Fitch removes Rating Watch Negative on Distilleries; affirms at AAA(lka)

July 13, 2018 (LBO) – Fitch Ratings has removed the Rating Watch Negative on Distilleries Company’s National Long-Term Rating, and has affirmed the rating at ‘AAA(lka)’.

Full text of the statement is reproduced below.

Fitch Ratings-Colombo-13 July 2018: Fitch Ratings has removed the Rating Watch Negative (RWN) on Distilleries Company of Sri Lanka PLC’s (DIST) National Long-Term Rating, and has affirmed the rating at ‘AAA(lka)’. The Outlook is Stable.

The removal of the RWN reflects our view that DIST and parent Melstacorp PLC have effectively concluded the group’s restructuring exercise without an increase in credit risk after the private placement of DIST shares to Melstacorp in February 2018. Melstacorp, which owns 92% of DIST, has yet to meet the requirement set by the Colombo Stock Exchange to increase the company’s public float to 7.5% from 3.2% but we think this is more of a formality at this stage.

Fitch rates DIST based on the consolidated profile of Melstacorp due to the strong linkages between the two entities, as defined in our Parent and Subsidiary Rating Linkage Criteria. The affirmation of DIST’s National Long-Term Rating reflects the group’s strong credit profile, underpinned by its entrenched market position in Sri Lanka’s alcoholic-beverage sector and the high entry barriers, which drive strong operating cash flows and low leverage, and offset the weaknesses in its other, less operationally significant, investments.

DIST’s rating also factors in the group’s enhanced operating scale and cash flow diversity following the increase in its effective shareholding and management control of Aitken Spence PLC (ASP) to 51% in March 2018, from 49% previously. Fitch believes DIST’s rating has a higher tolerance for leverage (defined as lease adjusted debt net of cash/operating EBITDAR) following the acquisition, and we have increased the leverage threshold above which the rating could be negatively impacted, to 2.0x from 1.5x to reflect this. We proportionately consolidate ASP’s financials with that of Melstacorp in arriving at the rating to reflect our view that Melstacorp may provide support to ASP in a hypothetical distressed scenario only to the extent of its proportionate shareholding in light of ASP’s large public float.

KEY RATING DRIVERS

Strong Linkages with Parent: There are strong operational and legal linkages between DIST and Melstacorp’s subsidiaries, and DIST accounted for an estimated 71% of Melstacorp’s consolidated revenue and 77% of its EBITDAR, excluding Melstacorp’s insurance subsidiary, in the financial year to March 2018 (FY18). DIST and Melstacorp share the same board of directors, and DIST has previously provided financial support to weaker group entities in the form of corporate guarantees.

ASP Improves Business Risks: We believe the combined credit profile of Melstacorp and ASP is among the top tier of Sri Lankan corporates for credit quality. We have assessed ASP’s standalone credit profile as slightly weaker than that of DIST due to ASP’s exposure to segments with more volatile cash flows such as leisure and plantations, and ASP’s slightly higher leverage (2.5x in FY18). This is offset by the greater diversification of Melstacorp’s earnings and larger operating scale as a result of the combination.

Melstacorp’s consolidated earnings continue to be underpinned by the strong alcoholic-beverage sector, which we expect to account for more than 65% of the proportionately consolidated EBITDA of the combined group in the medium term.

Margin to Improve: We expect the group’s EBITDAR margin to rise by around 150bp in FY19 (FY18: 24%) as we forecast DIST’s standalone EBITDAR margin will recover to around 37%-38% from FY19 due to better sourcing strategies. DIST’s EBITDAR margin rose to 41% in 4QFY18, after falling to around 24% in the first three quarters of FY18 (FY15-FY17 average: 39%) due to higher costs as a result of a doubling of import duty on ethanol – a key input – in 2016. We also believe DIST will be able to pass on higher costs as we do not foresee a significant increase in excise duty levied on hard liquor over the medium term.

Leverage to Peak in FY19: We expect Melstacorp’s leverage, including its 51%-share of ASP’s net debt and EBITDA, to peak at 1.5x in FY19 (FY18 estimate: 1.4x) mainly due to large capex plans at ASP’s power and leisure segments. Leverage is also high at the group’s telecom subsidiary, Lanka Bell Limited, and plantation subsidiaries. We expect Lanka Bell to continue incurring high capex as it expands its 4G coverage. Volatile tea and rubber prices continue to affect the group’s plantation business, although revenue improved in FY18.

Leading Alcoholic-Beverage Maker: DIST accounts for over 60% of Sri Lanka’s hard-liquor production and has been able to maintain its market leadership due to its entrenched DCSL brand and access to a country-wide distribution network. The complete advertising ban on alcoholic beverages acts as a high entry barrier and further strengthens DIST’s dominance. However, hard-liquor makers’ volumes are likely to drop following the government’s more favourable taxation policy towards beer makers from November 2017. We expect DIST’s volumes to remain flat in FY19 despite the policy given its strong market position and revenue to grow by low-single digits thereafter as it passes on higher input costs.

Importance to State Revenue: We expect the alcoholic-beverage sector’s importance to government revenue to reduce the risk the government will hobble the industry. Incremental excise tax increases on hard liquor will likely be slow as prices beyond consumer affordability could lower the government’s income. Excise taxes on liquor contributed an estimated 8% to government tax revenue in 2016, with DIST accounting for around half of this amount.

Acquisitive Nature – Event Risk: We believe the group’s restructuring will allow management to increase its focus on acquisitions in non-alcoholic beverage segments. Melstacorp disposed of its investment in a fully owned licensed finance company, Melsta Regal Finance Limited, in March 2018 while it increased its stake in its plantation-sector assets in September 2017. The group has historically pursued acquisitions actively and, while it has not indicated any specific targets at present, DIST’s rating could come under pressure if there are significant debt-funded acquisitions, particularly those that weaken the group’s overall business risk and increase cash flow volatility.

DERIVATION SUMMARY

DIST is Sri Lanka’s leading alcoholic-beverage manufacturer, with a strong portfolio of well-known brands and access to an extensive distribution network. DIST’s ‘AAA(lka)’ rated peers, Sri Lanka Telecom PLC (SLT, AAA(lka)/Stable) and Dialog Axiata PLC (AAA(lka)/Stable) enjoy a larger operating scale, reflecting the size of the local telecom market and the companies’ market leadership in fixed line and mobile, respectively. DIST’s operating scale is smaller because a significant portion of the country’s alcoholic-beverage consumption occurs outside the formal sector, which is not recorded.

DIST is also exposed to more regulatory risk in the form of increases in indirect taxation, but these risks are counterbalanced by its entrenched market position and high entry barriers, which allow the company to pass on cost inflation and maintain margins, supporting substantially stronger free cash flows (FCF) than the telcos. DIST’s capex as a proportion of revenue is also considerably lower than the telcos, and most of DIST’s investments in other businesses are discretionary. The telcos’ high capex intensity is driven by the need to continually upgrade infrastructure and keep abreast of evolving technology, and to service growing network traffic, while competition keeps tariff increases in check, resulting in larger and more sustained negative FCF than DIST.

KEY ASSUMPTIONS

Fitch’s key assumptions within our rating case for the issuer include:
– Consolidated revenue to grow by mid-single digits in FY19 before increasing to high-single digits over FY20-FY21
– Consolidated EBITDAR margin to improve 25% in FY19 on the back of improving alcohol-beverage segment margins (FY18: 24%)
– Lower excise tax hikes as the government would be mindful of falling revenue collection if demand were to decline
– Capex to peak at LKR13 billion in FY19, mainly on account of power and leisure segment-related capex by ASP
– A group dividend payout of 30% of net profit over FY19-FY21

RATING SENSITIVITIES

Developments that May, Individually or Collectively, Lead to Positive Rating Action
– There is no scope for an upgrade since the company is at the highest rating on the Sri Lankan National Rating scale.
Developments that May, Individually or Collectively, Lead to Negative Rating Action
– Consolidated financial leverage (measured as adjusted net debt/EBITDAR excluding Continental Insurance Lanka Limited and 51% consolidation of ASP) increasing to over 2x on a sustained basis (end-March 2018: 1.4x)
– A structural change in the domestic alcoholic-beverage industry that considerably weakens DIST’s competitive position

LIQUIDITY

Comfortable Liquidity Position: The group had a comfortable liquidity position at end-March 2018, with LKR19 billion of unutilised but committed credit lines and LKR16 billion of unrestricted cash and cash equivalents available to meet LKR19 billion of debt maturing in the next 12 months. The group has strong access to local banks due to its position as one of Sri Lanka’s largest corporates and its solid credit profile.