Fitch Ratings has revised the Outlook on Sri Lankan home builder Home Lands Skyline (Pvt) Ltd.'s (HLSL) National Long-Term Rating to Negative, from Stable. The agency has simultaneously affirmed the rating at
'A(lka)'.
The Negative Outlook reflects the deteriorating operating conditions for home builders, such as HLSL, which may lead to weakened home sales, slower cash collections and tighter liquidity in the next 12-18 months. We estimate that the company would become dependent on bank borrowings in such a scenario, whereas banks' appetite for the sector could diminish should the weak conditions persist or worsen.
A sustained weakening in HLSL's liquidity could lead to a multi-notch rating downgrade. HLSL's rating reflects its short operating history at its planned scale. This is partly offset by its improving brand in the mass-affluent market segment - where homes are priced at around LKR30 million per unit (around USD80,000) on average, its vertically integrated business across design, construction, and facility management and low leverage at
present.
KEY RATING DRIVERS
Housing Demand to Slow: We expect new sales to remain below 200 units in the financial year ending March 2024 (FY24), similar to our estimate of 190 units for FY23, but significantly lower than the 400-500 units seen in prior years.
This is based on our expectation that Sri Lanka's economy will contract by 2.2% in 2023, with unprecedently high inflation and hikes in income taxes and interest rates eroding the income levels for a majority of the population.
Meanwhile, surging construction costs have driven-up house prices, reducing affordability further. Appetite for condominiums as an investment has fallen.
The Central Bank of Sri Lanka's Condominium Property Volume Index showed a 64% yoy decline in new sales in 3Q22, similar to the trend seen with HLSL. The company has deferred new project launches by
12-18 months to manage the weak demand. Its monthly home sales rose to 24 units in January 2023, but we believe there are large downside risks from the economic headwinds.
Cash Collection to Slow: We expect free cash flow to turn negative in FY24 on slower cash collection from new projects. The company plans to launch two projects with over 1,000 units in FY24. We assume that HLSL will have to draw on external funding to bridge collection delays and pay for land acquisitions and construction.
There is a risk that banks could tighten lending to the property sector if economic challenges persist or deteriorate further, but the risk is mitigated by HLSL requiring at least 30% of units to be sold before commencing construction, with a 30% down payment in the first two months.
Interest Rate Hike, VAT Impact: We do not expect the 17% value added tax (VAT), which was introduced on new condominium sales, to significantly affect HLSL, as the company is able to reclaim the tax. This is because most of the value additions are carried out by HLSL's subsidiaries, with only a marginal cost passed on to homebuyers.
However, the sharp rise in bank mortgage interest rates to around 25%, from less than 10%, will dampen home sales, as around 15% of HLSL's home purchases are funded via bank mortgages.
Limited Record at Planned Scale: HLSL plans to launch 1,500 new units in the next two years, in addition to the 1,200 units to be completed over the same period. This compares with only 1,100 units completed since the company's inception.
HLSL's pipeline includes several large projects of 400-600 units. This would require it to balance cash collection, timely construction and fund raising, which could be challenging in the current environment.
HLSL also plans to diversify into retirement living facilities and
industrial parks over the longer term, which could heighten risk as these are unfamiliar businesses.
Limited Risk of Ongoing Projects: HLSL had only 250 unsold units valued at LKR9.0 billion as of end-2022, which we expect to be sold over the next 12-18 months.
It also has 1,200 units under construction, with over 800 slated for handover by mid-2023 and the balance by end-2024. We expect fewer challenges in collecting dues from ongoing projects, as buyers have settled more than 70% of the value. HLSL has LKR2.4 billion of committed undrawn project loans, which is more than sufficient to cover the balance of construction costs on existing projects, even if collections weaken significantly.
Costs and Sourcing Challenges Managed: Construction costs have surged by almost 75% due to the rise in global prices and rupee depreciation.
However, HLSL has been able to manage the impact to a large extent by passing the costs on to customers. The company has used the force majeure clause in its contracts to pass on LKR2.0 million-2.5 million in cost escalations to units already sold, while unsold units are priced LKR5.0
million-6.0 million higher to maintain margins.
Challenges in importing construction materials during FY22 have eased following special approval to import such products and improved foreign-currency liquidity within the banking system. HLSL also has access to foreign-currency revenue through sales to expat buyers, which helps pay for part of the imports.
DERIVATION SUMMARY
Domestic cable manufacturer, Sierra Cables PLC (A+(lka)/Stable), is rated one notch above HLSL to reflect its more established record in the market, evident from its profitable operations over many years.
Both companies are exposed to the cyclical construction sector, but we regard HLSL's liquidity buffers to be weaker to navigate a further deterioration in operating conditions, as reflected in the Negative Outlook.
HLSL is rated at the same level as domestic power company, Lakdhanavi Limited (A(lka)/Stable), despite the latter's large operating scale, geographic diversification and better liquidity position.
This is because Lakdhanavi is exposed to high counterparty risk,as it generates the majority of cash flow from Ceylon Electricity Board (CEB,
B(lka)/Stable). We expect Lakdhanavi's leverage to increase to much higher levels than HLSL in the next couple of years, but this should moderate once its expansion is complete.
Domestic power generator, Resus Energy PLC (BBB(lka)/Negative), is rated three notches below HLSL to account for its high counterparty risk. The company has only one customer, CEB, resulting in collection delays and weak liquidity.
Both HLSL and Resus are on a Negative outlook to reflect the liquidity pressure stemming from further delays in cash collections.
HLSL's credit considerations lead to a higher rating than for some large domestic banks, non-bank financial institutions and insurance companies, which are more exposed to sovereign stress due to holdings of large sovereign-issued securities for regulatory reasons.
The large financial institutions also have a broader exposure to the various
economic sectors.
KEY ASSUMPTIONS
Fitch's Key Assumptions Within Our Rating Case for the Issuer:
- Contracted sales of LKR7.7 billion in FY23 and again in FY24, rising to LKR14.3
billion in FY25 - Cash collection of LKR11.1 billion in FY23, LKR9.5 billion in FY24 and LKR14.3
billion in FY25 - Mid-teen EBITDA margin to be maintained from FY24 amid increased revenue
recognition with projects reaching completion and better ability to pass on cost increases - Land acquisitions of around LKR1.7 billion a year over FY24-FY26
- No dividend pay-out in the medium term, as per the company's policy