Sri Lanka VAT increase on alcohol won’t affect consumption: Fitch

Feb 01, 2017 (LBO) – Firm demand for alcohol will absorb higher prices caused by Sri Lanka’s introduction of 15 percent value added tax (VAT) in November 2016, Fitch Ratings said.

“The inelastic demand for refined alcohol and rising per capita income should allow companies –including Distilleries Company of Sri Lanka PLC and Lion Brewery (Ceylon) PLC – to pass on taxes to consumers without worrying about them shifting to the more affordable illicit market,” a statement said.

High Contribution to State

Successive Sri Lankan governments have consistently used excise taxes as a tool to boost revenue to bridge budget deficits.

Excise tax on alcohol constituted around 7 percent of government revenue in 2015.

Alcohol consumption appears to be inelastic to higher taxes, but if this reverts we believe the government may hold back on further tax increases, especially with the importance of the sector’s contribution to government revenue.

The sector is also heavily regulated, with restrictions on advertising and limited issuance of new retail licences creating high entry barriers that benefit entrenched players like Lion and DIST.

Spirits Regaining Market Share

Fitch expects hard liquor’s share of the alcohol market to continue to rise in 2017. Taxes on a unit of pure alcohol of strong beer surpassed that of hard liquor after back-to-back tax increases in October and November 2015. As a result, revenues of DIST – the largest spirits maker – grew by 36 percent in 4QFY16 (three months ending March 2016), while gross revenue of Lion – the largest beer maker – contracted by 12%.

Spirit makers had previously been facing heightened competition from beer producers, given the competitive pricing on the basis of pure alcohol content, growing popularity of beer among the younger population, and rapid urbanisation in post-war (post-2009) Sri Lanka.

Improving Financial Metrics

Fitch expects Lion’s financial leverage to improve in FY18 (year ending 31 March 2018), benefitting from lower capex and normalised returns, bringing its leverage ratios below Fitch’s negative triggers, having weakened in FY17 due to the floods.

DIST was placed on RWN in September 2016, reflecting a potential rise in financial risks due to the purchase of new shares of its subsidiary Melstacorp Limited. Resolution of the RWN will depend on the details of DIST’s capital structure.

Outlook Sensitivities

Regular Excise Tax Increases: Companies may find it difficult to revise prices on a regular
basis if the government decides to raise taxes multiple times within the same year (as seen in
2015), which could affect profitability. Similarly, consumers may shy away from the mainstream
market if the price increases are significant and imposed at short intervals.