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Saturday November 27th, 2021
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Distilleries, Melstacorp ‘AAA-(lka); Fitch rating confirmed despite expected tax hike

ECONOMYNEXT – Fitch Ratings has confirmed an ‘AAA(lka)’ domestic rating of Distilleries Company of Sri Lanka, the island’s largest alcohol producer and its parent Melstacorp.

Sri Lanka has a large and expanding public service mainly expanded with unemployed graduates for which taxes have to be collected from private citizens.

Last year 53,000 unemployed graduates were hired into the state service, their first-year allowance alone costs 12.7 billion rupees.

Fitch says it expects spirits to remain resilient in the next 12-18 months despite ongoing disruptions from the pandemic.

“The sector’s recovery following the lifting of lockdowns has been robust,
reaching pre-pandemic levels within a short period, reflecting the ‘defensive’ nature of the sector and pent-up demand,” Fitch Ratings said.

The segment has grown by 3 per cent in the financial year ending 31 March 2021 (FY21), despite liquor stores being closed for almost three months.

Fitch also expects revenue growth in spirits to moderate from weaker incomes and an escalating cost of living, which it says could lead lower-income consumers to cut spending or shift to the cheaper illicit market.

It also expects a tax hike in the sector but maybe moderated to prevent more poor people moving into hooch (kasippu), Fitch Ratings said.

“We believe any tax hikes will not be too prohibitive, to prevent consumers shifting to the illicit market which could lead to national revenue loss,” Fitch Ratings said.

Tax revenue from this sector has grown 10 per cent in 2020 from 7 per cent.

“DIST has products across all price points, which should mitigate such risk, but may face difficulty in passing on cost increases or potential tax hikes as consumers become more price-sensitive,” Fitch says.

Full statement reproduced below:

Fitch Ratings – Colombo – 30 Sep 2021: Fitch Ratings has affirmed the National Long-Term Ratings of Sri Lanka-based conglomerate Melstacorp PLC and its subsidiary Distilleries Company of Sri Lanka PLC (DIST) at ‘AAA(lka)’.

The Outlook is Stable.
Fitch rates DIST based on the consolidated profile of Melstacorp due to strong legal and operational linkages between the two entities, as defined in our Parent and Subsidiary

Rating Linkage criteria.
Melstacorp’s rating reflects its leadership in the domestic spirits market which has helped the group’s cash flows to remain resilient through the Covid-19 pandemic, despite temporary but material losses in sectors such as leisure. The ratings could come under pressure if Melstacorp continues to make large investments that dilute the cash-flow stability of its spirits business or are not immediately cash-flow accretive.

KEY RATING DRIVERS

‘Strong’ Linkages: DIST, which is stronger than its parent Melstacorp, contributes more than 70% to the group’s consolidated EBITDA via its spirits business. We view the linkages between the two entities as ‘Strong’, as reflected in a high level of ownership and control of DIST by Melstacorp – including sharing the same board of directors and unrestricted cashflow fungibility between the two entities.

Defensive Performance in Spirits: We expect spirits to remain resilient in the next 12-18 months despite ongoing disruptions from the pandemic. The segment grew by 3% in the financial year ending 31 March 2021 (FY21), despite liquor stores being closed for almost three months.

The sector’s recovery following the lifting of lockdowns has been robust, reaching pre-pandemic levels within a short period, reflecting the ‘defensive’ nature of the sector and pent-up demand.

We expect revenue growth in spirits to moderate from weaker incomes and an escalating cost of living, which could lead lower-income consumers in particular to cut spending or shift to the cheaper illicit market.

DIST has products across all price points, which should mitigate such risk, but may face difficulty in passing on cost increases or potential tax hikes as consumers become more price-sensitive.

Spirits are less exposed than beer to import restrictions or currency depreciation, due to the lower amount of imported inputs in the manufacturing process, which should contain cost surges.

Potential Excise Tax Hike: We believe the government may increase excise tax on alcoholic beverages in the near term amid its weakening finances. However, tax revenue from this sector grew to 10% in 2020 from a typical 7%, as revenue from other sources has declined amid the pandemic.

We believe any tax hikes will not be too prohibitive, to prevent consumers shifting to the illicit market which could lead to national revenue loss.

Gradual Recovery in Leisure: We expect Melstacorp’s leisure segment, held via its 51% share in Aitken Spence PLC (ASP), to post positive EBITDA in FY22 following a LKR2.0 billion EBITDA loss in FY21 based on Melstacorp’s share.

The recovery will be led by ASP’s Maldives operations, which accounts for around 60% of segment EBITDA, amid improving tourist arrivals and occupancy levels since late-2020.

The booking for the winter season is in line with pre-pandemic levels, as travel restrictions have been eased in most of its feeder markets such as Europe, India and the Middle East.

We expect the recovery in ASP’s Sri Lankan operations to be much slower amid high
ongoing Covid-19 rates in the country, domestic lockdowns and travel restrictions in key markets.

The government has fast-tracked the inoculation drive with the intention of opening the country for tourism by year-end. However, the success of this programme is yet to be seen, and we forecast a full recovery in the domestic leisure sector only towards end-2022.

We expect the domestic segment to continue its operating losses in FY22, but will be offset by strong performance in the Maldives.

Margins to Improve: We expect Melstacorp’s EBITDA margin to widen to 24% by FY23
from 22.3% in FY21, benefitting from a revenue mix shift to high-margin spirits, power, and maritime and logistics. Leisure’s recovery should also support margins, but we expect leisure’s contribution to fall to around 16% of group EBITDA from a traditional 20%.

We expect cost escalations across most segments, including beverages, amid domestic inflation and currency depreciation. However, cost pass-through may become difficult in a weak operating environment, and could pressure margins.

Low Leverage Despite Investments: We expect Melstacorp’s net leverage – defined as net adjusted debt/operating EBITDAR (including Melstacorp’s 51% share of ASP’s net debt and EBITDAR, but excluding its insurance subsidiary) -to fall below 2.5x from FY23 (FY21:2.5x) amid rising EBITDAR.

We believe investments will resume from FY23, at around LKR5 billion per annum. Melstacorp is looking to expand further into consumer and healthcare, but the contribution from these investments will be less than 5% to EBITDA in the near term.

DERIVATION SUMMARY
In comparison with Dialog Axiata PLC (AAA(lka)/Stable), Melstacorp’s operations are smaller in scale (albeit more diversified), as a significant portion of the country’s alcoholicbeverage consumption occurs outside the formal sector, which is not recorded.

In contrast, Dialog’s larger operating scale reflects the size of the local telecom market and its market leadership in the fixed-line and mobile segments.

Melstacorp is also exposed to more regulatory risk in its spirits business due to excise tax hikes, but this is counterbalanced by its entrenched market position and high entry barriers, as well as the importance of excise taxes to government revenue. Consequently, the company is able to pass on cost inflation and maintain EBITDAR margins, supporting substantially stronger FCF generation than at Dialog.

Melstacorp’s capex as a proportion of revenue is also considerably lower than that of Dialog, and most of its investments are discretionary.

Local conglomerate Hemas Holdings PLC (AAA(lka)/Stable) and market leader in the
domestic beer market Lion Brewery Ceylon PLC (AAA(lka)/Stable) are rated at the same level as Melstacorp, reflecting their conservative approach to expansion, which has helped them to maintain lower leverage. Melstacorp continues to be aggressive with its expansion, helped by FCF generation stronger than its peers.

Melstacorp’s rating also reflects its larger scale than Hemas and Lion, supported by its strong market position in the relatively large domestic spirits market.

Lakdhanavi Limited (AA+(lka)/Stable) is a Sri Lanka-based power generation and
engineering and construction company, and its rating reflects cash-flow stability from fixed long-term contracts and significant revenue generation from overseas operations. Fitch rates Lakdhanavi one notch below Melstacorp, to reflect its counterparty risk from its exposure to Ceylon Electricity Board (AA-(lka)/Stable) and its large investments which will keep leverage high in the next few years.

Melstacorp, given its credit strengths, is rated higher than a number of large banks, nonbank financial institutions and insurance companies in the country. Despite their individual credit strengths, these large financial institutions are more exposed to sovereign stress than Melstacorp, due mainly to the substantial sovereign-issued securities held for regulatory reasons; and in the case of the banks and non-bank financial institutions, their broader exposure to numerous sectors in the local economy amid the weak operating environment.

KEY ASSUMPTIONS

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

– Revenue to increase by the low-single digits in FY22 amid a gradual recovery in the leisure sector and growth in maritime and logistics operations. Revenues to reach pre-pandemic levels by FY23, helped by a full recovery in the leisure sector

– EBITDA margin to stabilise at around 24% from FY23, benefitting from a revenue mixshift towards the high-margin beverage, power and maritime and logistics segments and recovery in the leisure sector

– Smaller excise-tax hikes, as the government is likely to be mindful of falling revenue collection if demand were to decline

– Capex to average around LKR2.5 billion per annum over the next two years, spent mainly on maintenance

– Group to resume M&A and other investments from FY23, with an average annual spend of LKR5 billion

– Dividend pay-out of LKR3.5 billion per year over FY22-FY25

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:

– Consolidated financial leverage – measured as adjusted net debt/EBITDAR (including 51% consolidation of Aitken Spence PLC but excluding Continental Insurance Lanka Limited (National Insurer Financial Strength: A(lka)/Stable)) – rising to over 5.5x for a sustained period.

– Group operating EBITDAR/interest paid + rent (including 51% consolidation of Aitken Spence PLC but excluding Continental Insurance Lanka Limited) falling below 1.8x for a sustained period (FY21: 3.2x).

– Weakening in the group’s business risk profile, as reflected in a significantly lower EBITDA contribution from the beverage segment, due to large investments in other riskier businesses without a commensurate improvement in leverage, or due to a weaker competitive position in spirits.

LIQUIDITY AND DEBT STRUCTURE
Comfortable Liquidity Position: Melstacorp had about LKR17 billion in unrestricted cash at end-June 2021 to meet LKR25 billion of debt maturing within the following 12 months.

Around LKR20 billion of the near-term maturities are working capital-related debt, which we expect to be rolled over in the normal course of business – given the group’s stable cashflow generation. The group’s liquidity position is also strengthened by LKR33 billion in uncommitted but unutilised credit facilities, which we believe the local banks will honour due to Melstacorp’s position as one of Sri Lanka’s largest corporates and its solid credit profile.

ISSUER PROFILE
Melstacorp PLC is a leading Sri Lankan conglomerate with exposure to the spirits, telcos, plantation, leisure, maritime and logistics, and power sectors. Melstacorp’s core spirits business is carried out by its subsidiary Distilleries Company of Sri Lanka PLC (DIST:AAA(lka)/Stable).

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