Sri Lanka’s Abans outlook cut to negative over soft-peg collapse

ECONOMYNEXT- Fitch Ratings has cut the outlook of Sri Lanka’s Abans Plc, a consumer goods retailer to ‘negative’s from ‘stable’ due to difficulties in importing after a forex shortages emerged from a broken soft-peg.

The rating agency confirmed Aban’s ‘AA-(lka)’ rating but said there were risks in next 12-18 months.

“The Negative Outlook reflects the deteriorating operating conditions for consumer-durable retailers, such as Abans, who are finding it increasingly difficult to import finished goods for resale due to the country’s continuing foreign-currency shortage” the rating agency said.

“Demand for consumer durables is also weakening owing to falling disposable incomes amid high inflation and sharp product price rises impacting affordability.”

The rating agency said Abans has some ability to curtail costs to preserve its margin and liquidate inventory in the near term to moderate the impact.

Sri Lanka has an unstable soft-peg called a flexible exchange rate which collapses whenever money is printed under flexible’ or discretionary policy by the country’s stimulus happy economists.

Sri Lanka’s who think there is prosperity at the end of a depreciation tunnel has depreciated the currency from 4.77 to 360 in a bid to grow exports at the expense of real wages of workers and temporary gains companies get from delays in hiking utility prices.

The rupee fell from 203 to the Us dollar to around 360 to the US dollar over the past month after the flexible exchange rate peg lost credibility after two years of money printing and was allowed to fall from March.

Rates have been jacked up from 7.50 to 14.50 percent to help stem the fall of the flexible exchange rate.

The company’s cash flow will be affected deterioration in the ability of consumer durable retailers to import goods inthe next year amid growing scarcity of foreign exchange in the domestic market, Fitch said.

With commercial banks prioritizing the opening of letters of for essential items in the country many import sector companies have run out of business in the past two years.

More than 350 non-essential goods, including some consumer durables, now require an import license
from the government.

The agency said, even if the licensed are being secured, difficulties in opening LCs will occur due to the unresolved forex shortage.

The full statement is reproduced below:

Fitch Revises Outlook on Abans PLC to Negative;Affirms at ‘AA-(lka)’

Fitch Ratings – Colombo/Singapore – 29 Apr 2022: Fitch Ratings has revised the Outlookon Sri Lankan consumer-durable retailer Abans PLC’s National Long-Term Rating toNegative, from Stable. Fitch has simultaneously affirmed the rating at ‘AA-(lka)’.

The Negative Outlook reflects the deteriorating operating conditions for consumer-durable retailers, such as Abans, who are finding it increasingly difficult to importfinished goods for resale due to the country’s continuing foreign-currency shortage.Demand for consumer durables is also weakening owing to falling disposable incomesamid high inflation and sharp product price rises impacting affordability

This increases the risk that Abans’ EBITDAR coverage of interest and rent will remainbelow 1.3x in the next 12-18 months, which is not commensurate with a ‘AA-(lka)’ rating.We think the company has some ability to curtail costs to preserve its margin andliquidate inventory in the near term to moderate the impact.

KEY RATING DRIVERS

Tightening Imports, Cash Flow Pressure: We believe Abans’ cash flow could be pressured by a deterioration in the ability of consumer durable retailers to import goods inthe next year amid growing scarcity of foreign exchange in the domestic market. Banksare prioritising essential imports, such as medicine, food and fuel, as per governmentdirections, leaving little room for imports of finished goods. The country’s externalreserves barely covered one month of imports as at end-March 2021.

More than 350 non-essential goods, including some consumer durables, now require alicense from the government as a means of controlling imports. Fitch expects larger importers like Abans to be able to secure necessary licenses, but it will be difficult to openletters of credit (LC) amid the currency shortage.

Risk of Business Disruption:Abans imports around 80% of the products it sells and itsoperation could be impaired if it cannot import finished goods from global suppliers usingLCs. The company has managed to import part of its requirements in the recent months,albeit with delays, supported by its long-standing relationships with banks and extendedcredit terms from global suppliers. Abans has resorted to local purchases for the balance.However, local manufacturers have a limited product range and continued reliance onlocal products could shrink Abans’ scale.

Abans is setting up a local plant to manufacture refrigerators and air conditioners toaddress import pressure, which it targets to come online by mid-2022. We estimate thenew plant will generate LKR8 billion-10 billion in revenue once it reaches a steady state,which we evaluate at 25% of revenue in the financial year ending March 2021 (FY21).However, this would not completely offset the disruption risk, as Abans may continue tofind it challenging to import manufacturing components. Abans’ inventory covered five tosix months of sales as at FYE22.

Inflation to Stifle Demand: We expect Abans’ revenue to contract by around 15% inFY23, reflecting a 40% volume drop that should be largely offset by price increases. Webelieve consumers will limit non-discretionary purchases, spending most of their incomeon essentials amid rapidly rising inflation. Retailers are likely to revise prices to reflectsignificant currency depreciation, with the rupee falling by 70% since March 2022,making products unaffordable for most consumers. However, Abans’ better access tolicenses, bank LCs and credit should support its market share over smaller importers, as
seen in the past year.

Shrinking Margin: We expect Abans’ FY23 EBITDAR margin to contract to around9.5%, from 13.4% in 9M21, amid currency-led cost pressure that we do not think thecompany will be able to fully pass on to customers. Abans has recently been able to priceproducts in line with currency depreciation, as reflected in its stable margin. We estimatelease-adjusted net debt/EBITDAR, including the consolidation of Abans’ immediateparent, Abans Retail Holdings (Pvt) Limited (ARH), and ARH’s real-estate projectColombo City Centre (CCC), to weaken to 5.6x in FY23, from 3.9x at end-2021.

Lower Fixed-Charge Cover: We expect fixed-charge coverage – defined asEBITDAR/interest paid and rent – to weaken to 1.2x in FY23 amid the recent 700bppolicy rate hike. Around 75% of Abans’ debt is short-term and is used for working capitalpurposes. We believe this debt will reprice quickly, raising Abans’ interest costs byaround LKR700 million a year. However, Abans can mitigate the interest rate impact bycutting overheads, like marketing and distribution costs, which account for 10% ofrevenue, and liquidating inventory, which stood at LKR11.0 billion at end-2021.

Limited Risk from Real-Estate Project: Pressure from Abans’ CCC project has easedfollowing strong apartment sales. Only a few apartments remained unsold at end-March2022, with remaining construction, including the hotel, almost complete. Constructioncosts and debt repayments on the project have been funded independently, with nosupport required from Abans. However, our forecasts factor in Abans injecting aroundLKR3.0 billion into the project over FY23-FY25 to meet any cash-flow shortfalls.

Parent’s Consolidated Profile: We assess Abans on the consolidated profile of its weakparent, ARH, based on ‘Open’ legal ringfencing and ‘Open’ access and control between thetwo entities under our Parent and Subsidiary Linkage Rating Criteria. There is noregulatory or self-imposed ringfencing of Abans’ cash flow and ARH has full ownershipand control of the subsidiary. Funding arrangements are largely decentralised, but theentities negotiate facilities as a group.

DERIVATION SUMMARY

Singer (Sri Lanka) PLC (A+(lka)/Negative), the country’s largest consumer-durableretailer by revenue, has stronger core operations than Abans, as it has a broader portfolioof products and brands across price points and better local manufacturing capability.

However, Singer has a weaker financial profile, reflecting the aggressive loan growth atits finance subsidiary, Singer Finance (Lanka) PLC (A(lka)/Negative), amid the pooroperating environment and rising interest rates. Abans’ marginally weaker business profileis mitigated by its stronger financial profile, even after including debt and potentialfinancial support for the CCC real-estate project, resulting in Abans being rated one notchabove Singer. Both companies are on Negative Outlook due to the risks stemming fromtightening imports and rising interest rates on their operation and credit profiles.

Abans is rated one notch below DSI Samson Group (Private) Limited (DSG:AA(lka)/Stable), a leading domestic footwear and tire manufacturer, due to the higherlikelihood of disruption to Abans’ business from its high exposure to imported finishedgoods. DSG has been benefitting from greater import substitution in the country amidfalling reserves and foreign-currency shortages. It also has modest foreign-currencyearnings, which support import requirements elsewhere in the group. We expect DSG tomaintain a better financial risk profile than Abans in the next year or two.

Sierra Cables PLC (A+(lka)/Stable) is rated one notch below Abans to reflect its smallerscale and cyclical demand in the construction and infrastructure sectors, compared withthe more stable demand for consumer-durable goods. This is, however, mitigated bySierra’s lower leverage. We expect both companies to face business disruption stemmingfrom import challenges, which could affect their leverage and liquidity in the next 12-18months, although Sierra has a better financial profile to help it withstand incrementalrating pressure.

KEY ASSUMPTIONS

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

-Revenue’s to decline by 15% in FY23 due to import restrictions and lower demand. Thisshould be mitigated by strong price rises. Revenue growth should pick up in 2HFY24with improved external finances and a higher contribution from the local manufacturingplant.

– EBITDAR margin to deteriorate to 9.4% in FY23 (9MFY22: 13.4%) amid lowerrevenue and escalating product costs, before improving to around 10.0% from FY24,helped by a revenue recovery.

– Annual capex of LKR1.3 billion in FY22 and FY23, mainly to set-up the localmanufacturing plant. Capex to taper off to maintenance capex from FY24.

– Capital infusion of LKR3.0 billion to the CCC project over FY23-FY25 to meet fundingshortfalls.

– Annual LKR200 million-250 million dividend payments over the medium term.

– A hypothetical annual capital infusion of around LKR300 million-500 million to Abans’finance subsidiary, Abans Finance PLC (A-(lka)/Outlook Evolving), to maintain anappropriate debt/tangible equity ratio, according to our criteria.

– Average interest rate to increase to 16% over FY23-FY24

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

– Not meeting the negative sensitivities for an extended period on account of a stabilizing operating environment could lead to the Outlook being revised to StableFactors that could, individually or collectively, lead to negative rating action/downgrade:

– Adjusted net leverage/EBITDAR, including full consolidation of ARH and the CCCproject, exceeding 6.5x for a sustained period.

– EBITDAR fixed-charge coverage, including full consolidation of ARH and the CCCproject, falling below 1.3x for a sustained period.

– A significant weakening in the company’s liquidity position.

– Further restrictions on consumer durable imports.

LIQUIDITY AND DEBT STRUCTURE

Adequate Liquidity: Abans had LKR787 million of cash on hand as of end-2021, againstLKR2.9 billion in short-term debt. Around LKR1.0 billion of the short-term debtcomprised contractual maturities of term loans, which were supported by the cash on handand around LKR800 million in uncommitted, but unutilised, credit lines from banks. Thebanks have stood by these lines, including during the height of the Covid-19 pandemic,but there is a risk they may reduce exposure to sectors such as consumer durables ifimport challenges persist or worsen.

The balance LKR1.9 billion in short-term debt is backed by net working capital on thebalance sheet of LKR9.0 billion. This provides some buffer for margin erosion andreceivables pressure before working capital liquidation will no longer be adequate torepay short-term debt in a stressed environment.