Strong Healthcare Segment: Softlogic Holdings PLC (SHL) owns a majority stake in Asiri Hospital Holdings PLC (Asiri).
Asiri accounted for over 50% of SHL's consolidated EBITDAR in the first nine months of financial year ending March 2013 (9MFY13). Asiri benefits from strong structural demand for private-sector healthcare services in Sri Lanka, and has low business risk. Robust demand should help increase dividend income to SHL from Asiri in the medium-term.
Cyclical IT and retail: SHL's Information Technology segment experienced margin decline in FY12. This was mainly due to lower demand amid a weaker domestic environment, and a revised pricing strategy aimed at reducing the substantial domestic grey market for such hardware. The retail segment performed better, supported by higher credit sales (through bank-cards, and in-house financing). Fitch Ratings expects margins at both the retail and IT segments to come under pressure in 2013 owing to macroeconomic pressures.
High structural subordination: As a holding company, SHL is dependent on dividend income from its core operating assets to service its own obligations. Therefore, SHL's creditors are structurally subordinated to creditors at its operating assets. Furthermore, Fitch does not expect SHL's leisure-sector assets to upstream dividends until at least 2015, when these assets start generating meaningful cash flows.
High leverage to decline: Financial leverage (measured as lease adjusted debt net of cash/operating EBITDAR) at the SHL holding company level is likely to increase over to about 5.15x by FYE13 according to company projections (FY12: 3.8x). This is largely due to a debt-funded capital injection into SHL's financial services segment during the period, as well as the transfer of an indirectly held stake in Asiri to direct ownership by SHL. A weaker performance in SHL's IT segment and subsequently lower dividends to SHL was also a driving factor.
Insufficient healthcare dividends: Negative rating action could follow if financial leverage at the holding company is sustained above 3.5x, or if there is a structural weakening in the credit profiles of SHL's key dividend paying subsidiaries, including a sustained increase in Asiri's consolidated financial leverage over 3.0x, or if SHL's group EBITDAR/interest plus rent (excluding the finance company subsidiary) is sustained below 1.25x (end-9MFY13: 1.31x).
Fitch expects that higher dividends from Asiri will allow the holding company's leverage to remain within the 3.5x parameter by FY14. In addition, management expects to use Rs1.375 billion (about US$11 million) of cash from the part-divestment of its life insurance subsidiary in March 2013 to reduce holding company debt.
Limited medium-term upside: Fitch does not expect positive rating action in the next 12-24 months, as management projections put holding company leverage at around 5.15x by FYE13.
Liquidity and debt structure
Refinancing risk falling: There is moderate refinancing risk at the holding company for FY14, after considering cash from the divestment of SHL's insurance subsidiary, and higher projected dividends from Asiri in FY14. Refinancing risk can be eliminated if SHL rises up to Rs 750 million in long-term debentures as planned. At a group level SHL has secured long-term financing with sufficient grace periods on capital repayment, particularly for its debt-funded leisure projects, which reduces the group's medium-term debt-servicing burden to some extent.
Key rating issues
Strong healthcare sector and improving dividends to SHL
SHL effectively controls 51% of Asiri Hospital Holdings PLC (Asiri), which is the largest listed private hospital group in Sri Lanka in terms of revenue and profits. The structural demand for private healthcare services is likely to remain strong across economic cycles given their nondiscretionary nature, and the State's low investments in this sector (1.4% of 2011 GDP, 1.3% in 2010), amid growing per capita income levels.
The Asiri group spent over Rs 7 billion on capex between FY08 and FY12, in order to expand its healthcare coverage and capacity, which increased its bed capacity by 132% to 603, while the number of properties increased to four from three. Fitch expects Asiri's newest 268-bed facility, The Central Hospital Limited (the Central), which commenced operations in 2010, to drive the group's EBITDAR growth in the longer term as economies of scale improve. We expect EBITDAR margins at Asiri to remain above 30% over the medium-term, helped by improving economies of scale on the back of double-digit revenue growth.
Asiri will spend approximately over Rs 3 billion in capex in FY14 and FY15 — most of this is for its new hospital property in the township of Kandy in the Central Province. Asiri will be the first of the large domestic private healthcare providers to set up shop in this location. The Central Province is the third-largest contributor to Sri Lanka's GDP in 2010 (10%). Fitch does not expect financial leverage at Asiri to increase above 3.0 xs as a result of higher capex and dividend payments to the holding company, helped by Asiri's strong operating cash flows.
IT and retail sectors: Cyclical demand and high competition
SHL's IT segment primarily consists of a local distribution network for Nokia phones and Dell hardware. Competition in this sector is high, stemming mostly from grey-market operators. SHL revised its pricing strategy in FY13 in an attempt to reduce the impact from grey-market participants. This, together with inflationary cost pressures on disposable income, has resulted in lower sales and profit margins for the IT segment.
IT segment sales declined by 14% in 9MFY13 versus the comparable period in FY12 due to lower volumes and selling prices on average. This is in turn mainly due to the 12% weakening of the local exchange rate in 2012, which has eroded consumer income and increased product prices.
SHL is an emerging third player in the consumer electronics and white-goods retail business, and started retailing global clothing brands in 2009. SHL has the third-largest retail network of over 150 multi-brand stores in the country, which Fitch considers to be its key competitive advantage. SHL plans to expand this store network to 300 by FYE15. Its electronics brands include distributorships for mainstream names such as Samsung (consumer electronics other than phones) and Panasonic, as well as a host of smaller names.
The non-essential nature of demand for consumer electronics, white goods, and branded clothing items will result in volatile earnings for this segment across economic cycles. The retail segment posted 27% sales-growth in 9MFY13 compared to 9MFY12, while operating margins improved on higher volumes. This is underpinned by higher credit sales. Bank credit cards and in-house consumer financing in aggregate funded 54% of retail sales in 9MFY13, compared with 18% in 9MFY12.
Fitch expects retail margins to come under pressure over the medium-term as a result of SHL's aggressive foray into this segment, a weak domestic economy in FY14.The increasing popularity of zero interest schemes on bank credit cards may erode in-house consumer financing margins in the longer term. However, because consumer finance-debtors have limited access to bank credit, consumer-financing profits should benefit retail players such as SHL in the medium-term.
Arrears in SHL's consumer-finance portfolio are healthy at present, totalling a reported 3.3% of total debtors at end-9MFY13, while arrears greater than 180 days were 0.4%. Fitch expects debtors in arrears to increase in FY14 as the loan book seasons. However, the ultimate credit risk to SHL is likely to remain low, driven by the short duration of consumer credit contracts (typically 12 months), and SHL's ability to foreclose on the underlying asset without legal recourse, as part of the Consumer Credit Act. Overall, the performance of the retail and IT segments is likely to remain under pressure in FY14.
Foreign currency risk manageable but could increase
SHL has secured US dollar-denominated long-term funding lines for its new leisure-sector projects, retail sector expansion, and healthcare segment operations. However, much of this will be drawn down in Q4FY13 (ending March) and in FY14. At end-9MFY13, about 11% of SHL's group-debt was denominated in US dollars. SHL does not have a natural hedge against a depreciation of the local exchange rate, as at present the group does not have operating cash flows denominated in foreign currency. The foreign-currency risk is particularly high in the retail sector, where a majority of costs are also denominated in US dollars due to its products being imported and sold domestically.
SHL expects to hedge 50% of its exposure to foreign-currency risk using derivative contracts with local banks. However, the duration of such contracts is limited to six months according to local regulations, which exposes SHL to revised contract pricing based on exchange-rate volatility on contract renewal. If SHL's leisure sector projects remain on track to generate meaningful cash flows from FY15, the group's foreign-currency risk will decline, as a considerable portion of leisure sector cash flows will be denominated in foreign currency.
Debt-driven subsidiary funding could increase risk in the long-term
Over the longer term, SHL's holding company-level balance sheet may face higher financial risk if further capital injections into its operating subsidiaries are debt-funded, in the absence of fresh shareholder funds at the holding company level. Subsidiaries that could be particularly capital-hungry are SHL's insurance company, Asian Alliance Insurance PLC (AAI), and licensed finance company, Softlogic Finance PLC (SLF), as well as its city hotel project.
Both AAI and SLF have regulatory capital requirements, in the form of maintaining minimum solvency and capital adequacy ratios (CAR), respectively. At end-9MFY13 AAI's life and non-life solvency ratios stood at 1.88 and 2.37, respectively, and were well above the required minimum of 1.00. However, SLF's total CAR stood at 11.06%, compared with the required minimum of 10%. Fitch expects asset growth at SLF to moderate in FY14 compared to FY13, owing to higher import duties on vehicles since mid-2012. However, SLF's internal capital generation rate is low, stemming from weak earnings, and is likely to underscore a further weakening in capitalization in FY14. Regulatory capital securities with going-concern and gone-concern loss absorbent features, such as hybrid equity or subordinated debt raised at SFL could improve its CAR and reduce funding risks to the holding company's balance sheet.