Fitch affirms Distilleries Company of Sri Lanka at AAA

Fitch Ratings has affirmed Distilleries Company of Sri Lanka PLC's (DIST) National Long-Term Rating at 'AAA(lka)'. The Outlook is Stable. KEY RATING DRIVERS Leading Alcohol Manufacturer: DIST continues to be the market leader in alcoholic beverage production in Sri Lanka due to its strong brands, which drive demand and access to retail points across the island. DIST's product portfolio includes its mass-market Extra Special Arrack brand, which accounts for the majority of sales, and licensed international brands channelled through its subsidiary Periceyl (Pvt) Ltd. As of the latest published statistics, DIST accounted for around half of Sri Lanka's total alcoholic beverage production and 72% of the country's total arrack production. Spirits to Regain Market Share: We expect the trend of drinkers switching to beer from hard liquor to reverse in 2016, as taxes on the alcohol content in strong beer have caught up with those on hard liquor (spirits) after increases in excise taxes in October and November 2015. Taxes on strong beer increased 70% while taxes on spirits increased 24% from October 2014 to November 2015. Arrack production declined 3% annually over 2011 to 2014, resulting in a smaller share in alcohol sales for arrack, DIST's main product. However, Fitch expects sales of spirits to grow in the mid-single digits over the next three years, which will help the segment to regain lost market share. Demand to Grow: We expect demand for alcohol in 2016 to rise as tax-led price increases are likely to be absorbed by rising disposable income. Disposable income is likely to rise, driven by higher per capita income along with the mid-single digit economic growth for Sri Lanka, and following the recent increase in public-sector pay, higher tax exemptions for private-sector employees and reduced essential-goods prices. Resilient Operating Profile: Profitability remains healthy, which is reflected in the EBITDA margin continuing to be over 30% at 31.
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4% in the financial year ended 31 March 2015 (FY15). EBITDA margins are supported by DIST's ability to pass on tax increases to the consumer.
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Regulatory Risk: The industry is highly regulated, with a complete ban on advertising and licensing across the value chain acting as a barrier to entry. The industry is also characterised by high and frequent tax revisions, which put increasing pressure on industry players. This risk is partially mitigated by liquor's contribution to government coffers, with Fitch estimating that liquor taxes will account for 5.1% of total government revenue in 2014. Successive governments have consistently used taxes on alcohol to boost revenue to bridge budget deficits. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Revenue to grow by mid-single digits over the next three years - Relatively stable EBITDAR margins driven by lower operating costs and the new bottling line RATING SENSITIVITIES Negative: Future developments that may, individually or collectively, lead to a negative rating action include: - Consolidated financial leverage (measured as adjusted net debt/EBITDAR excluding Melsta Regal Finance Ltd (MRF)) increasing to over 1.5x on a sustained basis. (end-March 2015: 0.9x) - Consolidated funds flow from operations coverage of interest and fixed charges such as operating lease rentals, excluding MRF, weakening to below 4.0x, on a sustained basis. (end-March 2015: 6.7x) - A structural change in the domestic alcoholic beverage industry that considerably weakens DIST's competitive position Positive: There is no scope for an upgrade since the company is at the highest rating on the Sri Lankan National Rating Scale. LIQUIDITY At end-September 2015, the group (excluding its finance company subsidiary) had LKR2.3bn of cash and LKR12.5bn in unused facilities to meet LKR5.4bn of short-term debt. In addition, DIST has good access to bank funding because it is one of the larger corporates in Sri Lanka with a resilient cash flow.