlas's stationery business fits into Hemas's FMCG segment and Atlas will be able to leverage on Hemas's established distribution network once the integration is completed. We expect Atlas to contribute around 15% and 25% to group revenue and EBIT, respectively, in FY19, its first year of full consolidation. Expansion Limits Leverage Improvement: We do not expect Hemas to engage in any other large scale M&A that is similar to Atlas in the medium term, but the company will continue to spend LKR3 billion-4 billion on organic expansion in its core segments in the next few years. We estimate Hemas will generate around LKR4 billion per annum in cash flow from operations in the next few years but this may be insufficient to fully cover the planned capex and shareholder returns. We do not expect an improvement in company leverage in the medium term amid higher borrowings and a moderating operating performance. FMCG Pressures: We expect the FMCG segment slowdown to continue in the next 12-18 months due to pressures in Bangladesh (around 15% of FMCG revenue in FY17) arising from the restructuring of Hemas's distribution network and increased competition. Bangladesh was the segment's growth driver in the last three years with revenue CAGR of over 50% but we expect the growth to materially decelerate in the near term as the company's moves to resolve the issues may take time. We believe Hemas may have to keep investing in its Bangladesh distribution network and marketing efforts to support its bigger operational scale and counter competition, which would keep margins below historical levels in the medium term. We don't expect a recovery in domestic FMCG volumes in the near term as weak personal income and inflationary pressures may force consumers to continue to cut down on personal and home care spending. Domestic margins may also remain pressured due to a pickup in input costs and currency depreciation, which the company may find difficult to fully pass on to customers amid weak demand. However, steps taken by the company to streamline its supply chain operations are likely to generate cost savings to offset margin pressure to an extent. Hemas's FMCG revenue was flat yoy in 9MFY18 while EBIT margin contracted 270 bp over the same period. Leisure Slowdown to Persist: We expect Hemas's hotel (around 50% of leisure sector EBIT) performance to continue to weaken in the medium term on declining occupancy and room revenue due to a slowdown in tourist arrivals, oversupply of graded accommodation and competition from the informal sector. Hemas's hotel sector revenue was flat in 9MFY18 while EBIT margins contracted almost 5 percentage points yoy. Healthcare Stability: We believe the healthcare segment can offset most of the other segments' earnings volatility. We expect the drug distribution arm to continue winning market share from distributors exiting the market on price regulations, primarily on branded drugs. Hemas, which focuses on generic drugs, saw its market share rising to 30% in FY17 (22% in FY16) due to the lack of branded drugs in the market and acquisition of competitor brands. We expect the pharma segment and its hospital chain to continue growing in the medium term, supported by a rapidly ageing population, rising incidence of non-communicable diseases and undersupply in public healthcare services. However, the hospital sector may face regulatory pressure on pricing of certain services. We expect Hemas's local drug manufacturing business to be the key growth driver for the segment. Less than 15% of Sri Lanka's drug requirements are produced locally with the government looking to increase it to 100% in the medium term with private-sector participation. Hemas plans to double its capacity by FY20 to cater to this demand. Hemas currently sells most of its output to the government under a long-term buyback program and we believe the company will be able to secure a similar contract for most of the new capacity. Any excess capacity can be used to produce its own branded products or for contract manufacturing. Increased Mobility Contribution: We expect the mobility segment contribution to group EBIT to increase to 17% by FYE20 from 10% in FY17, supported by capacity expansion and exposure to high-margin businesses. The company is setting up a container yard and integrated logistics park to cater to the increased transhipment activity at the Colombo port and the growing demand for third-party logistics service. The new facility should contribute to the segment's top line and EBIT from FY19 when it is fully operational. We expect Hemas's ship agency business to continue its growth, helped by extended service offerings and new partnerships. We do not believe the recent de-regularisation of foreign ownership in ship agency and freight forwarding businesses will have an immediate impact on the sector as it will take time and effort for foreign shipping lines to set up operations with similar service offerings provided by their local partners such as Hemas. DERIVATION SUMMARY Hemas is a well-diversified conglomerate similar to Richard Pieris & Company PLC (A(lka)/Stable) and Sunshine Holdings PLC (A-(lka)/Stable). Hemas is rated two notches above Richard Pieris to reflect its low leverage and higher exposure to defensive end-markets compared with the latter's modest presence in the cyclical plantation sector. Hemas is rated three notches above Sunshine due to its stronger business profile stemming from substantially higher cash flows from its defensive pharmaceutical and FMCG businesses and its larger operating scale. Sunshine's financial profile has weakened compared with Hemas due to its debt-funded acquisition in the cyclical plantation sector. Hemas is rated one notch above leading beer manufacturer Lion Brewery (Ceylon) PLC (A+(lka)/Negative) to reflect its cash flow diversity, lower regulatory risks and strong financial profile. KEY ASSUMPTIONS Fitch's Key Assumptions Within Our Rating Case for the Issuer - Excluding acquisitions, organic revenue growth to average in the high single digits in FY19 and FY20 on expansion in the pharmaceutical and mobility segments, offset to an extent by the continued weakness in the FMCG and leisure segments. - EBITDAR margin to contract and stabilise at around 12.5%-13% in the next two years amid cost pressures, competition and price regulation across most segments. - Capex to average around 7% of revenue in the next two years to support the planned expansion. - Dividend payout ratio of about 30% of net income to be maintained over FY18-FY21. - Three months of Atlas results taken into consideration in FY18 with the full 12-month results consolidated from FY19. - No M&A activity in the next two to three years. RATING SENSITIVITIES Developments that May, Individually or Collectively, Lead to Positive Rating Action - Improvement in business risk profile while maintaining the current financial profile. Developments that May, Individually or Collectively, Lead to Negative Rating Action - Group gross adjusted debt/EBITDAR rising above 2.0x on a sustained basis - Any significant integration issues or deviation from the company's conservative approach to new investment. LIQUIDITY Strong Liquidity Position: As at end-December 2017, Hemas had about LKR10.3 billion of unrestricted cash and LKR5.8 billion in unutilised credit facilities to meet LKR2.0 billion of debt maturing in the next 12 months. We do not expect Hemas to generate positive free cash flow in the next 12 months due to working capital investments, high capex and the acquisition of Atlas but its large cash reserves at hand places the company in a strong liquidity position. Hemas has another LKR1.9 billion of short-term working capital-related debt, which we expect to be rolled over by lenders in the normal course of business.