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Fitch Publishes Lakdhanavi Limited’s First-Time ‘AA+(lka)’ Rating; Outlook Stable

Fitch Ratings has published Sri Lanka-based power producer Lakdhanavi Limited’s first-time National Long-Term Rating of ‘AA+(lka)’. The Outlook is Stable.
Fitch rates Lakdhanavi based on the consolidated profile of the parent, LTL Holdings (Private) Limited (LTLH), due to the strong legal and operational linkages between the two entities, as defined in our Parent and Subsidiary Rating Linkage Criteria.

The rating reflects LTLH’s leading market position in the country’s power sector, stable cash flow generation stemming from fixed long-term operation and maintenance (O&M) contracts and power purchase agreements (PPAs), strong EBITDA margins offset by the small operating scale of its business segments other than O&M and power generation, which are inherently more volatile.

The rating also reflects Fitch’s assessment that the group will maintain an adequate financial profile with EBITDA/interest coverage (including proportionate consolidation of subsidiaries Lakdhanavi Bangla Power Limited (LBPL: 51%) and Feni Lanka Limited (Feni: 56%) above 2.5x over the rating horizon.


KEY RATING DRIVERS

Strong Linkages with Parent: We view the operational and legal linkages between Lakdhanavi and its weaker parent, LTLH, to be strong under our Parent and Subsidiary Rating Linkage Criteria. The linkages include LTLH’s strong control over Lakdhanavi’s board, presence of a centralised treasury, unrestricted cash flow fungibility between the two entities and upstream guarantees provided by Lakdhanavi.

LTLH’s Weak Linkages with CEB: We view LTLH’s links with its parent, Ceylon Electricity Board (CEB, AA+(lka)/Negative), to be weak and rate it on a standalone basis. Even though CEB controls LTLH’s board, the presence of minority shareholders, LTLH’s independent management team, separate financing arrangements and LTLH’s record of no cash leakages other than modest dividends after considering its investment plans supports our view of weak linkages. Fitch believes CEB has limited incentive to access LTLH’s cash beyond dividends because of the latter’s small size; any large outflows will be negative for Lakdhanavi’s rating.

Stable Cash Flow from O&M: We expect Lakdhanavi’s O&M business to contribute significantly to group’s gross profit over the next few years supported by its fixed long-term contract with one of Sri Lanka’s largest thermal power plants, and to a lesser extent from its operations in Bangladesh. Lakdhanavi’s O&M contract with the local power plant has 14 years remaining, which provides strong cash flow visibility. The O&M segment is more profitable compared to rest of the group.

Price Certainty from Long-Term PPA: Lakdhanavi’s power plants are secured with a 15-year PPA with the Bangladesh Power Development Board (BPDB). The cash flow is largely guaranteed through capacity-based tariffs payments and cost pass-through mechanisms, supporting stable cash flow. The company’s third power plant in Bangladesh, Feni Lanka, commenced operations in late 2019, doubling the capacity to 218MW. We believe the new plant will largely offset the lower capacity charges from existing power plants (eight-nine years of PPA left) in the coming years.

Impact from COVID-19 Manageable: We expect the COVID-19 impact on LTLH’s operations to be largely manageable, as 80% of gross profit is guaranteed through long-term fixed-price contracts. We expect the impact to stem mainly from smaller segments, such as transformers, switchgear and galvanising, owing to lower demand and disruptions to production. Overall, we expect a 2% revenue decline in financial year ending 31 March 2021 (FY21) but the gross margin to remain flat, as any weakness in the smaller segments will be offset by increased contribution from the new power plant in Bangladesh, which is comparatively more profitable.

Counterparty Risk: LTLH derives around 60% of its gross profit ultimately from CEB, which is rated at the same level as the parent – Government of Sri Lanka (B-/Negative) – because of the strong linkages. Lakdhanavi and other key power producers and related service providers have received their dues in a timely manner, despite CEB’s weaker credit profile, because of the essential nature of their service. The thermal power plant, for which Lakdhanavi provides O&M services, accounts for around 12% of Sri Lanka’s power generation in a country already facing power shortages. Even if there are delays in payments from CEB we expect them to be temporary.

We expect LTLH’s diversification from its Bangladeshi operations and other businesses to mitigate the risks from exposure to CEB. Lakdhanavi’s power plants have received on-time payments from BPDB, a public utility owned by the government of Bangladesh (BB-/Stable). We expect LTLH’s gross profit exposure to CEB to decline to around 50% (FY20: 60%) in the next few years amid increased contribution from the Bangladesh operations. That said, any further improvement in LTLH’s credit profile will be contingent on material improvement in the counterparty profile beyond our current expectations.

Large Investment may Weaken Coverage: LTLH does not have any large confirmed projects in the pipeline, except for the ongoing hydropower plant in Nepal. We expect LTLH to have access to around LKR13 billion of cash from a dividend, and the cash will be free of any encumbrances by FY23. This cash is currently restricted, as we expect LTLH to hold the dividend received from its associate, West Coast Power Limited (WCPL), as a guarantee against any default of the project loan due to a breakdown of the WCPL’s power plant. The project loan will be paid off by 2022. We expect the company to use this cash to fund its future expansion.

The Sri Lankan government has awarded Lakdhanavi a new 300MW Diesel/LNG power plant in Sri Lanka on a “build operate own transfer” basis following a tender procedure. The company is yet to receive the formal approval from the regulator and sign the PPA. Lakdhanavi and another partner will infuse 30% of the project cost with the remainder funded through debt. We expect LTLH to maintain its EBITDA/interest coverage above 2.5x over the next few years, based on the proposed funding structure However, an increase in the investment or inability to find an equity partner could weaken coverage further and weigh on the rating.

DERIVATION SUMMARY

Lakdhanavi is the leading Sri Lanka-based engineering, procurement and construction company. It is in the power sectors in Sri Lanka and Bangladesh with operations in power generation, O&M services, power plant construction and other ancillary services within the value chain. Lakdhanavi is rated one notch lower than diversified conglomerate Hemas Holdings PLC (AAA(lka)/Stable) and Sri Lanka’s leading beer manufacturer, Lion Brewery (Ceylon) PLC (AAA(lka)/Stable), to reflect its high counterparty risk and appetite for investments. Lakdhanavi has a similar financial risk profile to those of Hemas and Lion, characterised by a low level of leverage. Still, Lakdhanavi’s financial risk can weaken materially if the group invests in large debt-funded projects or counterparty risk profiles weaken considerably.

KEY ASSUMPTIONS

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

– Revenue to contract by a low single-digit percentage in FY21, amid the COVID-19 impact on manufacturing businesses, and offset largely by the full-year revenue contribution from Feni Lanka.

– EBITDAR margin in the low 30% in the next two years amid increased contribution from high-margin segments, such as O&M and power generation.

– Annual capex outflow of LKR2.0 billion over FY21-FY24 on the remaining construction of the Makarigad hydropower plant in Nepal, maintenance and any other expansion plans the company may decide on.

– Dividend payout of LKR 3.0 billion a year over FY21-24.

RATING SENSITIVITIES

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

– We do not anticipate any positive rating action in the next two years due to the company’s significant investment plans and counterparty risk profile.

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

– Group operating EBITDA/interest paid (with proportionate consolidation of its subsidiaries, LBPL and Feni) falling below 2.5x on a sustained basis (FYE20: 6.7x);

– Material weakening of the counterparty risk;

– Any strengthening of LTLH’s linkages with the parent, CEB.

LIQUIDITY AND DEBT STRUCTURE

Manageable Liquidity Position: The group had LKR1.8 billion of unrestricted cash available at end-March 2020 to meet LKR6.4 billion of debt maturing in the next 12 months. Around LKR2.4 billion of LTLH’s debt maturities in the next 12 months are short-term working capital lines, thus we expect banks to roll over these facilities as they fall due in the normal course of business. We expect the remaining LKR4.0 billion of contractual maturities to be met through internally generated cash and the group’s access to over LKR2 billion of unused uncommitted credit lines. We expect banks to stand by these lines because of LTLH’s strong credit profile and leading market position in the country.