Fitch issues affirmation correction on Melstacorp and Distilleries, at ‘AAA(lka)’; Outlook Stable

Fitch Ratings yesterday issued this correction of a release published on 22 October, correcting the leverage level above which negative rating action may be taken.

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 its Parent and Subsidiary Rating Linkage criteria. DIST contributes around 70% to Melstacorp’s consolidated EBITDAR, shares the same board of directors and has previously provided financial support to weaker group entities in the form of corporate guarantees.

The affirmations reflect Melstacorp’s ability to maintain leverage below 2.0x over the medium-term, despite large investments in core and non-core operations. Leverage is defined as net adjusted debt/operating EBITDAR, including Melstacorp’s 51%-share of Aitken Spence PLC’s net debt and EBITDA, but excluding its insurance subsidiary. Melstacorp saw net leverage weaken to 1.8x in the financial year ending March 2019 (FY19), from 1.3x in FY18, following significant debt-funded investments.

The group’s investment drive is supported by the strong operating cash flow of its core subsidiary, DIST, which is Sri Lanka’s market leader in spirits, enjoying a strong brand presence and high entry barriers. Fitch expects DIST to account for around 70% of Melstacorp’s group EBITDA, including its 51% share of Aitken Spence, over the medium-term. The ratings of Melstacorp and DIST could come under pressure if Melstacorp continues to make large debt-funded investments that dilute the cash-flow stability of its core spirits business or are not immediately cash-flow accretive.

Key Rating Drivers

Investments weigh on leverage: Fitch expects Melstacorp to pursue acquisitions and investments in non-alcoholic beverage segments in the medium term, in line with its stated strategy. The group expanded into the healthcare and cement sectors in FY19 for a total of Rs. 1.2 billion, and increased its stake in blue-chip conglomerate, John Keells Holdings PLC, to 9.9%, from 3.5%, for Rs. 12 billion, which was largely debt-funded. Fitch expects any new investments to be primarily funded by dividend income into the Melstacorp holding company from its investment portfolio, including from DIST, which it estimates at around Rs. 4.0 billion-4.5 billion a year, and possible asset sales, including a limited sell-down of DIST.

Strong contribution from alcoholic beverages: Fitch expects DIST to contribute around 70% to the group’s proportionately consolidated EBITDA in the medium term, benefiting from its strong brand presence and access to a countrywide distribution network. DIST increased its market share in spirits to around 70% in 2018, from around 65% in 2017, amid structural and operational pressure faced by some competitors. There is also a complete advertising ban on alcoholic beverages, which acts as a high entry barrier and limits competition.

Easing Excise Tax volatility: Fitch expects incremental excise-tax hikes on spirits to be gradual, as lower sales volume off sharp tax increases, as seen after the late-2017 tax revision, could reduce Government revenue. Excise taxes from the alcoholic-beverage sector increased by less than 1% in 2018, despite an 8% rise in sales volume, with the majority of the volume increase coming from beer. Excise tax on alcoholic beverages is a key source of Government income, accounting for around 7% of tax revenue.

DIST saw a drop in sales volume in 2018 following the 2017 excise-duty revision, which brought down taxes on beer. This led to consumer demand shifting to beer, away from spirits, which has become cheaper on an equivalent-alcohol basis. DIST has also lost volume to the illicit market owing to the high tax regime and weak economic conditions, which has made its products less affordable. The Government reduced the excise tax difference between spirits and beer to 20% in March 2018, from 34%, which partly contributed to DIST’s net revenue growth of 10% in 1QFY20.

Short-term challenges from leisure: Fitch does not expect Melstacorp’s leisure segment, held via its 51% share in Aitken Spence, to fully recover in FY20 from the drop in tourist arrivals following the 2019 Easter Sunday terrorist attacks. The leisure segment accounts for around 20% of Melstacorp’s group EBITDA. Aitken Spence is Sri Lanka’s largest resort operator. The occupancy rates of its properties sank following the attacks and Fitch does not expect a full recovery during FY20, with the government estimating a 25%-30% drop in tourist arrivals in 2019. This risk is mitigated by the earnings contribution from the group’s Maldives operations, including its 500-room new luxury resort, which opened in 2019.

Stronger margin: Fitch expects Melstacorp’s EBITDAR margin to expand by around 200bp by FY21, from 22.3% in FY19, due to a stronger EBITDAR margin at DIST. DIST has already seen an 11pp yoy improvement in its margin in 1QFY20, helped by volume recovery and better sourcing strategies, which Fitch believes will be sustained in the medium term. However, the group’s EBITDAR margin may face short-term pressure from the leisure segment. Fitch also does not expect a material recovery in the group’s loss-making telco and plantation businesses in the medium term, but the impact is not significant to the ratings.

Derivation summary

Melstacorp is a leading conglomerate in Sri Lanka, with exposure to the alcoholic beverage, plantation, telecom, leisure, power and logistics sectors. Its core subsidiary, DIST, is the country’s leading spirits manufacturer, with a strong portfolio of well-known brands and access to an extensive distribution network. 

In comparison with its ‘AAA(lka)’ rated peer, Dialog Axiata PLC (AAA(lka)/Stable), Melstacorp’s operations, though more diversified, are smaller in scale, as a significant portion of the country’s alcoholic-beverage consumption occurs outside the formal sector, which is not recorded. In contrast, Dialog enjoys a larger operating scale, reflecting the size of the local telecom market and the companies’ market leadership in the fixed line and mobile segments.

Melstacorp is also exposed to more regulatory risk in its spirits business due to hikes in excise taxation, 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 free cash flow (FCF) generation than at Dialog. 

Melstacorp’s capex as a proportion of revenue is also considerably lower than Dialog’s and most of its investments in other businesses are discretionary. Dialog’s high capex intensity is driven by the need to continually upgrade infrastructure to keep abreast of evolving technology and to service rising network traffic, while competition keeps tariff increases in check, resulting in larger and more sustained negative FCF than for Melstacorp.

Melstacorp is rated three notches above Lion Brewery (Ceylon) PLC (AA-(lka)/Stable) – the country’s biggest beer manufacturer – reflecting Melstacorp’s much larger operating scale and dominant market position in spirits, which is more popular than beer and hold a share of about 70% in the domestic alcoholic-beverage market. DIST has also been less sensitive to tax changes historically than Lion.

Fitch’s parent and subsidiary rating linkage methodology was used to derive DIST’s rating. The ratings of Melstacorp and its stronger subsidiary, DIST, are aligned due to strong linkage between the two entities. No Country Ceiling or operating environment aspects affect the ratings.

Key assumptions

• Consolidated revenue growth to remain subdued in FY20 amid challenges in Aitken Spence’s leisure segment, but to recover by a high-single digit percentage from FY21, supported by a broad economic recovery
• Consolidated EBITDAR margin to improve to around 24% by FY21 on stronger alcoholic-beverage volume and a recovery in the leisure segment (FY19: 22.3%)
• Smaller excise-tax hikes, as the government is likely to be mindful of falling revenue collection if demand was to decline
• Capex to peak at Rs. 9 billion in FY20 on account of Melstacorp’s 51% share of power and leisure-segment capex at Aitken Spence, and moderate to around Rs. 4 billion a year from there onwards
• M&A and other investment spending to average around Rs. 5 billion a year over FY21-FY23, although the companies have not provided any specific guidance
• Group dividend payout of Rs. 1.5 billion a year over FY20-FY22

Rating sensitivities

Developments that may, individually or collectively, lead to positive rating action:

• There is no scope for an upgrade, as the company is already at the highest rating on Sri Lanka’s national rating scale.

Developments that May, Individually or Collectively, Lead to Negative Rating Action:

• Consolidated financial leverage – measured as adjusted net debt/EBITDAR, including 51% consolidation of Aitken Spence but excluding Continental Insurance Lanka Limited, increasing to over 2.0x for a sustained period (FY19: 1.8x)
• A structural change in the domestic alcoholic-beverage industry that considerably weakens DIST’s competitive position
• A significant weakening of the business risk profile due to new investments in sectors that are less competitive or generate more volatile operating cash flow than the spirits business.

Liquidity and debt structure

Comfortable liquidity position: Melstacorp had about Rs. 22 billion in unrestricted cash and Rs. 24 billion in unutilised credit facilities at end-June 2019 to meet Rs. 30 billion of debt maturing in the next 12 months. Fitch expects Melstacorp to settle around Rs. 10 billion of short-term debt during FY20, which was to be used for investments that did not take place. 

Fitch also expects around Rs. 11 billion of working capital-related debt to be rolled over in the normal course of business given the group’s healthy working-capital cycle, which further supports liquidity. The group has strong access to local banks due to its position as one of Sri Lanka’s largest corporates and its solid credit profile.

Distilleries Company of Sri Lanka PLC; National Long Term Rating; Affirmed; AAA(lka); RO:Sta Melstacorp PLC; National Long Term Rating; Affirmed; AAA(lka); RO:Sta.