Fitch affirms Sunshine Holdings at A(lka); outlook stable

Fitch Ratings has affirmed Sri Lanka-based Sunshine Holdings PLC's National Long-Term Rating at 'A(lka)'. The Outlook is Stable. The rating on the diversified conglomerate reflects its exposure to defensive end-markets, strong market positions in its diversified products and Fitch's expectations of steady free cash flow generation over the medium term. These strengths are counterbalanced by the regulatory risk faced by the pharmaceutical distribution business, the exposure to commodity price volatility in its palm oil business, and the weak tea plantations segment. The rating also takes into account Fitch's expectations that Sunshine's net leverage, defined as lease-adjusted net debt /operating EBITDAR (including proportionate consolidation of EMSPL, the holding company for the agriculture and consumer goods segments), is likely to remain below 1.5x over the medium term, supported by strong EBITDA generation and modest capex requirements beyond the financial year ending March 2018 (FY18). KEY RATING DRIVERS Regulatory Risks in Pharmaceuticals: Fitch believes that Sunshine's operating cash flows will recover after the authorities introduced price ceilings on 48 essential drugs from October 2016. This is because of improving sales volumes in the company's branded generic drug portfolio, which is now sold at lower prices due to the price control.. Nevertheless this underscores that regulatory risk for this business has increased since we first assigned the rating in December 2015. Healthcare Margins to Recover: Fitch expects the EBITDA margins in the healthcare business to return to around 7.5% over the next two years, after they contracted by 270bp to 5.7% in FY17. The recovery will be driven by increasing contribution from higher-margin diagnostics, wellness and beauty segments. We also believe Sri Lanka's rapidly ageing population and urbanisation will support demand for healthcare over the long term. Palm Oil Supports Profitability: We believe the palm oil segment will be a key contributor to growth in operating cash flows in the medium term, based on our assumptions that global palm oil prices will average USD665/tonne in 2018 and USD675/tonne in 2019 and in the long-term. Sunshine is the largest palm oil producer in Sri Lanka, accounting for more than 50% of domestic output, and is well-positioned to benefit from the growth in local demand, increased capacity in the near term and the government's protectionist tariffs on imports. Palm oil is the largest contributor to Sunshine's profitability, accounting for 36% of the group's proportionate EBITDA in FY17 (FY16: 24%). The government reduced import taxes on edible oil by around 20% in November 2017 to make up for lower domestic supply volumes due to adverse weather conditions. This is likely to cause a slight dip in Sunshine's palm oil margins in near term, but we expect margins to recover as taxes rise in line with the historical trend once supply improves over the medium term. Margin Pressure in Branded Tea: EBITDA margin in Sunshine's branded tea segment weakened by 660bp to 8.9% in FY17, due primarily to the rising tea prices in the Colombo Tea Auction over the last 12-14 months. Intense price competition, particularly in the lower end of the market also limits Sunshine's ability to pass on cost increases to customers in full. Nevertheless, we expect tea costs to moderate with the easing of supply-side pressures, which should benefit the segment's margin. Sunshine's strategy to tap the higher growth hotel, restaurant and catering industries should also support the segment's top-line and profitability growth. Volatile Tea Segment: Fitch expects the tea plantations' cash flow volatility to persist over the medium term due to lower land and labour productivity, and cost pressures arising from periodic wage increases. The tea plantation business broke even operationally for the first time in three years during FY17, but we believe that the segment's long-term viability is still inhibited by volatile export demand and an escalating cost structure. Sunshine's continued strategy to focus on quality over volume should help it to secure relatively high prices at auctions, which may mitigate the adverse impacts on profitability. Long-Term Benefits from Investments: Fitch expects the capacity expansions in Sunshine's power and dairy segments to stabilise its cash flows in the long term by reducing the share of contribution from the volatile tea and palm oil businesses. We estimate that the contributions to EBITDA from the power and dairy segments to exceed LKR190 million once the increased capacity goes into operation by FYE19. Balance-Sheet Strength Intact: Fitch expects Sunshine to maintain its net leverage at below 1.5x over the medium term (FY17: 0.8x) despite short-term operational pressures. Our view is supported by our expectations of steady EBITDA generation, capex reduction from FY19 and already low group debt. Fitch views the structural subordination of the holding company to be limited, given the low net debt at the main operating subsidiaries. Rating Sensitivities Amended: Fitch believes that a leverage metric net of cash is more appropriate than a gross leverage metric to assess Sunshine's financial risk, because we now expect the company to maintain a conservative approach when deploying its significant cash balance in investments and expansions. However the agency has also tightened Sunshine's negative rating sensitivities on leverage and fixed charge cover as described below, in order to capture the higher regulatory risks associated with the pharmaceuticals business, which is a key driver of Sunshine's 'A(lka)'/Stable rating. DERIVATION SUMMARY Sunshine and its close peer Richard Pieris & Company PLC (RPC, A(lka)/Stable) are both exposed to the volatile plantation segments However we believe RPC has a stronger business risk profile, stemming from sizeable cash flows from its defensive grocery retail business and larger operating scale, compared with Sunshine's pharmaceutical and fast-moving consumer goods businesses. However RPC has higher financial risk than Sunshine, which results in both companies being rated at the same level. Hemas Holdings PLC (AA-(lka)/Stable) is rated two notches above Sunshine to reflect its stronger business risk profile with greater exposure to defensive end-markets and a larger operating scale, as well as its conservative financial profile. Lion Brewery (Ceylon) PLC (A+(lka)/Negative) is rated one notch above Sunshine because it has stronger EBITDA margins from its dominant market position in the local beer manufacturing industry, which benefits from high entry barriers. Singer (Sri Lanka) PLC (A-(lka)/Stable) is a leading consumer durables retailer and has larger operating scale than Sunshine, but its cash flows are more volatile during economic downturns, and it has significantly higher leverage than Sunshine, which results in a lower rating. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Sunshine include: - Revenue growth to slow down in FY18 to low single-digit levels due to price controls in the pharmaceuticals segment and to recover gradually to mid-single digits over the next two years. Recovery will be driven primarily by the expanding palm oil business, the expected rebound in pharmaceuticals, and growing contributions from the diagnostics and healthcare retail segments - EBITDAR margins to be maintained in the low double digit range over FY18-21 despite challenges faced by the pharmaceuticals and tea planation segments - Capex of LKR4.5 billion over FY18-21 for expansion across the board - Sunshine to maintain its current dividend policy RATING SENSITIVITIES Developments that May, Individually or Collectively, Lead to Negative Rating Action - A sustained increase in Sunshine's lease-adjusted debt net of cash/EBITDAR (including proportionate consolidation of EMSPL) over 1.5x (FY17: 0.8x) - Sunshine's EBITDAR coverage of gross interest + rent (including proportionate consolidation of EMSPL) falling below 3.0x (FY17: 4.3x) on a sustained basis - Adverse impact on growth and profitability arising from sustained regulatory pressure in the healthcare and agriculture segments Developments that May, Individually or Collectively, Lead to Positive Rating Action - No positive rating action is expected in the next 12-18 months given the regulatory risks in the pharmaceuticals segment, cyclical risks of the commodity business and execution risks associated with new business ventures LIQUIDITY Satisfactory Liquidity: As at end-FY17, Sunshine had LKR1.9 billion of unrestricted cash and LKR2.9 billion in unutilised credit facilities to meet LKR358 million of contractual maturities falling due in the next 12 months. This places Sunshine in a comfortable liquidity position that will be adequate to meet the company's capex and dividend payout requirements for FY18.