Fitch downgrades HMGT

Fitch Ratings Lanka downgraded Hayleys MGT Knitting Mills PLC’s (HMGT) National Long-term rating to ‘BBB(lka)’ from ‘BBB+(lka)’. The Outlook is Negative.

The downgrade primarily reflects HMGT’s lower operating margins. The company’s inability to increase sales prices in the face of significantly increased cotton prices is a key concern for the rating.

Fitch also notes that HMGT’s operations management may require strengthening due to lapses in the debtor and inventory management areas as recently indicated in a company announcement. The non-value adding expenses – provisions for bad debts and for slow moving stock – escalated to sizable proportions in H111 (end-September 2010) and amounted to over US$ 1.25m, indicating a significant leakage of the company’s profits.

The Negative Outlook indicates that Fitch is concerned for HMGT’s ability to improve its margins in the face of high competition and high input costs as well as a possible loss of bargaining power with the local apparel manufacturers, given the recent removal of the Generalised System of Preferences Plus scheme (GSP+) tariff benefit, as the full negative impact may yet to be seen. HMGT’s rating can deteriorate further if margins and performance do not improve in the near-term.

Additional risks for HMGT’s rating could arise from the deterioration of leverage through increased borrowings for additional capacity without a commensurate increase in EBITDA, sizable dividend outflows from the company and/or a situation of continuous increase in local costs such as wages (up 25% yoy as at H111) amidst stagnating sales valued by a stable exchange rate.

Fitch further highlights that HMGT’s concentration in EU (specifically UK) sales is significantly high (over 90%), indicating that the company’s sales are linked directly to the performance of the retail brands in these geographies.

HMGT could be negatively impacted from sluggish demand or if any of its major EU retail buyers curtails orders.

Fitch notes that HMGT’s strengths in manufacturing are centred on speed to delivery and manufacturing flexibility, while specialisation on polyester manufacturing capabilities is a risk mitigant.

Fitch also expects HMGT’s parent – Hayleys PLC, ‘AA-(lka)’/Negative - to increase management control over the subsidiary to recover profitability over the short-term. Furthermore, HMGT management has indicated that it will revise input prices in a timely manner to reflect the volatility in the input prices, which may help a margin recovery.

HMGT’s operating EBITDAR margin deteriorated to 6.0% in H111 (FYE10: 13.3%), weakening its leverage (total adjusted net debt/operating EBITDAR) in H111 to 4.3x (FYE10: 2.3x). 90% of total borrowing was short term in nature, highlighting its refinance risk, although Fitch notes that majority of these working capital lines are directly related to the level of business activity and can self-liquidate.

HMGT’s liquidity was adequate based on unutilised facilities of US$ 8.3m as at end-September 2010.