Fitch affirms Sri Lanka-based retailer Abans at ‘BBB+(lka)’ with stable outlook

Fitch Ratings has affirmed Sri Lanka-based retailer Abans PLC's (Abans) National Long-Term Rating at 'BBB+(lka)' with a Stable Outlook. A full list of rating action is at the end of this commentary. The affirmation reflects Fitch's view that Abans will continue to make meaningful progress towards improving its net leverage, defined as lease-adjusted debt net of cash/operating EBITDAR, to around 6.0x by the end of the financial year to 31 March 2019 (FY19). We expect this to be supported by a recovery in profitability because the company will be better able to pass through costs to customers, as well as operating efficiencies and moderating capex and investments. Abans' net leverage improved significantly to 6.8x in the 12 months to end-June 2018 from 7.2x at FYE18 and 7.7x at FYE17. However we may take negative rating action in the next six to 12 months if Abans deviates from its deleveraging trend. Abans' rating also reflects its strong market position in consumer durables retail in Sri Lanka, its extensive brand portfolio supported by a wide distribution network and a well-managed hire-purchase (HP) business, which are partly offset by its investment in a large real estate project. However the risks stemming from the non-core investment has substantially reduced over the past 18 months because the project is near completion, which has reduced pressure on Abans for additional funding. KEY RATING DRIVERS Leverage to Improve: We expect the pace of Abans' deleveraging to pick up in FY19 as profitability recovers, dividend inflows from its associate company increase, and efficient use of working capital. We expect Abans to be able to reduce leverage to around 6.0x by FYE19 when it starts realising the full benefits of the cost efficiency measures that are being put in place. Abans has also decided to limit capex to maintenance levels in the medium term and refrain from shareholder returns in the next couple of years, which should help keep leverage at levels commensurate with the rating. Margin to Widen Modestly: We expect Abans' EBITDAR margin to expand around 150 bp in the next 18-24 months from the 5.4% trough in FY18, which will be helped by a better cost pass-through and operating efficiencies. Management plans to reduce the store network in the next 12 months, which it expects to result in a net annual cost saving of around LKR200 million. We estimate this will widen margin by 50bp, based on our FY19 revenue projections. Abans cut selling, general and administrative costs as a percentage of sales by almost 200bp in FY18 and will target further cuts by eliminating redundancies and integrating processes over the medium term. The company's EBITDAR margin expanded 100bp yoy in 1Q19. However these improvements will be partly offset by continued pressure from currency depreciation on 85%-90% of Abans' cost of goods sold, which the company may not be able to fully pass on to customers. Consequently we do not expect Abans' margins to recover to the high-single digit range of the past but expect it at around 7% in the medium term, which is essential to maintain net leverage at a level commensurate with the rating. Demand to Remain Sluggish: Fitch expects Abans' revenue growth to slow in the next 12-18 months as the recent increase in fuel prices by more than 25% will reduce the discretionary income of consumers, which will reduce demand for consumer durables. We believe the fuel price rise will more than offset the recovery in demand in January-June 2018 stemming from better earnings in the agriculture sector, low personal taxes and stable interest rates. Revenue growth will also be muted by the company's price increases in the past couple of months and changes to the HP sales mix to improve cost pass-through. Abans' consumer durables retail revenue fell 7% yoy in 1Q19. Turnaround in Abans Engineering: We expect Abans Engineering, which is involved in the installation and maintenance of mechanical, ventilation and air conditioning systems, to recover in FY19 after the new management revised its pricing strategy to guarantee a minimum margin from projects and transferred currency risk to the customer, which was previously borne by the company. Abans Engineering is the market leader and has strong growth potential due to the new buildings coming up. The company had an order book of LKR 2.9 billion at FYE18 (1.8x of FY18 revenues), providing strong revenue visibility. We expect the business to contribute around 5% to Abans' EBIT once it reaches a steady state compared with operating losses of LKR200 million in FY18. No Further Cash for Property: The Colombo City Center (CCC) project which is a joint venture with a Singaporean partner will not upstream any dividend to Abans until the project loan is fully paid down in 2025. However, the business risk from the project has subsided because the project is due to be completed by mid-2019. Proceeds from pre-sales have been better than expected, and 85% of its retail space has been pre-leased. Management expects CCC to open by end-August, which should help with sales of the remaining inventory. Around 70% of the apartments were sold by end-July 2018. Abans is not likely to need to provide further cash, if the project encounters any temporary cash flow deficits, because the company's shareholders will seek funding from other sources. Therefore we do not expect Abans to inject the remaining LKR300 million of its initial capital commitment. DERIVATION SUMMARY Abans is the number two player in terms of revenue in consumer durables retail in Sri Lanka, with a strong portfolio of well-known brands and an extensive distribution network. Abans is rated one notch below its closest peer, Singer Sri Lanka PLC (A-(lka)/Stable), the market leader, to reflect its weaker financial profile and thinner EBITDAR margins. Abans is rated at the same level as DSI Samson Group (Private) Limited (BBB+(lka)/Stable) because Abans' weaker financial risk profile offsets its stronger business risk profile compared with DSI. DSI is the market leader in locally manufactured footwear, but faces a number of structural challenges, including increasing competition from cheap imports and reducing pricing power. At the same time, DSI's local tyre business is under pressure due to the lower sales of two-wheelers and three-wheelers following an increase in taxes. KEY ASSUMPTIONS Fitch's Key Assumptions within Our Rating Case for the Issuer - Revenue growth to slow in FY19 and recover to high-single digits from FY20 - EBITDAR margins to recover and stabilise at around 7% in the medium term - Capex to fall to around LKR150 million a year in the medium term, mainly for maintenance and store upgrades - Dividend income from associates to amount to LKR650 million in FY19, and LKR250 million in FY20 - Dividend pay-out to be maintained at 15% of net profit in the medium term RATING SENSITIVITIES Developments that May, Individually or Collectively, Lead to Negative Rating Action - Any deviation in Abans' current deleveraging trend in the next six to 12 months that prevents the company from improving its adjusted net debt/operating EBITDAR to around 6.0x and fixed-charge coverage (ratio of EBITDAR to gross interest + rent excluding Abans Finance) to 1.3x (FYE18: 1.2x) by FYE19. Developments that May, Individually or Collectively, Lead to Positive Rating Action - A sustained improvement in Abans' adjusted net debt/operating EBITDAR to less than 5.0x and its fixed-charge coverage to more than 1.5x. LIQUIDITY Manageable Liquidity Position: As of end-March 2018, Abans had LKR600 million of unrestricted cash and LKR7.5 billion of unutilised but committed credit lines to meet LKR9.3 billion of debt maturing in the next 12 months. However we expect the company to generate around LKR800 million in free cash flow in FY19, which should help bridge the shortfall. In addition, LKR6.6 billion of these maturities are short-term working capital lines and are backed by net working capital of LKR16 billion. As such, we expect banks to roll over these facilities as they fall due in the normal course of business. FULL LIST OF RATING ACTIONS Abans PLC - National Long-Term Rating affirmed at 'BBB+(lka)'; Stable Outlook - National Long-Term Rating on outstanding senior unsecured debentures affirmed at 'BBB+(lka)' - National Short-Term Rating on commercial paper affirmed at 'F2(lka)'