Fitch downgrades Sunshine Holdings to A-(lka), outlook stable

Jan 05, 2018 (LBO) – Fitch Ratings has downgraded Sri Lanka-based Sunshine Holdings PLC's National Long-Term Rating to 'A-(lka)' from 'A(lka)'. The Outlook is Stable. The downgrade reflects Fitch's expectations that Sunshine's net leverage - defined as lease-adjusted debt net of cash/operating EBITDAR, including proportionate consolidation of Estate Management Services (Private) Limited (EMSPL), the holding company for the agriculture and consumer goods segments - will remain higher than the level commensurate with a higher rating over the next three years. The higher leverage is due to the substantial increase in debt following Sunshine's acquisition of an additional stake in EMSPL from Tata Global Beverages for LKR2.9 billion on 28 December 2017. The acquisition will increase Sunshine's ownership of EMSPL to 60.0%, from 33.2%, and improve the fungibility of group cash flow. We expect operating cash flow from the group's palm-oil segment, a part of EMSPL, to improve in the medium-term, but this is unlikely to be sufficient to offset the higher debt. KEY RATING DRIVERS Higher Financial Risk: Sunshine's financial profile has weakened, as the acquisition has added LKR2.7 billion of additional debt. Fitch expects net leverage to increase to 2.5x in the financial year ending March 2018 (FY18), then modestly recover to around 2.3x through FY21, buoyed by a rising EBITDA contribution from the palm-oil business. We also believe Sunshine's structural subordination risk is heightened, as the holding company borrowed LKR1.4 billion for the share purchase, while its cash flow is dependent on dividend payments from subsidiaries. However, this is mitigated by Sunshine's increased control of EMSPL and better group fungibility of operating cash flow. Increasing Cash Flow Volatility: The EMSPL acquisition increases Sunshine's exposure to the agriculture business, which generates more volatile cash flow relative to Sunshine's comparatively defensive healthcare segment. We also believe that the long-term viability of Sunshine's tea-plantation segment is inhibited by unstable export demand, lower productivity and an escalating cost structure. However, this is mitigated by the rising cash flow contribution from the company's profitable palm-oil business, which contributed 71% of agri-segment EBITDA in FY17. Palm Oil Supports Profitability: We expect the palm-oil segment to be a key contributor to higher operating cash flow in the medium term, based on our forecast for global palm-oil prices to average USD665/tonne in 2018 and USD675/tonne from 2019. Sunshine is Sri Lanka's largest palm-oil producer, accounting for more than half of domestic output, and is well-positioned to benefit from rising local demand, increased near-term capacity and the government's protectionist import tariffs. Palm oil is the largest contributor to Sunshine's profitability, accounting for 36% of group proportionate EBITDA in FY17 (FY16: 24%). The government cut import taxes on edible oil by around 20% in November 2017 to make up for lower domestic supply volume due to adverse weather conditions. This is likely to cause a slight short-term dip in Sunshine's palm-oil margins, but we expect margins to recover in the medium-term as taxes revert to historical levels with improvements in supply. Margin Pressure in Branded Tea: The EBITDA margin of Sunshine's branded-tea segment weakened by 660bp to 8.9% in FY17, due to higher tea prices in the Colombo Tea Auction over the previous 12-14 months. Intense price competition, particularly in the lower -end of the market, also limits Sunshine's ability to fully pass on cost increases to customers. Nevertheless, we expect tea costs to moderate with easing supply-side pressure, 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. Long-Term Benefits from Investments: Fitch expects capacity expansion in Sunshine's power and dairy segments to stabilise cash flow in the long term by reducing the contribution share from the volatile tea and palm-oil businesses. We estimate the EBITDA contribution from the power and dairy segments to exceed LKR190 million by FYE19, once the increased capacity goes into operation. DERIVATION SUMMARY Sunshine's rating compares well against that of Richard Pieris & Company PLC (RICH, A(lka)/Stable). RICH is rated one-notch higher due to its stronger business risk profile from a lower exposure to the cyclical plantation segment compared with Sunshine, as well as substantially higher cash flow from its defensive grocery retail business and larger operating scale. Both companies have similar financial risk due to Sunshine's latest acquisition. Singer (Sri Lanka) PLC (A-(lka)/Stable) is a leading consumer durables retailer that has a stronger business-risk profile than Sunshine and a significantly larger operating scale, despite greater operating cash flow volatility. However, this is offset by Singer's much higher leverage, which results in both companies having the same rating. DSI Samson Group (Private) Limited (DSG, BBB+(lka)/Stable) is the market leader in the domestic rubber tyre and footwear markets and has a business-risk profile similar to that of Sunshine. However, DSG is rated one notch below Sunshine due its significantly higher leverage. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Sunshine include: - Revenue growth to slow in FY18 to low-single-digit levels (FY17: 10.3%) due to price controls in the pharmaceutical segment, and to recover gradually to mid-single digits over the next two years. Recovery will be driven by the expanding palm-oil business, Fitch's expected rebound in pharmaceuticals and a rising contribution from the diagnostics and healthcare retail segments - EBITDAR margins to be maintained in the low-double-digit range over FY18-FY21 (FY17: 14.2%), despite challenges faced by the pharmaceutical and tea plantation segments - Capex of LKR4.5 billion over FY18-FY21 for expansion across the board - Sunshine to maintain its dividend policy RATING SENSITIVITIES Developments that May, Individually or Collectively, Lead to Negative Rating Action - An increase in Sunshine's lease-adjusted debt net of cash/EBITDAR (including proportionate consolidation of EMSPL) over 3.0x for a sustained period - Sunshine's EBITDAR coverage of gross interest + rent (including proportionate consolidation of EMSPL) falling below 2.0x for a sustained period - 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 - A sustained reduction in Sunshine's lease-adjusted debt net of cash/EBITDAR (including proportionate consolidation of EMSPL) below 1.5x LIQUIDITY Satisfactory Liquidity: Sunshine had LKR2.0 billion of unrestricted cash and LKR2.8 billion in unutilised credit facilities as at end-September 2017 to meet LKR1.8 billion of contractual maturities falling due in the next 12 months. This places Sunshine in a comfortable liquidity position that is adequate to meet the company's FY18 capex and dividend payout requirements.