ECONOMYNEXT – Fitch Ratings has confirmed an ‘AAA(lka)’ rating of Sri Lanka’s Lion Brewery on strong balance sheet, despite expectations of a tax hike on beer and recent lockdowns.
The outlook is stable.
“This reflects Lion’s strong balance sheet that acts as a buffer against further operating disruptions and a weak consumer environment in the next 12 months,” the rating agency said.
“We expect a strong rebound in operating cash flow due to the gradual lifting of Covid-19-related movement restrictions, and believe Sri Lanka’s rising vaccination rates support shorter periods of lockdowns.
“Lion has significant rating headroom to weather even more prolonged disruptions to its operations in the next 12-18 months, due to a strong balance sheet.
Sri Lanka’s rulers hired 53,000 unemployed graduates into an already bloated workforce last year after cutting taxes in 2019, and printed large volume of money triggering the worst balance payments deficits in history.
In an upcoming budget taxes and expected to be raised with salaries and pensions being the largest expenses.
“Fitch expects the government to increase duties on alcoholic beverages towards the end of 2021, due to weak finances,” the rating agency said.
After printing money, the state driven by Mercantilist ideology slammed import controls despite warnings on classical economics principles that money is fungible and will flow into areas favoured by the ruling class and bureaucrats.
“Fitch does not foresee severe import disruptions for Lion, which remains a key source of government tax revenue,” the rating agency said
“This view was reiterated by a Central Bank of Sri Lanka statement in June 2021 that underscored the need to prioritise imports of capital and intermediate goods.”
As predicted intermediate goods imports hit 6.93 billion rupees by July 2021, 6.5 billion dollars in pre-pandemic 2019.
The full statement is reproduced below:
Fitch Affirms Lion Brewery at ‘AAA(lka)’; Outlook Stable
Fitch Ratings – Colombo – 01 Oct 2021: Fitch Ratings has affirmed Sri Lanka-based Lion Brewery (Ceylon) PLC’s National Long-Term Rating at ‘AAA(lka)’. The Outlook is Stable.
This reflects Lion’s strong balance sheet that acts as a buffer against further operating disruptions and a weak consumer environment in the next 12 months. We expect a strong rebound in operating cash flow due to the gradual lifting of Covid-19-related movement restrictions, and believe Sri Lanka’s rising vaccination rates support shorter periods of lockdowns.
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
Significant Rating Headroom: Lion has significant rating headroom to weather even more prolonged disruptions to its operations in the next 12-18 months, due to a strong balance sheet.
Fitch expects Lions leverage to remain below 1.0x in the medium term (end-June 2021: 0.2x), even after factoring in muted revenue growth in the financial year ending 31 March 2022 (FY22) and a decline in the EBITDA margin due to challenges in passing through cost inflation amid a weak operating environment.
Higher Working Capital: We have factored in a lengthening of Lion’s cash conversion cycle to 110 days over FY22-FY23 (FY21: 90 days) to account for the possibility of slower receivables collection, and buffer stocks of raw material imports as a contingency measure because of the country’s challenging import environment. We have also conservatively assumed that Lion will pay almost all of its pre-dividend free cash flow as dividends, against around 17% net-income dividend payout over FY19-FY21.
Manageable Import Disruptions: Lion has not seen any severe disruptions to date when importing raw materials. The company has also managed to secure its commodity requirements for FY22. Fitch does not foresee severe import disruptions for Lion, which remains a key source of government tax revenue. This view was reiterated by a Central Bank of Sri Lanka statement in June 2021 that underscored the need to prioritise imports of capital and intermediate goods.
Excise Tax Increase Likely: Fitch expects the government to increase duties on alcoholic beverages towards the end of 2021, due to weak finances. We believe further tax increases over the rating horizon of FY22-FY25 will be gradual, as the industry is important to government revenues. Excise duties from alcoholic-beverage makers made up 10% of government tax revenue in 2020.
Fitch expects the current excise tax regime – where spirits are taxed higher per proof litre than beer – to be maintained over the medium to long term, as it encourages the consumption of drinks with lower alcohol content.
Sales Volume to Fall: Fitch expects Lion’s volumes to decline by 8% yoy in FY22 (FY21: down 3% yoy), due to pandemic related stresses weighing on Sri Lanka’s economic recovery. We expect strong beer sales volumes, with alcohol content of more than 8%, to decline by around 5%, against 25% for mild beers (with less than 5% alcohol). Strong beer volumes should be more resilient than mild beer as strong beer is mostly consumed off-premise. We expect mild beer to only recover meaningfully in late FY23, in line with our expectations for tourism.
Decline in the EBITDA Margin: We project Lions EBITDA margins based on gross revenue to fall by 70bp to 11.6% in FY22, owing to our expectation of lower volumes and cost escalations. The company also faces some foreign-currency risk on its imported inputs amid the country’s weak external finances. Lion is also exposed to rising freight rates given its import requirements. We believe Lion may absorb some of these cost escalations, as the prevailing environment remains weak for a complete pass-through of costs.
Parent-Subsidiary Linkage: Fitch notches Lion above the consolidated profile of its parent, Carson Cumberbatch PLC, due to its financial independence and 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.
DERIVATION SUMMARY
Lion is rated at the same level as leading conglomerate Melstacorp PLC (AAA(lka)/Stable), whose rating reflects a dominant market position in spirits, with a share of about 70% in the domestic alcoholic-beverage market, and strong free-cash-flow (FCF) generation. Melstacorp’s stronger FCF generation than Lion is counterbalanced by its more aggressive expansion and investment policy against Lion’s more conservative approach.
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 market leadership 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.
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)/Stable) and higher investment appetite, which may increase leverage.
Sunshine Holdings PLC (AA+(lka)/Stable) rating reflects its leading positions in defensive sectors. The sectors range from healthcare – where it imports and distributes pharmaceutical and surgical products – to fast-moving consumer goods, such as packaged tea retailing, and palm oil plantations, which benefit from a domestic shortage and local protectionist measures. We rate Sunshine one notch below Lion to reflect its smaller operating scale as well as the regulatory and commodity price risks associated with its healthcare and palm oil operations.
Lion, given its credit strengths, is rated higher than a number of large local banks, non-bank financial institutions (NBFIs) and insurance companies. These large financial institutions are more exposed to sovereign stress than Lion despite their individual credit strengths, due mainly to the substantial sovereign-issued securities held for regulatory reasons, and in the case of banks and NBFIs, their broader exposure to numerous sectors in the local economy.
KEY ASSUMPTIONS
Fitch’s Key Assumptions Within Our Rating Case for the Issuer:
– Net revenue to increase by 1.6% in FY22 due to our expectation of an increase in the selling price;
– The EBITDA margins on gross revenue to decline by 70bp to 11.6% in FY22 due to lower volumes and cost escalations. We expect a marginal recovery to 11.8% in FY23 on account of improving volumes;
– Excise duties for beer to rise by 10% in FY22, and then steady growth of 5% over FY23-FY25;
– Capex of LKR2.5 billion in FY22 to ease bottlenecks in the production process, and then LKR1.3 billon annually over FY23-FY25;
– In the absence of a publicly stated dividend policy, all pre-dividend FCF to be paid as dividends. This is also done to capture the risk of the parent extracting more than the average payout;
– Working capital outflow of around LKR800 million in FY22 as we have stressed the receivables collection days to capture the dampened operating environment. Inventory turnover days to remain in-line with end-FY21 levels as the company looks to build buffer stocks owing to market uncertainty.
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 5.0x for a sustained period;
– A decrease in EBITDA/interest coverage to less than 2.0x on a sustained basis;
– Stronger links with parent Carson, according to 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 LKR13.8 billion in cash and LKR6 billion in uncommitted and unused credit lines at end-June 2021, against debt maturities of LKR9.8 billion falling due in the next 12 months. This includes around LKR8 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.
ISSUER PROFILE
Lion is Sri Lanka’s largest brewery with a strong distribution network of around 2,800 outlets across the island. In addition to its own brands, Lion also brews and markets Carlsberg branded beer.