Fitch affirms Sunshine Holdings at ‘A-(lka)’; Outlook Stable

Fitch Ratings has affirmed Sri Lankabased Sunshine Holdings PLC’S National Long-term Rating at ‘A-(lka)’. The Outlook is Stable. The rating on Sunshine reflects its strong market positions in its diversified portfolio of products, which has elements of relatively defensive end-market demand, and the strong brand names associated with most of its offerings.

These strengths are counterbalanced by the heightening regulatory risk faced by the pharmaceutical import and distribution business and the exposure to commodity price volatility in its palm oil and tea plantation businesses.

The rating also takes into account Fitch’s expectations that Sunshine’s net leverage defined as lease-adjusted net debt/operating EBITDAR including proportionate consolidation of Estate Management Services (Private) Limited (EMSPL), the holding company for the agriculture and consumer goods segments - is likely to remain below 3.0x over the medium term. The financial profile has improved following a recent equity infusion and net leverage has fallen, but over the medium term, free cash generation should improve as capex requirements have moderated.

Sunshine’s net leverage improved to around 2.1x by end September 2018, from 2.4x at endmarch 2018, supported by Rs. 775 million in proceeds from an equity issuance to SBI Ven Holdings Pte Limited in July 2018.

Fitch expects Sunshine to use the proceeds to pay down debt, which increased after Sunshine used debt to increase its stake in EMSPL. We expect the company’s moderation in capex, resilient profitability in the palm oil business and high-margin diagnostics, wellness and beauty sectors to help maintain Sunshine’s net leverage at below 3.0x over the medium term.

Fitch believes the second round of government price caps on 23 essential drugs and two medical devices in September 2018 and the depreciating Sri Lankan rupee will reduce Sunshine’s healthcare-sector profitability. We expect healthcare EBITDA margins to fall to 5.9 percent in the financial year to March 2019 (FY19) from 6.5 percent a year earlier, but should recover from FY20 due to improvement in sales volume of drugs and growing contribution from the higher-margin diagnostics, wellness and beauty segments. Nevertheless the more frequent government price controls underscore the regulatory risk for the business.

Fitch expects the palm oil segment to continue to be the key driver of growth in operating cash flows from the agricultural segment in the medium term. Global crude palm oil (CPO) prices decreased to average US$ 535/tonne in 3Q18 from around US$ 650/ tonne in 2017 due to robust output and a more challenging export market.

However Sunshine’s domestic prices started to increase from 2QFY19 due to the depreciating Sri Lankan rupee and a recent increase in import duty. Fitch sees the risk of sustained pressure on global CPO prices, although the impact domestically will be softened by the higher duty and rupee weakness.

Fitch believes the segment’s profitability to be supported by resilient domestic demand for palm oil. Sunshine is well-positioned to benefit from growing local demand as it is the largest palm oil producer in Sri Lanka, accounting for more than 50 percent of domestic output. Palm oil is the largest contributor to Sunshine’s profit, making up almost 25 percent of the group’s proportionate EBITDA in FY18.

Fitch expects the tea plantations’ cash flow volatility to continue over the medium term due to lower land and labour productivity, and cost pressures arising from periodic wage increases. The tea plantation business’s operating performance improved significantly in FY18 as a result of persistently high auction prices, with operating margin reaching 11.1 percent from 3.9 percent in FY17. However, operating margin was just 2.6 percent in 1H FY19 due to weaker prices. We expect supply-side pressures, ensuing cost escalations and volatile demand to hinder the segment’s long-term viability.

Fitch believes Sunshine’s branded-tea segment will partly offset the volatility in the tea plantation segment’s profitability. The branded-tea segment’s EBITDA margin declined in FY18 to 8.4 percent from 8.9 percent FY17 as a result of higher tea prices in the Colombo Tea Auction over 2017. The situation reversed when tea prices declined in 1H FY19, enabling the segment to improve margins, which partly countered the weaker profitability in the tea plantation segment. However, Fitch expect the intense price competition, particularly in the lower-end of the market, to keep the branded-tea segment’s margins in check over the medium term.

Fitch expects the capacity expansions in Sunshine’s power and dairy segments to increasingly contribute to cash generation and as such stabilise consolidated cash flows in the long term by reducing the share of contribution from the volatile tea and palm oil businesses. We estimate that the energy segment to annually contribute Rs.180 million to EBITDA in the next two years. Contribution to EBITDA from the dairy business, which we estimate to be around LKR80 million-120 million, should start from FY20 when the farm reaches its full capacity.