LBO - Fitch Ratings has maintained the Rating Watch Negative (RWN) on alcoholic beverage manufacturer Distilleries Company’s (DIST) National Long-Term Rating of ‘AAA(lka)’, as the company takes steps to complete its restructuring exercise and resolve its capital structure, which will require regulatory approval.
Fitch placed Distilleries on Rating Watch Negative in September 2016 to reflect potentially higher financial risks following a group restructuring exercise.
Fitch said it will resolve the Rating Watch Negative once Distilleries obtains the requisite regulatory approval to complete a private share placement to Melstacorp PLC, without which the company will have a negative net asset position.
Fitch further stated that the RWN resolution may take longer than the typical six-month period if regulatory approval is delayed.
Full statement from Fitch Ratings is reproduced below.
KEY RATING DRIVERS
Restructuring Pending Regulatory Approval: Melstacorp, a then closely held subsidiary of DIST, issued new shares to DIST in August 2016 for which DIST paid by way of a LKR24.8 billion promissory note. DIST’s shareholders then swapped their shares for Melstacorp shares on 30 September 2016, making DIST a 99.95% owned subsidiary of Melstacorp. At the same time, DIST wrote-off its erstwhile investment in Melstacorp, leaving a negative net asset position of LKR19 billion on DIST’s balance sheet at 31 December 2016. DIST received an advance of LKR20 billion in January 2017 for which it expects to privately place new shares to Melstacorp. The private placement will be subject to Securities and Exchange Commission approval.
Strong Linkages with Parent: We have assessed DIST on the basis of its parent’s consolidated financial profile because we consider the linkages between DIST and Melstacorp to be strong, as defined in our Parent and Subsidiary Rating Linkage criteria. DIST accounted for 72% of Melstacorp’s consolidated revenue and 85% of its EBITDAR in the financial year to March 2017 (FY17), excluding financial subsidiaries. The two companies also share the same board and DIST had previously provided financial support to weaker group entities in the form of corporate guarantees.
EBITDA Margin to Improve: We expect DIST’s standalone EBITDAR margin to recover to around 25%-30% over FY18-FY21, from around 19% in 1QFY18, as the company adopts better sourcing strategies. We also believe DIST should be able to pass on higher costs stemming from recent indirect-tax hikes; these included the introduction of a 15% VAT and 2% Nation Building Tax from November 2016, the doubling of import duty on ethanol – a key input – to LKR800 per litre in 2016 and sharp excise-tax hikes in 2015, which should not significantly increase for the next year. The group’s EBITDAR margin contracted to 31.1% in FY17, from 33.3% in FY16, mainly due to the contraction in DIST’s standalone EBITDAR margin to 36.5% in FY17 (FY16: 41.4%).
Rating Headroom to Improve: We expect Melstacorp’s consolidated group leverage, measured by net adjusted debt/EBITDAR, excluding financial subsidiaries, to peak at 1.6x in FY18 (FY17: 1.3x) and gradually improve along with a recovery in profit margins. Leverage is high at the group’s telecom subsidiary, Lanka Bell Limited, and plantations subsidiary, Balangoda Plantations PLC. We expect Lanka Bell to continue incurring high capex, although moderating from LKR3.5 billion in FY17, as it continues to expand its 4G coverage. Volatile tea and rubber prices continue to affect the group’s plantations sector.
Leading Alcoholic Beverage Manufacturer: 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 beverage products acts as a high entry barrier and further strengthens DIST’s market dominance.
Importance to State Revenue: We expect the alcoholic beverage sectors’ importance to government revenue to mitigate prohibitive regulation that could inhibit the industry’s survival. As such, incremental excise tax increases on hard liquor should 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 more than half of this amount.
Acquisitive Nature – Event Risk: We believe the group’s restructure will likely allow management to increase its focus on acquisitions in non-alcoholic beverage segments. The group has historically actively pursued acquisitions and, while it has not indicated it is pursuing specific acquisitions 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 has a smaller operating scale relative to other ‘AAA(lka)’ rated peers, Sri Lanka Telecom PLC (SLT, AAA(lka)/Stable) and Dialog Axiata PLC (AAA(lka)/Stable), because a significant portion of the country’s alcoholic beverage consumption occurs outside the formal sector in which DIST operates. DIST is also exposed to more regulatory risk in the form of recurrent increases in indirect taxation, but these risks are counterbalanced by its substantially stronger free cash flow (FCF). The larger operating scale of SLT and Dialog reflects the size of the local telecom market and the companies’ market leadership in fixed line and mobile, respectively. However, the companies require heavy capex to continue upgrading infrastructure and to service customers, driving negative FCF.
DIST is rated four notches above Lion Brewery (Ceylon) PLC (A+(lka)/Negative), Sri Lanka’s largest beer manufacturer. Lion has a significantly weaker financial profile compared with DIST, with leverage expected to remain above 3x for the next two years. Lion also has a smaller operating scale despite its market leadership in the beer industry, as the industry itself is still small in comparison with the hard liquor market, which DIST dominates. There has also been a shift back towards hard liquor consumption from beer, as higher taxes on beer production have removed the price advantage it previously enjoyed.
KEY ASSUMPTIONS
Fitch’s key assumptions within our rating case for the issuer include:
– Group revenue growth to slow to low single-digits over FY18-FY21 as volume remains stagnant due to high prices (18% in FY17).
– Group EBITDAR margin to contract to 22% in FY18 and recover by around 100bp annually from FY19, as DIST passes on costs.
– Lower excise tax hikes, as the government would be mindful of falling revenue collection if demand were to decline.
– Capex of LKR3 billion annually over FY18-FY21, mainly on account of Lanka Bell as it expands its 4G coverage.
– A group dividend payout of 30% over the forecast period
RATING SENSITIVITIES
Developments that May, Individually or Collectively, Lead to Positive Rating Action
Fitch will resolve the RWN once regulatory approval for the restructuring exercise is obtained. However, the resolution of the RWN could take longer than the typical six-month period if approval is delayed.
Developments that May, Individually or Collectively, Lead to Negative Rating Action
The rating could be downgraded if DIST is unable to obtain necessary regulatory approval.
LIQUIDITY
Comfortable Liquidity Position: The group had a comfortable liquidity position at end-March 2017, with LKR16 billion of unutilised but committed credit lines and LKR2 billion of unrestricted cash available to meet LKR3 billion of term debt maturing in the next 12 months. We expect the group to roll over LKR6 billion of short-term debt, mostly funding the group’s working capital. The group has strong access to local banks due to its position as one of Sri Lanka’s largest corporates and solid credit profile.
Fitch placed Distilleries on Rating Watch Negative in September 2016 to reflect potentially higher financial risks following a group restructuring exercise.
Fitch said it will resolve the Rating Watch Negative once Distilleries obtains the requisite regulatory approval to complete a private share placement to Melstacorp PLC, without which the company will have a negative net asset position.
Fitch further stated that the RWN resolution may take longer than the typical six-month period if regulatory approval is delayed.
Full statement from Fitch Ratings is reproduced below.
KEY RATING DRIVERS
Restructuring Pending Regulatory Approval: Melstacorp, a then closely held subsidiary of DIST, issued new shares to DIST in August 2016 for which DIST paid by way of a LKR24.8 billion promissory note. DIST’s shareholders then swapped their shares for Melstacorp shares on 30 September 2016, making DIST a 99.95% owned subsidiary of Melstacorp. At the same time, DIST wrote-off its erstwhile investment in Melstacorp, leaving a negative net asset position of LKR19 billion on DIST’s balance sheet at 31 December 2016. DIST received an advance of LKR20 billion in January 2017 for which it expects to privately place new shares to Melstacorp. The private placement will be subject to Securities and Exchange Commission approval.
Strong Linkages with Parent: We have assessed DIST on the basis of its parent’s consolidated financial profile because we consider the linkages between DIST and Melstacorp to be strong, as defined in our Parent and Subsidiary Rating Linkage criteria. DIST accounted for 72% of Melstacorp’s consolidated revenue and 85% of its EBITDAR in the financial year to March 2017 (FY17), excluding financial subsidiaries. The two companies also share the same board and DIST had previously provided financial support to weaker group entities in the form of corporate guarantees.
EBITDA Margin to Improve: We expect DIST’s standalone EBITDAR margin to recover to around 25%-30% over FY18-FY21, from around 19% in 1QFY18, as the company adopts better sourcing strategies. We also believe DIST should be able to pass on higher costs stemming from recent indirect-tax hikes; these included the introduction of a 15% VAT and 2% Nation Building Tax from November 2016, the doubling of import duty on ethanol – a key input – to LKR800 per litre in 2016 and sharp excise-tax hikes in 2015, which should not significantly increase for the next year. The group’s EBITDAR margin contracted to 31.1% in FY17, from 33.3% in FY16, mainly due to the contraction in DIST’s standalone EBITDAR margin to 36.5% in FY17 (FY16: 41.4%).
Rating Headroom to Improve: We expect Melstacorp’s consolidated group leverage, measured by net adjusted debt/EBITDAR, excluding financial subsidiaries, to peak at 1.6x in FY18 (FY17: 1.3x) and gradually improve along with a recovery in profit margins. Leverage is high at the group’s telecom subsidiary, Lanka Bell Limited, and plantations subsidiary, Balangoda Plantations PLC. We expect Lanka Bell to continue incurring high capex, although moderating from LKR3.5 billion in FY17, as it continues to expand its 4G coverage. Volatile tea and rubber prices continue to affect the group’s plantations sector.
Leading Alcoholic Beverage Manufacturer: 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 beverage products acts as a high entry barrier and further strengthens DIST’s market dominance.
Importance to State Revenue: We expect the alcoholic beverage sectors’ importance to government revenue to mitigate prohibitive regulation that could inhibit the industry’s survival. As such, incremental excise tax increases on hard liquor should 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 more than half of this amount.
Acquisitive Nature – Event Risk: We believe the group’s restructure will likely allow management to increase its focus on acquisitions in non-alcoholic beverage segments. The group has historically actively pursued acquisitions and, while it has not indicated it is pursuing specific acquisitions 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 has a smaller operating scale relative to other ‘AAA(lka)’ rated peers, Sri Lanka Telecom PLC (SLT, AAA(lka)/Stable) and Dialog Axiata PLC (AAA(lka)/Stable), because a significant portion of the country’s alcoholic beverage consumption occurs outside the formal sector in which DIST operates. DIST is also exposed to more regulatory risk in the form of recurrent increases in indirect taxation, but these risks are counterbalanced by its substantially stronger free cash flow (FCF). The larger operating scale of SLT and Dialog reflects the size of the local telecom market and the companies’ market leadership in fixed line and mobile, respectively. However, the companies require heavy capex to continue upgrading infrastructure and to service customers, driving negative FCF.
DIST is rated four notches above Lion Brewery (Ceylon) PLC (A+(lka)/Negative), Sri Lanka’s largest beer manufacturer. Lion has a significantly weaker financial profile compared with DIST, with leverage expected to remain above 3x for the next two years. Lion also has a smaller operating scale despite its market leadership in the beer industry, as the industry itself is still small in comparison with the hard liquor market, which DIST dominates. There has also been a shift back towards hard liquor consumption from beer, as higher taxes on beer production have removed the price advantage it previously enjoyed.
KEY ASSUMPTIONS
Fitch’s key assumptions within our rating case for the issuer include:
– Group revenue growth to slow to low single-digits over FY18-FY21 as volume remains stagnant due to high prices (18% in FY17).
– Group EBITDAR margin to contract to 22% in FY18 and recover by around 100bp annually from FY19, as DIST passes on costs.
– Lower excise tax hikes, as the government would be mindful of falling revenue collection if demand were to decline.
– Capex of LKR3 billion annually over FY18-FY21, mainly on account of Lanka Bell as it expands its 4G coverage.
– A group dividend payout of 30% over the forecast period
RATING SENSITIVITIES
Developments that May, Individually or Collectively, Lead to Positive Rating Action
Fitch will resolve the RWN once regulatory approval for the restructuring exercise is obtained. However, the resolution of the RWN could take longer than the typical six-month period if approval is delayed.
Developments that May, Individually or Collectively, Lead to Negative Rating Action
The rating could be downgraded if DIST is unable to obtain necessary regulatory approval.
LIQUIDITY
Comfortable Liquidity Position: The group had a comfortable liquidity position at end-March 2017, with LKR16 billion of unutilised but committed credit lines and LKR2 billion of unrestricted cash available to meet LKR3 billion of term debt maturing in the next 12 months. We expect the group to roll over LKR6 billion of short-term debt, mostly funding the group’s working capital. The group has strong access to local banks due to its position as one of Sri Lanka’s largest corporates and solid credit profile.
