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Sri Lanka’s Sierra Cables downgraded to ‘BB(lka)’ on Coronavirus, on negative watch

ECONOMYNEXT – Fitch Ratings has downgraded Sri Lanka’s Sierra Cables, a power cables maker by one notch to ‘BB(lka)’ from ‘BB+(lka) and also placed the firm on negative rating watch.

“The downgrade reflects Fitch’s assessment that Sierra’s cash flow will weaken materially due to the business interruption in the domestic construction industry caused by the coronavirus pandemic,” the rating agency said.

“We do not expect operating conditions to normalise to prepandemic levels for at least 12-18 months, as state and private-sector funded infrastructure projects will be deferred and liquidity pressure will increase among construction companies which are Sierra’s debtors.”

The full statement is reproduced below:

Fitch Downgrades Sierra Cables PLC to ‘BB(lka)’ on Coronavirus Risks; Places on RWN

Fitch Ratings – Colombo – 21 Apr 2020: Fitch Ratings has downgraded Sri Lanka-based cable manufacturer Sierra Cables PLC’s National Long-Term Rating to ‘BB(lka)’ from ‘BB+(lka)’ and placed the ratings on Rating Watch Negative (RWN).

The downgrade reflects Fitch’s assessment that Sierra’s cash flow will weaken materially due to the business interruption in the domestic construction industry caused by the coronavirus pandemic.

We do not expect operating conditions to normalise to prepandemic levels for at least 12-18 months, as state and private-sector funded infrastructure projects will be deferred and liquidity pressure will increase among construction companies which are Sierra’s debtors.

We forecast Sierra’s leverage to increase above 4.5x in the financial year ending March 2021 (FY21), from our estimated 2.7x in FY20. This is based on our forecast that EBITDA could fall by 50% yoy to LKR300 million and revenue could fall by 38% yoy to LKR3.6 billion.

The RWN reflects the risks that Sierra’s liquidity could weaken significantly in the near term, with around LKR150 million of cash at end-2019 (3QFY20) to meet debt maturities of around LKR1 billion in the next 12 months.

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Most of the maturities are working capital loans from banks, which we believe will be rolled over given the temporary nature of the current slowdown.

However, working capital could be pressured further in a prolonged downturn and may lead to difficulty in obtaining bank funding to make up for cash-flow shortfalls.

The company says banks have agreed to extend the principal due on term loans, amounting to around LKR250 million in 2HFY20, if interest is being serviced, which supports near-term liquidity.

Another negative rating action may be warranted if Sierra’s liquidity weakens further.

KEY RATING DRIVERS

Pandemic-Related Economic Disruption: Social-distancing measures have resulted in significant disruption to construction-sector cash flows, and Fitch does not expect the current lockdown to be completely lifted at least until May. Even once the lockdown is eased, we expect the economic impact from the pandemic to affect both domestic spending and investments, which drive construction activity. Existing projects will likely face cash-flow constraints as financial institutions may adopt a cautious approach in increasing exposure to this highly cyclical sector.

New public infrastructure projects are likely to be deferred at least in the next six to 12 months, while we expect payments for ongoing projects to be delayed significantly. Fitch forecasts Sri Lanka’s GDP growth to remain muted at around 2% for 2020 and the debt/GDP ratio to reach 90% (2019: 85%), as the government supplements its fiscal deficits with additional borrowings. A lockdown extended beyond May in a bid to contain domestic coronavirus infections could lead to further weakness in the economy.

Revenue to Decline: Fitch expects Sierra’s projects segment to experience revenue declines of around 40% yoy to LKR1.2 billion, on delays in ongoing construction projects and deferment of new construction. The impact on revenue from public tenders for infrastructure may be smaller and we have factored in a 25% yoy cut to LKR1.2 billion, as most projects are funded via bilateral agencies. However, the government is likely to defer new construction in the near term. Fitch also forecasts the retail-oriented dealer market to decline by 38% yoy to LKR780 million.

Fitch estimates Sierra’s FY20 revenue was more than LKR5.5 billion due to strong growth in private sector projects. Sierra expects this momentum to continue well into FY21, resulting in revenue of around LKR4 billion-5 billion. However, the assumptions in our rating case forecast incorporate significant execution risks to the company’s targets amid a stressed economic environment in the next 12-18 months.

Tight Cash Flow, Interest Coverage: Fitch expects Sierra to generate LKR3.6 billion in revenue and LKR300 million in EBITDA for FY21, but the company is likely to see a deterioration of its working-capital cycle. Sierra’s receivable collection cycle for the tenders and projects segment is likely to increase owing to a contraction in cash flow, as both the private and public sectors are likely to defer payments as a result of their strong bargaining power. Sierra generates around 40% of its revenue from government-related projects – with the Ceylon Electricity Board (AA+(lka)/Negative) an essential client.

Fitch expects Sierra’s funds from operations (FFO) interest cover to fall to 1.9x by FYE21, before recovering to 2.1 by FYE22. Sierra has deferred its discretionary capex plans and will only incur a minimum maintenance component for the medium term, and has flexibility to defer dividends to conserve cash.

Constrained Profitability: Fitch expects Sierra’s EBITDA margin to decline by 100bp to 8.5% in FY21, from our previous base-case assumption of 9.5%, due to a limited ability to cut costs in line with falling revenue. Sierra’s production costs will rise given most raw materials are imported amid a 10% weakening in the Sri Lankan rupee against the US dollar in the year to date. However, the currency depreciation is counterbalanced by Fitch’s expectation of lower prices for key commodity inputs, such as copper and aluminium, which are expected to be around 4% lower for FY21. Sierra can also pass on some of the cost increases on existing contracts as they are drawn up on a cost-plus basis.

Sierra Industries to Weaken: Fitch believes it would be challenging for Sierra’s PVC business, Sierra Industries, to replicate the revenue highs of FY19 and FY20 from large project wins.

The National Water Supply and Drainage Board (NWSDB) – Sierra Industries’ main client – is likely to delay its tender process for the year and defer any new projects undertaken in light of the pandemic-related stress on public finances. Fitch believes the sector has strong growth potential upon normalisation of operations, with only 50% of the country’s population having access to piped water. The NWSDB aims to increase the coverage with the help of both public and private-sector support, which is a long-term positive.

Slow Progress in Kenya: We expect Sierra’s subsidiary, Sierra Cables East Africa (SCEA), to remain unprofitable over FY20-FY23 as the company has not secured a majorcontract since setting up operations in 2017. As such, capacity utilisation is low and the plant will remain unprofitable until SCEA wins a substantial contract.

The long-term opportunity in the Kenyan market remains strong given the country’s low electrification, the inability of local companies to meet rising demand and the 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 local market share. Its smaller operating scale and significant exposure to cyclical endmarkets is reflected in a rating that is multiple notches lower than that of rated peers, such as DSI Samson Group (Private) Limited (BBB(lka)Positive) and consumer-durable retailers Singer (Sri Lanka) PLC (BBB+(lka)/Negative) and Abans PLC (BBB+(lka)/Negative). Sierra’s expansion into international markets will keep its business risk high 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 weaker parent, Sierra Holdings Private Limited, as the parent does not have majority board representation and has a low dependency on Sierra’s cash flow to service its own obligations.

KEY ASSUMPTIONS

Fitch’s Key Assumptions Within Our Rating Case for the Issuer

– Pandemic-related impact to be intense in most of 1QFY21, and ease gradually between
2QFY21-1QFY22.

– Revenue to decline by 38% in FY21 and recover by around 18% to LKR4.2 billion in
FY22, as the construction sector begins its recovery.

– EBITDA margin to contract by 100bp to 8.5% (previous base case: 9.5%) in FY21 amid
lower sale volumes and currency pressures. An average EBITDA margin of 9% for FY22-
FY23.

– Working capital outflow of around LKR100 million in FY21, despite falling revenue,
due to a longer working-capital cycle driven by increasing debtor days.

– Capex to hover at around LKR40 million in FY21, related mainly to maintenance, with
an average of around LKR100 million a year over FY22-FY23.

– No dividends in FY21, with around LKR25 million a year over FY22-FY23.

RATING SENSITIVITIES

Factors That Could, Individually or Collectively, Lead to Positive Rating
Action/Upgrade::

– Fitch may resolve the RWN and assign a Stable Outlook if the operating environment
stabilises such that Sierra’s FFO net leverage is on track to fall below 4.0x by FY22
(FY20: 2.7x, FY21: 4.7x)

Factors That Could, Individually or Collectively, Lead to Negative Rating
Action/Downgrade:

– Deterioration in the FFO interest cover to below 1.5x (FY20: 3.0x, FY21: 1.9x)

– Significant deterioration in liquidity

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years.

The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Bestand worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

LIQUIDITY AND DEBT STRUCTURE

Tight Liquidity: Sierra had LKR157 million of unrestricted cash as of end-December 2019 to meet around LKR1 billion of repayments falling due in the 12 months. Around LKR760 million consists of working capital lines, which we expect lenders to roll over given the temporary nature of the disruption.

Around LKR250 million is comprised of maturities of long-term loans, which have been extended by around three months subject to timely servicing of interest. Sierra has satisfactory bank access in light of its record of timely repayments. Sierra has LKR73 million in uncommitted unused credit lines, and obtained an additional LKR100 million uncommitted facility in March, which could further support near-term liquidity visibility.