Fitch affirms Lion Brewery at ‘AAA(lka)’; Outlook Stable

Nov 11, 2020 (LBO) – Fitch Ratings has affirmed Sri Lanka-based Lion Brewery (Ceylon) PLC’s National Long-Term Rating at ‘AAA(lka)’. The Outlook is Stable.

The affirmation and Stable Outlook reflect our expectation that Lion’s credit metrics will remain comfortably within its rating parameters in the next 12-24 months, despite a temporary weakening in operating cash flows due to disruptions arising from the coronavirus pandemic.

Lion’s rating is underpinned by its market leadership in the Sri Lankan beer industry, which is protected by high entry barriers stemming from the licensing requirements and a ban on media advertising, well-established brand and extensive retail and distribution network.

KEY RATING DRIVERS

Pandemic Induced Sales Decline: Fitch expects Lion’s net revenue to fall by 28% yoy to LKR14.8 billion in the financial year ending 31 March 2021 (FY21) as a result of domestic movement and social restrictions and closure of international borders, which have been implemented to curb the spread of coronavirus infections. Risks to our forecasts include the uncertainty over government directed lockdowns and tourism demand remaining muted beyond the next 12 months.

We believe Lion’s mild beer products – beer with less than 5% alcohol by volume – will see a sharper 60% yoy sales decline in FY21 as demand is more cyclical and tourism-dependent, than the more popular strong beer variants. We assume Lion’s net revenue will return to pre-pandemic levels only in FY23.

Strong Financials Act as Buffer: Fitch expects Lion’s financial risk profile to remain strong despite a temporary deterioration in earnings, and that leverage, measured by net debt/EBITDA, will remain below 1.0x in FY21-FY22. This is after conservatively assuming that Lion will pay out almost all of its pre-dividend free cash flow despite a low dividend payout ratio of 14% historically, while spending around LKR1 billion on maintenance capex. Lion has sufficient production capacity over the next few years with plant utilisation at 66% at end-FY20.

EBITDA Margins, Working Capital: We project Lion’s EBITDA margins to decline by 400bp yoy to 29% in FY21 on lower sales and limited ability to cut fixed overheads. We forecast Lion’s EBITDA margin to improve to 30% in FY22 and 31% in FY23 on recovering sales – although this is lower than the average 34% peak in the last two years. This conservative approach to our margin expectation aims to capture the frequent changes in excise duties in the sector, which have the potential to hamper Lions volumes and profitability. We expect Lion’s cash conversion cycle to be temporarily high in FY21, given the weaker operating environment, which could weigh on receivable collection.

Able to Source Raw Materials: Lion is able to access raw materials despite import controls on non-essential goods as the company has negotiated the required credit periods with its suppliers. Carlsberg Brewery Malaysia Berhad, a significant minority owner of Lion, is also willing to help with the sourcing of key raw materials in the event Lion is unable to source directly from its suppliers.

Linkage with Parent: Fitch rates Lion on its standalone strength due to its financial independence from its ultimate parent, Carson Cumberbatch PLC, and the presence of a large minority shareholder – Carlsberg Breweries A/S (BBB+/Stable), which owns 29% of Lion directly and indirectly.

We assess the linkages between Lion and Carson as weak, as defined in Fitch’s Parent and Subsidiary Rating Linkage Criteria. Lion has a stronger credit profile than Carson. The two companies operate as separate entities, with separate funding arrangements and liquidity management. There are also no cross-default clauses or cross-guarantees between the debt of the two entities.

High Regulatory Risk: Domestic alcoholic beverage producers face frequent revisions to excise duties, which can cause operating cash flow-volatility over a one- to two-year period. Over the longer term, producers have been able to pass-on cost increases given healthy demand. In December 2019, excise taxes were increased per proof litre; however, this was offset by a reduction in indirect taxes thereby not significantly impacting selling prices.

Fitch expects the current excise tax regime – where spirits are taxed higher per proof litre than beer – to be maintained over the medium term as it encourages the consumption of drinks with lower alcohol content. We believe further tax increases will be gradual, as the industry is important to government revenues. Excise duties from alcoholic-beverage makers made up 7% of government tax revenue in 2019.

DERIVATION SUMMARY

Fitch rates Lion and Hemas Holdings PLC (AAA(lka)/Stable) at the same level. Hemas has strong exposure to the defensive healthcare and consumer sectors which contribute around 85% to its EBITDA, while catering to diversified end-markets. Meanwhile, Lion’s rating reflects its dominant position in the local beer industry, helped by high entry barriers. We expect Hemas to maintain leverage at the same level as Lion in the medium term.

Lion is rated at the same level as leading conglomerate Melstacorp PLC (AAA(lka)/Stable), whose rating reflects its dominant market position in spirits, with a share of about 70% in the domestic alcoholic-beverage market, and strong free-cash-flow generation. Melstacorp’s stronger FCF generation than Lion is counterbalanced by its more aggressive expansion and investment policy compared with Lion’s more conservative approach.
Lakdhanavi Limited (AA+(lka)/Stable) is a Sri Lanka-based power generation company with exposure to engineering and construction of power-plant components, and operation and maintenance services. Fitch rates Lakdhanavi one notch below Lion to reflect its counterparty risk related to its exposure to Ceylon Electricity Board (AA+(lka)/Negative) and higher appetite for investments.

KEY ASSUMPTIONS

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

  • Net revenue to decline by 28% yoy in FY21 due to lower sales volumes as a result of the pandemic-related lockdowns.
  • EBITDA margin to decline by 400bp yoy to 29% in FY21, and then improve to 30% in FY22 as we expect sales to rise.
  • Excise duty on strong and mild beer to increase by 5% per annum over FY22-FY24.
  • Annual capex of LKR1.3 billion over FY21-FY24. We have also assumed almost all pre-dividend FCF to be paid as dividends in the absence of a stated dividend policy.
  • We expect a marginal working capital outflow in FY21 – we believe trade receivables may rise but this would be offset by lower inventory given the dampened demand.

RATING SENSITIVITIES

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

  • There is no scope for an upgrade, as the company is already at the highest rating on Sri Lanka’s national rating scale.
    Factors that could, individually or collectively, lead to negative rating action/downgrade:
  • An increase in Lion’s leverage, measured as total debt net of cash/EBITDA, to over 4.0x for a sustained period.
  • A decrease in EBITDA/interest coverage to less than 2.8x on a sustained basis.
  • Stronger links with parent Carson Cumberbatch PLC as per Fitch’s Parent and Subsidiary Linkage Rating Criteria or weakening of the parent’s consolidated credit profile.

LIQUIDITY AND DEBT STRUCTURE

Comfortable Liquidity: Lion had LKR13 billion in cash at end-June 2020 compared to debt maturities of LKR10.3 billion falling due in the next 12 months. This includes LKR9.5 billion of working-capital debt that we expect lenders to roll over in the normal course of business, given Lion’s healthy operations and business profile despite the downturn.