OREANDA-NEWS. S&P Global Ratings today lowered its long - and short-term South Africa national scale ratings on building materials distributor Distribution and Warehouse Network Ltd. (DAWN) to 'zaB/zaB' from 'zaA-/zaA-2'.

The downgrade follows our analysis of DAWN's restated accounts and its recognition of additional debt-like obligations on its balance sheet. DAWN's adjusted leverage at the end of fiscal 2016 (ended March 31) was materially higher than our previous base-case assumptions, and the high debt resulted in significantly weaker credit metrics than we expected.

DAWN reclassified a distribution center operating lease of South African rand (ZAR) 392 million and brought a written put of ZAR64 million (for the remaining share of the Swan Plastics business) on to its balance sheet for the first time. In addition, reported debt increased to ZAR433 million at end-March 2016, compared with ZAR271 million at end-September 2015. Consistent with our criteria, we included the reclassified lease, the written put, and the increased debt in our calculation of DAWN's adjusted debt, which resulted in adjusted leverage materially higher than we originally forecast. Although DAWN paid down debt with the proceeds of its 2015 sale to the Grohe group of 51% of its interest in the Watertech building product manufacturing companies, the paydown was neutralized by DAWN's increased working capital facilities in 2016. In view of this increased debt and consistent with our criteria, we reassessed DAWN's financial risk profile to significant from modest, and now expect credit metrics to remain constrained over the next 12 months.

DAWN's operating performance in the second half of fiscal 2016 was significantly weaker than our expectations. DAWN experienced a sharp reduction of demand for its products and services due to South Africa's weakened economy. DAWN decided to lower prices and reduce inventory but experienced an unexpectedly large working capital related cash outflow to compensate for poor collections from South African government departments (including at the national, provincial, and municipal level). As a result, DAWN's cash flows showed more deterioration than we expected.

Moreover, in fiscal 2016, DAWN recognized impairments of about ZAR400 million on investments in certain African joint ventures and associates. We understand that management no longer expects to derive its projected returns from certain investments, and views the collectability of other debts as poor. The company also reduced fair value of inventory and lowered expectation of receipts from the government for work they had contracted for and delivered.

In our view, these impairments were a one-off event, and we expect that from fiscal 2017, DAWN's EBITDA margin will start to gradually recover. However, DAWN's profitability will likely remain vulnerable, and be lower than that of rated peers due to the company's high exposure to highly cyclical construction end-markets and lack of geographic diversity. We have therefore revised our assessment of DAWN's business risk profile to vulnerable from weak to reflect these risks. We also factored in DAWN's small reported revenues and EBITDA, and deterioration in its operating efficiency (including weak working capital management). These risks are only partly mitigated by DAWN's still-highly-diversified product offering, brand portfolio, and a comprehensive distribution network that, in our view, provides certain barriers to entry and a competitive advantage.

In our base case, we assume: Revenue growth in the mid - to upper-single digits, on the back of real GDP growth in South Africa of 0.5%-1.5% in 2016-2017, inflation, and DAWN's broadly flat sales volumes and a modest increase in prices due to the company's better brand positioning versus local peers. Adjusted EBITDA margin recovering to 4.5%-5.0% in fiscal 2017 and 2018, compared with about 3% in fiscal 2016, supported by a cost-saving program and stricter working capital management, implemented by the new management team. Maintenance and fleet replacement capital expenditure (capex) of about ZAR70 million annually over fiscal 2017 and 2018.Non-seasonal working capital release of about ZAR100 million in fiscal 2017 and breakeven in subsequent years. Based on these assumptions, we arrive at the following credit measures for DAWN: Adjusted debt to EBITDA of less than 4x in 2017; andAdjusted FFO to debt of just above 20%.In our view, DAWN's capital structure is exposed to refinancing risks stemming from its short-term debt maturity profile. At the end of financial 2016, the weighted-average maturity of its debt was less than two years. Although we note that, thus far, DAWN's banks have provided support, we believe that DAWN's capital structure exposes it to future liquidity issues. We aim to monitor this situation.