ECONOMYNEXT – Fitch Ratings said it has confirmed the national long-term rating on Sri Lankan copper and aluminium cable manufacturer Sierra Cables at ‘BB+(lka)’ with a stable outlook, given a recovery in demand and profitability.
The company’s PVC pipe subsidiary was doing better although its unit in Kenya was not, a statement said.
The confirmation of the rating reflects Fitch’s expectation that Sierra’s leverage will continue to improve in the next 12 months, driven by a sustained recovery in demand and profitability in the financial year to 31 March 2020 (FY20).
The full statement follows:
Fitch Ratings has affirmed the National Long-Term Rating on Sierra Cables PLC at ‘BB+(lka)’. The Outlook is Stable.
The affirmation reflects Fitch’s expectation that Sierra’s leverage will continue to improve in the next 12 months, driven by a sustained recovery in demand and profitability in the financial year to 31 March 2020 (FY20) due to strong project-based revenue growth and the sustained turnaround in its previously unprofitable subsidiary Sierra Industries due to sizeable contract wins.
We expect Sierra’s net leverage, defined as lease-adjusted debt net of cash/operating EBITDAR excluding cash flows from overseas operations, to remain below 3.5x – the upper-limit for its rating. Leverage was high at 3.8x at FYE19, but has since improved to 1.7x based on trailing 12-month EBITDA to end-June 2019 (1QFY20).
Sierra’s rating also reflects its modest market share in the domestic copper and aluminium cable market, which is counterbalanced by its exposure to cyclical end-markets, such as infrastructure and construction. The rating also factors in risks associated with its investments in international markets, where the company has yet to establish itself.
Key Rating Drivers
Balance Sheet to Strengthen: Sierra’s deleveraging will be aided by improved profitability owing to better demand in its end-markets. Consolidated revenue rose by 15% yoy in FY19 and continued to increase by 44% yoy in 1QFY20 as several projects have reached the final phase of construction.
Sierra Industries’ return to profitability will also help to improve Sierra’s profitability, although persistent losses at Sierra Cables East Africa (SCEA) may offset some of the benefit.
Net leverage at the end of June 2019 was 1.7x, falling from 3.8x at FYE19 and 6.0x at FYE18.
Leverage at FYE19 improved from a year earlier as Sierra refrained from major expansionary capex, halted its dividend payments and paid down LKR319 million in debt with funds from the disposal of its loss-making subsidiary Sierra Power in April 2018. At FYE19, Sierra’s capacity utilisation stood at 73%, which provides the company with flexibility to defer its expansions until domestic demand picks up.
Construction Sector Activity to Improve: Fitch expects the construction industry – which is a key driver of demand for local copper and aluminium cable products – to improve in the medium term, subject to the easing of heightened political uncertainty following the completion of the upcoming presidential election in November 2019. Heightened political uncertainty since the November 2018 constitutional crisis led to caution among investors and companies towards investing in large infrastructure investments.
Following the presidential elections, Sierra may gain from the renewal of its government contracts, which give revenue visibility over a 12-18 month period, and accounted for around 30% of Sierras consolidated revenue in FY19. Construction activity, which accounted for 7.6% of Sri Lanka’s GDP, declined by 2.1% yoy in 2018 due to a slowdown in government spending on infrastructure development, reduced private credit to the sector and the political uncertainty.
Improving Profitability: Fitch expects Sierra’s EBITDA margin to improve by 80bp to 9.2% in FY20 due to its ability to pass on cost increases following better pricing ability and Sierra Industries’ return to profitability. Fitch expects aluminium and copper prices, which account for around 70% of Sierra’s cost of sales, to decline in the medium term. However, the continued risk of local-currency depreciation remains a threat to stronger profitability, as the company imports most of its raw materials. Sierra’s EBITDA margin improved by 200bp in FY19 due to strong volume growth in cables, and better profitability at Sierra Industries after it won a sizeable government contract in early 2018.
Positive Contribution from Sierra Industries: Fitch expects Sierra Industries’ PVC pipe business to continue to improve and remain profitable after it won a USD5 million government contract in early 2018, and other contract wins. This provides strong revenue visibility over the next 12-18 months.
Fitch believes this sector has strong growth potential, with only 50% of the country’s population having access to a pipe-borne water supply. Sierra Industries is poised to benefit from the continuing expenditures by the National Water Supply and Drainage Board to increase coverage with the help of both governmental and non-governmental organisations.
Slow Progress in Kenya: We expect SCEA to remain unprofitable over FY20-FY23 as the company has not been able to secure a major contract since setting up operations in 2017. As such, capacity utilisation is low and the plant is likely to remain unprofitable until SCEA is able to win a substantial contract. The opportunity in the Kenyan market remains strong given the country’s low electrification, the inability of local companies to meet rising demand and availability of funding by foreign donors in the power sector. However, Sierra has yet to show it is able to tap the potential of the market.
Derivation Summary
Sierra is a copper and aluminium cable manufacturer with a modest product portfolio and a modest local and international market share. Its smaller operating scale and significant exposure to cyclical end-markets is reflected in a rating that is multiple notches lower than that of rated peers, such as DSI Samson Group (Private) Limited (BBB(lka)/Stable) and Abans PLC (BBB+(lka)/Stable). Sierra’s expansion into international markets, where the company needs to establish its market position, will keep its business risk elevated in the medium term compared with peers.
Sierra is rated on a standalone basis, reflecting Fitch’s assessment of weak linkages between Sierra and its relatively weaker parent, Sierra Holdings Private Limited, given the lack of majority board representation by the parent, as well as the parent’s low dependency on Sierra’s cash flow to service its own obligations.
Key Assumptions
– Consolidated revenue growth of around 4% in FY20 and then hover at around 3% during FY21-FY23 as construction projects come to the final phase and aided by contract wins by Sierra Industries.
– EBITDA margins to expand by around 100bps and average at 9.4% during FY20-FY23 amid an improvement in pricing power and a turnaround in operating profitability of Sierra Industries.
– Average capex of around LKR72 million in the next two years.
– Dividend payout to average around 50% of post-tax profits in the medium term.
RATING SENSITIVITIES
Developments That May, Individually or Collectively, Lead to Positive Rating Action
– An upgrade is not anticipated in the short to medium term until there is an improvement in the company’s size and scale of operations while maintaining the current financial profile.
Developments That May, Individually or Collectively, Lead to Negative Rating Action
– Adjusted net debt/EBITDAR, excluding cash flow from overseas operations, of over 3.5x for a sustained period.
– EBITDAR coverage – measured by EBITDAR, excluding cash flow from overseas operations/gross interest plus rent – falling below 2.0x for a sustained period.
– Delays or disruptions in overseas expansions, which could result in additional capital calls or lower profitability.
Liquidity and Debt Structure
Manageable Liquidity Position: As at end-March 2019, Sierra had LKR72 million of unrestricted cash and LKR670 million of committed but unutilised credit lines to meet LKR1.5 billion of short-term debt falling due in the next 12 months, of which short-term working capital debt amounts to LKR1.3 billion. Sierra’s net working capital position stood at LKR2 billion, and its working capital cycle is healthy at 162 days at FYE19, which improved to 104 days by the end of 1QFY20. Therefore we expect banks to roll over the company’s working capital facilities as and when they fall due. We further expect Sierra to generate free cash flows of LKR100 million in FY20.
Summary of Financial Adjustments
We have excluded EBITDA of Sierra’s African operations from its consolidated EBITDA when calculating adjusted net leverage and fixed-charge coverage ratios due to the company’s intention to retain any incremental operating cash flow from its African operations to fund overseas growth opportunities.
(COLOMBO, 23 October 2019)