"DSIHL's leverage has been driven higher due to weaker cash flow following the imposition of 12% retail VAT in Sri Lanka effective January 2013," Fitch said.
"Faced with increased price competition and weaker consumer purchasing power, DSIHL's sales volume fell markedly when it tried to raise prices gradually to recover the additional VAT burden."
Tariff protection indicates that the poor in Sri Lanka including school children have to pay more for shoes than the poor in other countries in Asia or Africa that has free trade and business owners are forced to be more competitive.
Tariff protected businesses are also able to collect or arbitrage taxes that would otherwise have gone to the state, reducing national tax revenues, analysts have said.
The full statement from Fitch is reproduced below:-
Fitch Downgrades DSI Holdings to 'BBB(lka)'; Outlook Stable
Fitch Ratings-Colombo/Sydney-10 April 2014: Fitch Ratings has downgraded DSI Holdings Limited's (DSIHL) National Long-Term Rating to 'BBB(lka)' from 'BBB+(lka)'. The Outlook has been revised to Stable from Negative.
The downgrade reflects Fitch's view that the footwear company's net leverage - measured as consolidated lease-adjusted debt net of cash/operating EBTIDAR - is likely to remain at over 4.25x in the medium term. DSIHL's leverage has been driven higher due to weaker cash flow following the imposition of 12% retail VAT in Sri Lanka effective January 2013.
KEY RATING DRIVERS
Negative Impact from VAT: DSIHL is the market leader in a fragmented retail industry targeting a relative price-sensitive segment, and the imposition of the retail VAT has hurt the group's competitive position. The VAT applies to retailers with quarterly revenue exceeding LKR250m, which leaves the larger industry players shouldering a bigger cost burden. Faced with increased price competition and weaker consumer purchasing power, DSIHL's sales volume fell markedly when it tried to raise prices gradually to recover the additional VAT burden.
Market Leader in Footwear: DSIHL's rating continues to reflect its market leadership in domestic footwear, supported by its well-known in-house brands, diverse product range and its extensive distribution network of over 200 retail and 90 wholesale points. Key risks include competition from small and medium scale manufacturers, volatility in prices of imported raw materials and exchange rate fluctuations.
Domestic footwear manufacturers are protected by high tariffs on footwear imports. A weak balance of payments and support for local industry underpins the likelihood the current high tariff regime will continue. Fitch also believes DSIHL's brand and distribution strengths should, to a certain extent, help protect its market position if import tariffs were removed or reduced sharply.
High Leverage: DSIHL's net leverage increased to 5.0x in the financial year ended 31 March 2013 from 3.7x at FYE12, mostly due to declining profitability and despite paying down debt following inventory liquidation at end FY13. Fitch expects its leverage to remain above 4.25x due to continued weakness in consumer purchasing power, the VAT's impact on cash flows, and as DSIHL's debt levels return to its usual levels to fund working capital expenditure and capex. Fitch expects EBITDAR margins to only show gradual improvement over the medium term as the company incorporates the VAT into pricing and implements cost controls, including a shift towards a franchise model.
Parent's Other Investments Sound: DSI Samson Group (Pvt) Ltd (DSG) fully owns DSIHL and controls the subsidiary's cash flows. DSG's operations consist mainly of DSIHL and Samson Rubber Industries (Pvt) Ltd (SRI), a company engaged in the manufacture and export of bicycle and other tyres. SRI's profile continues to remain sound with leverage trending lower (1.6x at 9M14 from 3.2x at FY13).
RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
-Net leverage above 5.5x on a sustained basis
-EBITDAR to Interest and operating lease rental coverage falling below 1.3x (FY13:1.1x)
-A weakening of DSG's credit profile
Positive: Future developments that may, individually or collectively, lead to a positive rating action include:
-Net Leverage below 4.25x on a sustained basis and
-EBITDAR margins above 12% on a sustained basis