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Hemas Holdings’ Sri Lanka rating lifted to ‘AAA(lka)’ by Fitch

ECONMYNEXT – Fitch Ratings has raised the domestic rating of Sri Lanka’s Hemas Holdings to ‘AAA(lka)’ from ‘AA-(lka)’ in the wake of a re-caliberation of the local rating scale after downgrade of the sovereign rating, low borrowings and less volatile business segments.

“Hemas’ rating reflects its increasing exposure to defensive healthcare and consumer goods, while gradually exiting cyclical non-core sectors such as leisure,” the rating agency said.

“The rating also benefits from Hemas’ exceptionally strong balance sheet and high rating headroom before the economic downturn.”

Fitch said leverage would be 0.4 to 0.5 times compared to a threshold of 3.5 times for the current rating.

The rating agency said its healthcare segment would be protected from import controls as it had been listed as essential goods.

Sri Lanka runs into frequent balance of payments trouble and knee-jerk import controls as the country lacks a credible monetary framework. Sri Lanka has resisted a credible external anchor (peg) by operating a highly unstable discretionary peg called a ‘flexible’ exchange ate.

It has also avoided a credible domestic anchor by running a highly discretionary ‘flexible’ inflation targeting regime while also collecting (or losing) forex reserves through a peg.

National scale ratings are a risk-ranking of issuers in a particular market designed to help local investors differentiate risk.

National scales are not comparable with Fitch’s international ratings scales or with other countries’ national rating scales.

The full statement on Hemas is reproduced below.

KEY RATING DRIVERS

Hemas Holdings Plc

The revision of Hemas’ National Long-Term Rating reflects the recalibration of the Sri Lankan national scale ratings as well as our view that Hemas will maintain its leverage – defined as net debt/EBITDA – in line with a rating.

Hemas’ rating reflects its increasing exposure to defensive healthcare and consumer goods, while gradually exiting cyclical non-core sectors such as leisure.

The rating also benefits from Hemas’ exceptionally strong balance sheet and high rating headroom before the economic downturn. We estimate steady leverage of around 0.4x-0.5x in the financial year ended March 2020 (FY20) and FY21 compared with the 3.5x leverage threshold for the current rating.

Stable Healthcare Revenue: During COVID-19: We expect Hemas’ pharmaceutical sales to remain stable throughout FY21 due to defensive demand and the government classifying pharmaceutical imports as essential goods, even as it imposed restrictions on a wide range of other imports to preserve foreign exchange.

Hemas continued its distribution operations during the country’s lockdown starting in March through third-party pharmacies, delivery partners and its own delivery platform. The business also has adequate inventory, providing a buffer against any supply shortages although supplies have so far held up.

We expect Hemas to mitigate the margin pressure stemming from currency devaluation owing to its contractual arrangements with global suppliers, cost efficiencies and price revisions. The company’s domestic pharmaceutical-manufacturing business was disrupted in the early part of Sri Lanka’s lockdown due to social distancing requirements.

However, Hemas says production capacity utilisation is improving and should normalise with the lifting of the lockdown in early May. We expect demand for domestic pharmaceutical manufacturing to increase in the medium term as Sri Lanka seeks to reduce foreign-exchange outflows.

There is also increased demand for contract manufacturing on behalf of foreign pharma companies to help mitigate the risk stemming from domestic price controls on imported pharmaceuticals..

Consumer Revenue to Improve: Sales disruptions in Hemas’ consumer segment, which accounts for around 45% of group EBIT and is based mainly in Sri Lanka, have been limited across most product categories since the lockdown.

The closure of grocery stores nationwide in early FY21 affected Hemas’ customer reach, but stronger sales through supermarkets and online platforms mitigated the impact. We expect the distribution network to be fully operational by mid-2020 and sales to normalise from 2HFY21, assuming the country-wide lockdown will ease gradually from May.

We do not expect a significant weakening in demand for the consumer segment, despite slower economic activity, due to its essential nature and its products’ low ticket value.

The segment’s production facilities were closed or were operating at lower utilization levels due to social distancing for the most part of 1QFY21 but are operational at present, subject to social distancing constraints on production capacity.

The segment was able to manage the impact from closures as it had sufficient finished goods inventory Hemas’ Bangladesh operations will remain muted for most of FY21 as the product portfolio is less defensive.

Biggest Impact on Leisure: Hemas’ 300-room hotel chain would be the hardest hit segment from the pandemic due to the indefinite closing of Sri Lanka’s borders and global travel restrictions. Hotels currently generate minimal revenue, which is insufficient to cover the high fixed costs.

We expect a continued cash burn, even with a minimal cost structure, until tourism picks up, which could be at least 12 months away.

However, the impact on Hemas’ cash flow should be manageable as the sector accounts for less than 5% of consolidated revenue, and we expect its operating losses from hotels to lower the group EBIT margin by less than 100bp in FY21.

Margins to Fall in FY21: We expect Hemas’ EBIT margin to contract to 5.5% in FY21, from around 8% historically, amid lower sales and near-term cost pressures in the consumer segment and hospitals, and losses in leisure, mitigated by the company’s cost-cutting measures.

Cost-saving measures across the group include pay cuts to preserve cash. We expect margins to recover to historical levels from FY22, helped by a strong rebound in the consumer segment’s volume, improved capacity utilisation in hospitals and the logistics business, and a slow but gradual pick-up in leisure.

Low Leverage: We expect Hemas’ net debt/EBITDA to remain comfortably below 1.0x over the next two years (9MFY20: 0.9x) amid lower capex and dividends to preserve cash, despite our expectations of weak operating performance in FY21.

We expect Hemas’ cash flow from operations to cover its capacity expansion and dividends over the next few years without depending on external funding. The company says its medium-term expansion would focus mostly on its core businesses with the ability to leverage on the existing infrastructure without significant capital outlay.