Fitch affirms Richard Pieris & Company at A(lka); outlook stable

Fitch Ratings has affirmed Sri Lanka-based conglomerate Richard Pieris & Company PLC’s (RICH) National Long-Term rating at ‘A(lka)’ with a Stable Outlook. Fitch has also affirmed the National ratings on RICH’s outstanding senior unsecured debentures at ‘A(lka)’.

RICH’s rating reflects the group’s strong diversification, market leadership in most end-markets and its established operations.

KEY RATING DRIVERS

Temporary Challenges in Retail: We expect RICH’s supermarket chain, which is the second largest in Sri Lanka in terms of stores, to experience some weakness in the short term due to dampened consumer spending amid slower economic conditions and the recent increase in the value-added tax (VAT) rate, which the company is likely to partly absorb. However, we believe demand will remain favourable over the medium to long term, helped by rising disposable income levels, rapid urbanisation and currently low supermarket penetration in the country.

Exports to Drive Growth: We expect RICH to increasingly focus on its export business, which benefits from the recovery in global markets and the depreciation of the local currency that makes local products more competitive overseas. RICH is one of the few conglomerates in the country with exposure to export markets, which accounted for 8% of its revenue in the financial year ended 31 March 2016 (FY16). The company is planning to add capacity in its natural foam latex mattress segment to cater to overseas demand. RICH also intends to tap new markets by exporting polyurethane mattresses and by diversifying into less-commoditised exports in the plantation segment.

Slow Recovery for Plantations: RICH’s plantation segment has recovered in the recent past as global prices have rebounded, but we do not believe it is sufficient to offset the structural decline in the sector stemming from continued supply-side pressures, such as lower productivity and high labour costs. Until RICH successfully implements a strategy to sustain sector profitability through yield improvements, value additions and cost efficiencies, we expect the weak plantation business to weigh on the company’s rating. In the meantime, expansion of its more profitable palm oil operations, for which there is rising domestic demand, should help to maintain the plantation business’s performance in the medium term.

Stable Group Balance Sheet: We expect RICH’s adjusted net leverage to remain flat (FY16: 2.7x) over the next two years due to a weak operating environment for some segments, continued expansions in retail, rubber and plantations, and high shareholder returns. However, we expect RICH to generate positive FCF from FY19, which should help reduce leverage significantly. This will be driven by a further pick-up in the retail operation and moderating capex. We do not expect any significant M&A activity over the next two years as we expect the company to focus on stabilising and organically growing its existing businesses.

Dividends Improve Holding Company Leverage: Leverage at the holding company level has improved in the past 18 months due to higher dividends from most subsidiaries and lower-than-expected investments. Fitch expects the holding company’s leverage to further improve over the next 2-3 years, helped by increased dividends from subsidiaries, debt restructuring at the group level that will give the holding company more flexibility to pay down debt, and expectations of a decrease in investments, especially in the finance subsidiary.

Although leverage at the holding company level has improved, debt at the subsidiary level has increased. Creditors of the holding company currently do not face significant structural subordination due to the low leverage at the subsidiary level, but the rating could come under pressure if leverage at the operating subsidiaries increase substantially.

DERIVATION SUMMARY

RICH is diversified with exposure to both defensive sectors and growth markets, similar to the other rated conglomerates in Sri Lanka, Hemas Holdings PLC (AA-(lka)/Stable) and Sunshine Holdings PLC (A(lka)/Stable).

RICH and Sunshine are exposed to the declining plantation sector, which increases their business risk compared with Hemas. Furthermore RICH’s leverage at the group and holding company levels are higher than those of its peers, which constrains its rating. However, we consider RICH’s exposure to export markets as an advantage versus peers.

KEY ASSUMPTIONS

Fitch’s key assumptions within our rating case for the issuer include:
– Revenue growth to average in the low double digits for FY17-FY20 due to capacity additions, favourable demand conditions for most sectors, and a turnaround in the plantation sector.
– EBITDAR margins to average in the low double digits for FY17-FY20 as margin improvement in the plantation business and efficiency gains are offset by cost pressures in the retail, rubber, tyre and plastics segments.
– Total capex to average 3%-4% of revenues for FY17-FY20.
– Dividend payout ratio to be around 35% for FY17-FY20.
– Operating lease multiple of 6.0x.

RATING SENSITIVITIES

Developments that may, individually or collectively, lead to positive rating action include:
– A sustained improvement in RICH’s adjusted net debt/EBITDAR (adjusted for finance subsidiary) to below 2.0x.
– A sustained improvement in the holding company’s net debt/EBITDAR to below 3.0x (FY16: 3.0x).
Developments that may, individually or collectively, lead to negative rating action include:
– A sustained increase in RICH’s adjusted net debt/EBITDAR (adjusted for finance subsidiary) to over 3.0x.
– RICH’s adjusted EBITDAR coverage of gross interest and rent (adjusted for finance subsidiary) falling below 2.5x on a sustained basis (FY16: 4.0x).
– Significant investments in non-core business activities, which could adversely impact profitability or cash flow generation of the group.

LIQUIDITY

As at end-March 2016, RICH had about LKR4.1bn of unrestricted cash and LKR4.6bn in unutilised credit facilities to meet LKR6.7bn of short-term debt (excluding customer deposits) falling due in the next 12 months, placing the company in a comfortable liquidity position. We do not expect the company to generate positive FCF in FY17 due to increased capex and higher dividend payments.