November 22, 2017 / 11:39 AM / in a year

Fitch Downgrades Sime Darby to 'BB+'; Off Rating Watch Negative

(The following statement was released by the rating agency) SINGAPORE/JAKARTA, November 22 (Fitch) Fitch Ratings has downgraded Malaysia-based Sime Darby Berhad's (Sime Darby) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) to 'BB+' from 'BBB+'. The Outlook on the ratings is Stable. The agency has also downgraded Sime Darby's senior unsecured rating to 'BB+' from 'BBB+'. Simultaneously, the ratings have all been removed from Rating Watch Negative (RWN), which was in place since 2 March 2017. The resolution of the RWN on Sime Darby's ratings and their downgrade follows shareholder and regulatory approval for the demerger of its plantation and property businesses. These businesses, especially Sime Darby Plantation Berhad (SDP, BBB+/Stable), were a key driver of Sime Darby's cash flows and earnings, contributing around 70% of consolidated EBITDA in the financial year ending June 2016 (FY16). Sime Darby is now significantly smaller in scale with lower business diversity. In addition, its remaining businesses, mainly motors and industrial equipment dealerships, do not benefit from robust market positions similar to that of SDP, which is the world's largest producer of certified-sustainable palm oil. They also have materially lower profit margins and are more prone to economic cycle volatility in our view than the plantation business. While Sime Darby's business profile has weakened significantly, its leverage profile - following restructuring within the group - remains largely unchanged in our estimate. KEY RATING DRIVERS Moderate Diversification Benefit for Motors: Sime Darby's motors division (66% of FY17 revenue) is the second-largest BMW dealer globally and currently represents 29 brands, ranging from luxury to mass-market brands as well as trucking names. However, luxury and super-luxury cars comprise more than 75% of total sales by value. The division is present in 10 countries in Asia-Pacific. However, China (including HK and Macau) and Malaysia dominate earnings, accounting for more than 70% of FY17 EBIT. While Sime Darby enjoys some geographical diversification, we believe the benefits are partly offset by a lack of meaningful share in any market and concentration in luxury brand sales. Apart from the retail and distribution of cars, Sime Darby is also involved in car assembly at its Inokom plant in Malaysia. The assembly operations have higher margins than the retail and distribution operations. The number of vehicles assembled by Sime Darby increased by 19% in FY17, and the company is seeking to expand its assembly operations by increasing the number of models and volume of cars built, as well as adding the assembly of engines. Volatile Industrial Equipment Business: Sime Darby's industrial division (33% of FY17 revenue) is one of the world's largest dealers of machinery made by Caterpillar Inc. (A/Negative). It offers a variety of services from sales of new machines, engines or used equipment to rental and a range of product support services. The industrial division is mainly exposed to the mining sector in Australia - profit after direct expenses in Australia formed around 60% of total profit in FY17 - and its earnings have declined over FY14-17, mainly due to cooling demand for coking coal. Coking coal prices have increased since 2H16 and Sime Darby's order book jumped 23% in FY17. These factors bode well for industrial sales and EBITDA, and we have assumed sustained growth over the next three years. However, we believe the division does not materially enhance Sime Darby's credit profile because of its volatility. Other Businesses Small: Sime Darby's remaining operations (around 1% of FY17 revenue) are dominated by logistics, which comprises of port and water operations in Shandong Province, China. Sime Darby Logistics operates the largest multi-purpose port in the Yellow River Delta. Sime Darby also has a joint venture with Australia's Ramsay Health Care Ltd to manage hospitals in Malaysia and Indonesia. In addition, Sime Darby has a 30% stake in Tesco Stores (Malaysia), which has over 60 hypermarkets and convenience stores. We view favourably Sime Darby's intent to gradually rationalise its exposure to these other businesses. This may also result in cash inflows from asset sales. Gradual Deleveraging: We estimate Sime Darby's FFO-adjusted net leverage to be around 3x in FY18. In addition to existing bank debt, the leverage estimate takes into account capitalisation of Sime Darby's substantial operating lease expenses. We forecast leverage to decline to below 2.5x by FY20, based on a sustained increase in EBITDA. While motors EBITDA should continue to grow steadily, we expect higher commodity prices to drive a recovery for the industrial division. We also assume lower capex, as Sime Darby narrows its business focus, and a decrease in cash dividend outflow from FY19. These assumptions lead to an estimate for positive FCF from FY19. DERIVATION SUMMARY Sime Darby's ratings can be compared with rated auto dealers in Asia such as China Grand Automotive Services Co., Ltd (China Grand Auto, BB-/Stable) and PT Mitra Pinasthika Mustika Tbk (MPM, BB-/Stable). China Grand Auto is the largest auto dealership in China, with more than 750 outlets in 28 provinces covering more than 50 brands. We view China Grand Auto's operating profile as slightly better than Sime Darby's, given its dominant position in a key market and more brand variety. Sime Darby's benefits from presence in multiple markets are offset by its focus on the luxury segment, while its industrial equipment business does not add much strength to its business profile, in our view. However, China Grand Auto's rating is constrained by its high leverage, which is estimated to remain at more than 2x higher than Sime Darby's over the next three years. MPM is the sole distributor of Honda motorcycles in the East Java, Indonesia, in addition to being a dealer for Nissan and Datsun cars in Indonesia. While its leverage is estimated to be similar to Sime Darby's over the next three years, it is significantly smaller in scale with revenue at less than one-fifth of Sime Darby's. In addition, Sime Darby has better brand and geographical diversification. These factors justify a two-notch rating differential between Sime Darby and MPM. KEY ASSUMPTIONS Fitch's key assumptions within the rating case include - Average revenue growth of 4% annually from FY18 (FY17: 6%) - Operating EBITDA margin to improve to 6% in FY19, from 3% in FY17, and remain stable thereafter - Capex of MYR1.7 billion in FY18, and around MYR800 million on average annually thereafter - Cash dividend outflow at around 50% of net income from FY19 RATING SENSITIVITIES We do not expect a positive rating action in the medium term, as we believe Sime Darby's operating profile is consistent with a 'BB' category rating. Developments That May, Individually or Collectively, Lead to Negative Rating Action -Inability to improve FFO-adjusted net leverage to below 3.0x by FY20 -Negative FCF generation on a sustained basis LIQUIDITY Manageable Liquidity: Sime Darby had MYR3.2 billion of debt, excluding perpetual sukuk, at FYE17, 98% of which was unsecured. Of the total, around MYR1.95 billion was working-capital-related debt and the current portion of long-term loans. By comparison, Sime Darby had cash and cash equivalents of around MYR2.1 billion. We expect the working-capital-related debt to be rolled-over. Sime Darby also has robust banking relationships and proven access to diverse sources of funding, which mitigate residual liquidity risks. Contact: Primary Analyst Akash Gupta Associate Director +65 6796 7242 Fitch Ratings Singapore Pte Ltd One Raffles Quay South Tower #22-11 Singapore 048583 Secondary Analyst Rufina Tam Associate Director +62 21 2988 6813 Committee Chairperson Vicky Melbourne Senior Director +61 2 8256 0325 Summary of Financial Statement Adjustments: Key adjustments made include: - Use of a 7x multiple to capitalise Sime Darby's operating lease expenses, majority of which are in Australia. - 50% equity credit has been provided to the MYR2.2 billion perpetual sukuk issue that has been transferred to Sime Darby Plantation but was on Sime Darby's balance sheet for FY17. We have included the sukuk under debt, and have treated distribution to holders as interest. - Items deemed as non-operating, such as income from investments, impairments, FX gains/losses and fair value gains and losses, have been excluded from operating EBITDA and CFO. 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