Fitch downgrades DSI Holdings to ‘BBB+’; Outlook Negative

Fitch Ratings said yesterday it has downgraded DSI Holdings Ltd.’s (DSIHL) National Long-Term rating to ‘BBB+(lka)’ from ‘A-(lka)’. The Outlook is Negative.

The downgrade reflects Fitch’s view that DSIHL’s medium-term net leverage – measured as consolidated lease-adjusted debt net of cash/operating EBTIDAR – is likely to remain over 3x. This follows the company’s recent guidance for increased capex and Fitch’s expectations of only a gradual improvement in its inventory days. Leverage was 3.42x for the financial year ended March 2012. Such leverage is more in line with a ‘BBB+(lka)’ rating, given the company’s business risk profile.

The Negative Outlook indicates that a further downgrade is possible in the next 12-18 months if expected operational improvements take longer than expected, resulting in net leverage being sustained beyond 4.25x, or interest and operating lease rental coverage (measured as operating EBITDAR/gross interest expense + operating lease rentals) falling below 1.5x. The latter was 1.53x at end-Q2FY13 and 2.56x at FYE12.

DSIHL’s rating continues to reflect its market leadership in the Sri Lankan footwear industry, its strong brands, a diverse product range, as well as its wide retail and distribution network. Key risks include competitive pressure from small and medium-scale manufacturers, and exposure to global crude oil- and rubber prices through its raw materials. The company is also exposed to exchange rate risk as a significant portion of its raw materials are imported.

In common with other domestic footwear manufacturers, DSIHL is protected by high tariffs on imported footwear. A sharp reduction or removal of tariffs seems unlikely given Sri Lanka’s weak balance of payments. Fitch also believes DSIHL’s brand and distribution strengths should, to a certain extent, help protect its market position, if import tariffs were removed or reduced sharply.

DSIHL’s net leverage increased in FY12 mostly on account of higher debt utilised to fund higher inventory days and capex, as sales fell below expectations. Weaker sales were in turn due to weaker demand since end-2011 stemming from higher inflationary pressures, as well greater price competition within the industry.

Consequently DSIHL’s consolidated EBITDAR margins fell to 14% at FYE12 (FYE11: 17%). Fitch expects DSIHL’s EBITDAR margins to reduce further in FY13 as the company winds down its inventory, before stabilising at around 13%-14% over the medium-term, helped by the group’s revised pricing strategies and a shift towards franchised sales-outlets.

DSIHL expects to raise capital expenditure for FY13-FY15 to an estimated 7% of revenue compared with a historical average of around 4% over FY05-FY10, driven primarily by construction of a head office building for its retail division.

Capex also includes improvements to DSIHL’s retail network and a Rs. 350 million investment in a 2MW hydro power generation plant. Fitch expects capex to be debt-funded, which could weaken DSIHL’s interest and operating lease rental coverage further as interest rates on bank borrowings are unlikely to fall at least in the near-term.

At end-Q2FY13, DSIHL had sufficient cash reserves and approved, but unutilised, bank lines (Rs. 85.3 million and Rs. 870.8 million respectively) to meet an estimated Rs. 321 million of term debt maturing in FY14 and FY15. However, Fitch expects DSIHL to generate negative free cash flow (operating cash inflows after deducting capex and dividends) in the medium-term due to high capex, which means that the company will have to draw down on additional bank credit to fund the deficit. Nevertheless, liquidity risk is not a serious risk given DSIHL’s access to domestic banks, and projected improvements in working capital management.

DSIHL is wholly owned by the D. Samson Group (DSG). DSG’s operations mainly consist of DSIHL and a company that manufactures and exports bicycle tyres. Fitch views the business risk of this exporter as being higher than DSIHL, given its evolving share in key export markets, and greater demand volatility for bicycle tyres across economic cycles, compared with footwear. DSG has full control of DSIHL’s cash

flow, and therefore a material weakening of DSG’s credit profile can also result in pressure on DSIHL’s rating.