Fitch affirms DSI Samson Group at ‘AA(lka)’; Outlook stable

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Fitch Ratings has affirmed Sri-Lanka based footwear and tire manufacturer and retailer DSI Samson Group (Private) Limited (DSG) at ‘AA(lka)’. The Outlook is Stable.

The affirmation and Stable Outlook reflect Fitch’s belief that DSG will maintain sufficient liquidity and healthy operating performance in the next one to two years such that its leverage and fixed-charge coverage will remain adequate for its rating.

The ‘AA(lka)’ rating reflects DSG’s market leadership in the highly fragmented and competitive footwear retailing space, which is supported by an island-wide network of 200 outlets and its in-house manufacturing. DSG is also a market leader in the domestic two-wheeler and three-wheeler tire segments.

The high competition in these segments is counterbalanced by recurring demand for most of DSG’s footwear and tire products.

KEY RATING DRIVERS

Recovery in Footwear Sales: Fitch expects DSG’s footwear revenue to recover by 11% in the financial year ending March 2022 (FY22), after an estimated 14% fall in FY21 due to severe movement restrictions in 1HFY21. School footwear revenue (around 7% of total sales in FY21) dropped by 43% in FY21 due to school closures, which ended in August 2020. However, school footwear revenue is likely to remain weak in FY22 due to the resurgence of the virus and ensuing temporary closures. We expect DSG’s footwear revenue to recover to pre-pandemic levels only in FY23.

We forecast DSG’s women’s and men’s footwear revenue to rise by 10% and 13% in FY22, respectively, due to relaxed social distancing measures. Growth in these two categories is also supported by increased marketing and product development to counter competition. DSG has a successful record of product development in its rubber slippers category.

This, and the prevailing import restrictions that have weakened smaller competitors, is likely to boost DSG’s market share in women’s and men’s footwear. Tire and Bike Sales to Increase: We expect DSG’s pneumatic tire sales to increase by 9% in FY22 due to import substitution caused by import restrictions on tires for motorcycles and three-wheelers. DSG has also shifted its focus to the fast-growing scooter tire market, which now accounts for 60% of its total motorcycle tire revenue.

Fitch expects exports of pneumatic tires to increase by 10% in FY22, after the segment was affected by manufacturing disruptions as a result of the pandemic. DSG’s solid tires are likely to see revenue growing by around 30% in FY22, in part due to a lower revenue base in FY21 as a result of disruptions in the logistic sector. The business has since recovered, but demand from outdoor sports globally remains muted.

Fitch expects DSG’s bicycle sales to rise by 40% in FY22 as the company increases output via a second manufacturing shift to meet strong demand from key export markets. Our forecasts incorporate a degree of execution risk associated with boosting bicycle production capacity sharply over a short period. Virus Resurgence a Risk: DSG generates over 60% of total sales from domestic retail, which makes the company vulnerable to any movement restrictions that may be imposed to control coronavirus infections.

Fitch therefore estimates footwear sales to reach prepandemic levels only by FY23. However, we do not expect country-wide lockdowns as seen in 1HFY21 to be imposed in the next 12-18 months, which should translate into gradual improvement in DSG’s retail and manufacturing activity. Leverage to Rise: Fitch assumes DSG’s leverage will rise to 4.2x in FY22 from an estimated 3.9x in FY21 due to lower profitability and higher working capital requirements.

We project DSG’s cash conversion cycle to increase to around 170 days over FY22, as the company builds inventory in case of supply-chain disruptions and to support growth, especially in its bicycle business. We have also factored in some pressure on DSG’s receivable collections amid the weak operating environment. Capex, Dividend Flexibility: Fitch expects DSG’s capex will rise to LKR2.4 billon in FY22 from an estimated LKR1.1 billion in FY21, as the company seeks to improve existing manufacturing processes and expand capacity.

According to DSG, much of the capex is uncommitted, and can be deferred if the operating environment weakens. While Fitch expects a 25% dividend pay-out ratio over FY22-FY24, DSG has shown its ability to declare a lower quantum than our rating case. We believe flexibility in capex and dividends should contain any spikes in leverage if the operating environment were to deteriorate. EBITDA Margins to Decline: Fitch believes DSG’s EBITDA margins are likely to decline to 11.4% in FY22 from an estimated 13% in FY21.

We believe DSG is likely to face increased input cost pressure as prices of rubber and petrochemicals used in the manufacturing process have risen. DSG also faces an increase in freight costs as it imports well over 60% of its raw materials. Global freight costs have risen by over 200% for key sea routes such as China-Colombo. DSG’s ability to pass on cost increases are limited by the weak operating environment, in our view.

DERIVATION SUMMARY

Local conglomerate, Sunshine Holdings PLC (AA+(lka)/Stable) is rated one notch above DSG because of its cash flows are mainly from the more defensive pharmaceutical and medical-device sectors, and the protected domestic crude palm oil sector.

Sunshine also has a much stronger financial profile than DSG and a comfortable liquidity position. Consumer durable retailers Singer (Sri Lanka) PLC (AA(lka)/Stable) and Abans PLC (AA(lka)/Stable) have a much larger operating scale than DSG.

They hold market leadership positions in a less fragmented industry. However, the demand for consumer durable goods tends to be more cyclical than for DSG’s key products, such as footwear, which are essential goods. DSG also has a better financial risk profile than Singer and Abans, which also face pressure from their financial services subsidiaries. As a result, Fitch rates all three entities at the same level. Sierra Cables PLC (AA-(lka)/Negative) is a copper and aluminum cable manufacturer, and is rated one notch lower than DSG to reflect its much smaller scale of operations.

The Negative Outlook on Sierra’s rating reflects its significant exposure to the cyclical construction industry, which is under stress from the pandemic and is likely to weigh on the company’s working capital position. Sierra’s expansion into international markets, where it is yet to achieve meaningful traction, will also heighten its business risk in the medium term.

KEY ASSUMPTIONS

Fitch’s Key Assumptions Within Our Rating Case for the Issuer: – Revenue to decline by 14% in FY21 and recover by 13% in FY22 to LKR29 billion as schools reopen and movement restrictions ease; – EBITDA margins to fall to 11.4% in FY22 due to a weaker Sri Lanka rupee and rising raw material and freight costs; – Working capital outflow of LKR1 billion in FY22 to support the recovery in sales. Receivable days to rise to 70 compared with a four-year average of 60, amid the weak operating environment; – Capex of LKR2.4 billion in FY22 mostly to improve existing machinery and increase warehousing and manufacturing capacity; – Dividend payment of LKR180 million in FY21 and then 25% of net income over FY22- FY24.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade: – No upgrade in the medium term, given the exposure to more volatile cash flows compared with higher-rated peers.

Factors that could, individually or collectively, lead to negative rating action/downgrade: – Fixed-charge coverage, measured as EBITDAR to interest paid plus rent, declining below 1.3x on a sustained basis (FY21 estimate: 2.5x); – An increase in leverage, measured as total adjusted net debt to EBITDAR, above 5.5x on a sustained basis. – Significant weakening in the company’s liquidity profile.

LIQUIDITY AND DEBT STRUCTURE

Manageable Liquidity: DSG had LKR974 million in unrestricted cash as of endDecember 2020, against debt maturities of LKR7.5 billion falling due within the next 12 months.

Of this, around LKR6.7 billion comprises short-term working-capital debt, while contractual maturities amounted to around LKR800 million. DSG has demonstrated it can roll over its working capital debt despite the weak operating environment, supported by a net working capital position of LKR10 billion and a healthy cash conversion cycle.

We expect the cash conversion cycle to temporarily rise to 170 days as a result of investments in inventory amid disruptions to the global supply chain. DSG has around LKR5 billion in unutilised uncommitted credit lines, most of which we believe it can draw upon to support liquidity. We expect banks to stand by these facilities given DSG’s leading market position across most segments.