Fitch affirms Sierra Cables at ‘BB+(lka)’; Outlook Stable

Fitch Ratings has affirmed Sri Lanka-based cable manufacturer Sierra Cables PLC’s National Long-Term Rating at ‘BB+(lka)’ with a Stable Outlook.  

The affirmation reflects its view that the rise in Sierra’s leverage is temporary and that the company will be able to deleverage in the next 12 months based on a sustained recovery in demand and profitability seen since the fourth quarter of the fiscal year ending March 2018 (FY18). 

Revenue increased by 30% in 4QFY18, compared with a 4% decline in 9MFY18, and EBITDA margin climbed to 12.2% from 5.9%. Weaker profitability during most of FY18 was the main contributor to the company’s high leverage, as Sierra was unable to pass on higher raw material prices and local-currency depreciation to customers. However, it has priced-in some of the cost of inflation with support from stronger demand since the start of 2018.  

Fitch expects net leverage – defined as lease adjusted debt net of cash/operating EBITDAR, excluding cash flow from overseas operations – to fall below 3.5x by FY19, the level above which the rating could be downgraded (FY18: 4.4x). However, an inability to make meaningful progress towards deleveraging in the next 12 months could result in negative rating action.   

Sierra’s rating also reflects its modest market share in the domestic copper and aluminium cable market, which is counterbalanced by its exposure to cyclical end-markets, such as infrastructure and construction. It also factors in risks associated with investments in international markets, where the company has yet to establish itself.

Key rating drivers  

Balance sheet to strengthen: Fitch expects Sierra’s adjusted net leverage to fall below 3.5x in the next year, helped by a turnaround in operations from the FY18 trough. Consolidated revenue saw early signs of recovery, with a 30% yoy pick-up in 4QFY18 aided by pent up demand, although weak demand in previous quarters reduced FY18 revenue growth to 5%. Fitch expects revenue to rise by around 20% in FY19 and the EBITDA margin to see a modest improvement to 8.7%, from 7.9%, as Sierra continues to price-in cost inflation on stronger demand. Its decision to rein-in capex and investment outflow in the short term and dispose of loss-making subsidiary, Sierra Power, in April 2018 for Rs. 168 million should help it deleverage.   

Weak but improving cable demand: Fitch expects local copper and aluminium cable demand to slightly recover in FY19, benefitting from the pent-up demand and resumption of infrastructure projects. However, revenue growth is likely to be in the single digits in the short term (3.1% growth in FY18), as institutional and retail customers remain cautious on large capital investments owing to high interest rates and domestic funding constraints.   

Sri Lanka is experiencing a slowdown in apartment and mixed-development projects, one of the key growth drivers for the copper and aluminium cable market, due to temporarily weaker demand. Fitch believes this will be offset by the sustained revival of government contracts since 4QFY18, which should continue for the next 12-18 months. Government contracts accounted for around 25% of Sierra’s consolidated revenue in FY18.   

Modestly better profitability: Fitch’s expectation that Sierra’s margin will improve by around 100bp is supported by its effort to pass on cost increases and the improving demand. Fitch expects aluminium and copper prices, which constitute around 70% of Sierra’s cost of sales, to increase further in the medium term. However, continued local currency devaluation remains a threat to stronger profitability. Sierra’s EBITDA margin contracted by more than 700bp in FY18 due to higher copper, aluminium and PVC prices and a 2%-3% depreciation in the local currency, most of which it absorbed.   

Positive contribution from Sierra Industries: Fitch expects the weakness in Sierra’s cable segment to be somewhat offset by an improved performance in its PVC pipe business under subsidiary, Sierra Industries, owing to new contract wins. Sierra Industries, which has been making operating losses, secured a large contract in early 2018, providing strong revenue visibility over the next 12 months. Fitch believes this sector has strong growth potential, with only 50% of the country’s population having access to a pipe-born water supply, thus, successful project completion should help Sierra secure similar contracts.   

Slow progress in Kenya: Fitch does not expect a strong contribution from Sierra’s Kenyan operations in the next couple of years. The company has not secured a large contract since commencing commercial operations in 2017 due to the Government halting new tenders for most of the year. Sierra says the Government has resumed awarding new tenders, but the value of contracts won by Sierra will be unknown till late 2018. As such, the plant is operating at low capacity utilisation and will remain loss-making if the company fails to secure substantial contracts.   

Kenya provides strong growth opportunities for Sierra in the long run in light of the country’s low electrification, inability of local companies to cater for rising demand and significant investments by foreign donors in the country’s power sector. However, Sierra is exposed to high political risk due to ongoing civil unrest in the country, which could disrupt production and lower project cash flow returns. Fitch expects the company to invest capex of around Rs. 100-150 million in Kenya in FY20 upon a business revival, but note that Sierra intends to fund this investment with internally generated cash flow and has the flexibility to delay this capex until its Kenyan operations turn around.  

Fitch has excluded EBITDA of Sierra’s African operations from its consolidated EBITDA when calculating adjusted net leverage and fixed-charge coverage ratios due to the company’s intention to retain any incremental operating cash flow from its African operations to fund overseas growth opportunities.  

Derivation summary  

Sierra is a copper and aluminium cable manufacturer with an extensive product portfolio and rising local and international market share. Its smaller operating scale and significant exposure to cyclical end-markets is reflected in the multiple notch difference against rated peers, such as Abans PLC (BBB+(lka)/Stable) and DSI Samson Group Ltd. (BBB+(lka)/Stable). Sierra’s expansion into international markets, where the company needs to establish its market position, will keep its business risk elevated 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 parent, Sierra Holdings Ltd., and the parent’s low dependency on its subsidiary’s cash flow to service its obligations.  

Key assumptions  

Fitch’s key assumptions within its rating case for the issuer:

• Revenue growth of around 20% in FY19, helped by contract wins by Sierra Industries and the Kenyan operations, followed by high-single-digit growth in the medium-term amid a domestic cable market recovery. 
• EBITDA margin to expand by around 200bp in the next two years on better cost pass through and a turnaround in Sierra Industries and the Kenyan operations.  
• Average capex of Rs. 150 million a year in the next two years, mostly in the Kenyan operations, assuming the operations start generating positive EBITDA 
• Dividend pay-out to average Rs. 100 million per year in the medium term.

Rating sensitivities  

Developments that may, individually or collectively, lead to positive rating action:

• An upgrade is not anticipated in the short-to medium-term until there is an improvement in the company’s size and scale of operations while maintaining the current financial profile. 

Developments that may, individually or collectively, lead to negative rating action:

• Adjusted net debt/EBITDAR, excluding cash flow from overseas operations, of over 3.5x for a sustained period (FY18: 4.4x).
• EBITDAR coverage – as measured by EBITDAR, excluding cash flow from overseas operations/gross interest plus rent – falling below 3.0x for a sustained period (FY18: 1.8x).
• Delays or disruptions in the planned overseas expansion, which could result in additional capital calls or lower profitability.

Liquidity  

Manageable liquidity position: Sierra had Rs. 314 million of unrestricted cash and Rs. 500 million of committed but unutilised credit lines as at FYE18 to meet Rs. 1.8 billion of short-term debt falling due in the next 12 months. 

However, Rs. 1.5 billion of these maturities are short-term working capital lines and are backed by net working capital of Rs. 1.8 billion. As such, Fitch expects banks to roll these facilities over as they fall due in the normal course of business. Sierra should generate negative free cash flow if it fully executes its capex plans, which may require further debt funding.