Fitch Downgrades Sri Lanka’s Lakdhanavi to ‘AA-(lka)’; Outlook Stable

Fitch Ratings has downgraded the Sri Lanka-based Lakdhanavi Limited’s National Long-Term Rating to ‘AA-(lka)’ from ‘AA+(lka)’. The Outlook is Stable.

The downgrade reflects the risk of disruptions to Lakdhanavi’s domestic operations from a potential fuel shortage and heightened counterparty risk due to its exposure to payments from the Sri Lankan government (Long-Term Foreign-Currency Issuer Default Rating: CC) through state-owned Ceylon Electricity Board (CEB: AA-(lka)/Stable), amid the country’s falling foreign-currency reserves and weakening fiscal position.

The downgrade also takes into account the company’s increasing exposure to CEB in the next few years with the commissioning of the new liquid natural gas (LNG) power plant, Sobadhanavi. We believe this constrains the rating on Lakdhanavi to the same level as CEB given the high counterparty concentration.

KEY RATING DRIVERS

Risks of Operational Disruptions: Sri Lanka’s falling foreign-currency reserves is creating challenges in importing fossil fuels, which drives around 50% of the country’s power generation. This has increased the risk that Lakdhanavi’s cash flows may be disrupted if its main customer, Yugadanavi, a large thermal power plant that provides 15% of the country’s power output to CEB, faces operating challenges.

Lakdhanavi derives around 40% of its gross profits from this plant, which is largely driven by capacity-based tariffs. However, if the plant is shut down, Lakdhanavi could lose around 25% of such gross profits, which is based on plant utilisation. In addition, the CEB may also have less incentive to make timely capacity tariff payments if the plant is not operational. Up until now, Lakdhanavi has not experienced any material payment delays from the plant.

Higher Counterparty Concentration: We expect Lakdhanavi’s EBITDA from CEB to rise to around 75% by the financial year ending 31 March 2025 (FY25) from around 50% in FY21, with the commissioning of the Sobadhanavi plant. We believe this will materially reduce Bangladesh’s contribution to Lakdhanavi’s gross profits to around 15%, diluting the geographic and counterparty diversification. At present, the company does not have any firm plans for overseas expansion. Lakdhanavi has started construction of the Sobadhanavi plant.

Challenging Macroeconomic Environment: Sri Lanka’s economic performance is likely to weaken in 2022 due to the challenging external position and pressure on its exchange rate. Foreign-currency shortages in 2021 hampered food and fuel imports, and continued external liquidity stress could worsen supply shortages, hurting economic activity. We expect GDP growth to slow to 2.0% in 2022, from an estimated 3.6% in 2021, before recovering to 4.3% in 2023 partly due to base effects and a gradual easing of domestic pressures, but downside risks to our forecasts remain.

Large Investments: We expect Lakdhanavi’s net leverage to rise to 5.9x by FY24 from 1.1x in FY21 due to its USD190 million investment in the 350MW Sobadhanavi power plant. The plant has secured a 20-year power purchase agreement (PPA) with CEB. Lakdhanavi will fund 30% of the cost of the plant via equity and 70% from a project loan. We believe this investment will materially reduce the group’s current cash reserves of LKR26 billion-27 billion, which would have otherwise helped to significantly strengthen the liquidity position amid operational disruptions and possible payment delays.

Rated on Parent’s Consolidated Profile: Lakdhanavi is a subsidiary of LTL Holding (LTLH), which has access to the subsidiary’s cash flows and its management team overlaps with that of the subsidiary. Lakdhanavi also contributes the majority of LTLH’s consolidated EBITDA. We assess Lakdhanavi’s standalone credit profile and its parent LTL Holding’s (LTLH) consolidated credit profile to be similar.

LTLH is majority-owned by CEB and CEB’s credit profile is assessed at the same level as LTLH. We consequently rate Lakdhanavi based on consolidated profile of LTLH group in line with our Parent and Subsidiary Linkage Rating Criteria.

DERIVATION SUMMARY

Lakdhanavi is rated one notch below domestic footwear and tire manufacturer DSI Samson Group (Private) Limited (DSG: AA(lka)/Stable) to reflect Lakdhanavi’s exposure to the Sri Lanka sovereign as a key counterparty. DSG has seen an improvement in its business profile as it benefits from import substitution in the country amid weak external finances. We believe DSG is less affected by import restrictions and foreign-currency shortages given its modest earnings from exports, which should help the company to maintain its net leverage below 4.0x in the next few years.

The leaders in the consumer durables retail sector in Sri Lanka, Singer (Sri Lanka) PLC (AA-(lka)/Negative) and Abans PLC (AA-(lka)/Stable), are rated at the same level as Lakdhanavi as they are also exposed to stress on the sovereign in the form of import restrictions, given they import the majority of the products they sell. Lakdhanavi’s high counterparty risk is balanced by the consumer durable retailers’ more discretionary demand and weaker financial profiles.

Lakdhanavi is rated one notch above domestic power producer Resus Energy PLC (A+(lka)/Negative), on account of Lakdhanavi’s large operating scale and geographic and business diversification. We believe CEB may prioritise payments to Lakdhanavi, which is the operation and maintenance (O&M) provider for one of the largest power plants in the country, and because of its investments in LNG power plants, which are critical for CEB’s future strategy. In contrast, Resus’ contribution to the country’s power sector is less than 1%. The Negative Outlook on Resus’ rating reflects the impact on liquidity and leverage from extended payment delays from CEB, from which it derives 100% of its cashflows, amid disruptions to the power sector.

KEY ASSUMPTIONS

Fitch’s Key Assumptions Within Our Rating Case for the Issuer:

– Revenue to decline around 5% in FY23 due to lower utilisation of the WCPL plant. Revenue to increase by 65% in FY24 and 42% in FY25 with the start of operations at the Sobadhanavi power plant.

– EBITDA margin to average 20%-25% over FY23-FY25.

– Capex of LKR5 billion in FY22 and LKR23 billion in FY23, mainly for the Sobadhanavi plant

– Dividend pay-out of LKR3.0 billion-4.0 billion per year over FY22-FY25.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

– LTLH’s consolidated net debt/EBITDA (with proportionate consolidation of LBPL and Feni) rising above 6.5x for a sustained period

– LTLH’s consolidated operating EBITDA/interest paid (with proportionate consolidation of LBPL and Feni) falling below 1.5x for a sustained period

– Material increase in the counterparty risk

Factors that could, individually or collectively, lead to positive rating action/upgrade:

– A sustained and substantial reduction in counterparty risk, as reflected in an improvement in the Sri Lanka sovereign’s credit profile and external financing position, that would lead to diminishing risks of disruption to Sri Lanka’s power sector

– LTLH’s consolidated net debt/EBITDA (with proportionate consolidation of LBPL and Feni) falling below 5.5x for a sustained period.

LIQUIDITY AND DEBT STRUCTURE

Liquidity Hinges on Uninterrupted Operations: The group had around LKR17.0 billion of unrestricted cash available at end-September 2021 to meet LKR16.0 billion of debt maturing in the next 12 months. Around LKR5.5 billion of LTLH’s debt maturities in the next 12 months are short-term working-capital lines, which we expect banks to roll over as they fall due in the normal course of business. We expect the remaining contractual maturities to be met through cash at hand and the group’s access to over LKR3.0 billion of unused uncommitted credit lines.

Even though Lakdhanavi derives 35%-40% of cashflows from its Bangladesh operations, the majority of the cash is used to pay outstanding project debt with very little up-streamed to the Sri Lankan operations as dividends. Lakdhanavi’s domestic liquidity position largely depends on the cash flows from its O&M operations and any disruption to such cashflows could put pressure on liquidity and refinancing options.

ISSUER PROFILE

Lakdhanavi is a leading Sri Lanka-based engineering, procurement and construction company. It is involved in the power sectors in Sri Lanka, Bangladesh and Nepal with operations in power generation, O&M services, power plant construction and other ancillary services.

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