Fitch Ratings has downgraded Sri Lanka’s Lion Brewery (Ceylon) PLC’s National Long-Term Rating to ‘A+(lka)’ from ‘AA-(lka)’. The Outlook is Negative. The agency has also downgraded the National Long-Term Rating on Lion’s outstanding senior unsecured debentures to ‘A+(lka)’ from ‘AA-(lka)’.
The downgrade reflects Fitch’s expectations that Lion’s net leverage, defined as lease-adjusted debt net of cash/operating EBITDAR, is unlikely to fall below 2.0x over the next three years due to lower beer sales from the higher taxes imposed over the last 18 months. We do not expect Lion’s EBITDA to recover to historical levels over the same period. The Negative Outlook reflects the potential for further downgrades should Lion’s sales volume not recover enough in the next 18 months to reduce leverage to less than 3.0x.
Lion’s net leverage worsened to 6.3x during the financial year ended-March 2017 (FY17), from 1.9x at end-FY16, as the beer volume dropped by more than 50% due to successive tax increases and a six-month halt in domestic production due to floods in 2016.
KEY RATING DRIVERS
Shift in Market Dynamics: Beer industry volumes saw large contraction between 2014 to 2016, while hard-liquor volume increased by almost 27%, as excise duties per unit of alcohol of strong beer surpassed that of hard liquor due to tax increases in 2015. In addition, the reinstatement of VAT on alcohol products and the introduction of taxes on beer cans with effect from November 2016 prompted consumers to substitute strong beer, which has an alcohol content of more than 8%, with the consumption of hard liquor. Strong beer accounted for more than 75% of Lion’s sales volume in FY17.
Lower EBITDA Margins: Fitch expects Lion’s EBITDAR margins to recover to around 24% in FY18, from 20% in FY17, after they were diluted due to a decline in the demand for beer caused by multiple tax increases and floods interrupting production in mid-2016, which led to Lion resorting to costlier imports. Fitch expects production to normalise and sales volume to improve as the company regains most of the retail shelf-space it lost last year. However, margins may remain below historical levels over the medium term because the excise duties on a unit of pure alcohol in beer surpassed that of hard liquor after the back-to-back tax increases, which could pressure beer volumes. We do not expect Lion to further increase beer prices as it may impede volume growth.
Market Leadership: Lion has a leading market position in the domestic beer industry. Its market share is supported by its entrenched brand and widespread retail coverage, with access to more than 2,250 outlets around Sri Lanka. Lion’s market share is protected to some extent by extensive industry entry barriers stemming from stringent restrictions on advertising and retail licenses. Lion also benefits from ample production capacity, which exceeds 1.5 million hectolitres per annum, and is sufficient to meet demand over the medium term.
Volatile Regulatory Framework: Frequent tax hikes and introductions inhibit the industry’s profitability. The government has consistently used excise taxes as a tool to boost revenue to bridge budget deficits; consequently, from October 2015 to November 2016 the industry – especially beer makers – was taxed from multiple fronts through higher excise duties, the introduction of beer-can taxes and reinstatement of VAT, dampening the competitiveness of beer. Fitch does not expect further drastic tax increases that could weaken demand, especially given the sector’s large contribution to government’s tax revenue.
DERIVATION SUMMARY
Lion’s rating is supported by its leading market position in the domestic beer industry, but counterbalanced by high regulatory risks in the form of frequent tax policy revisions that have caused operating cash flow volatility. Lion’s business risk profile is weaker compared with its closest rating peer, Hemas Holdings PLC (AA-(lka)/Stable). Hemas is a well-diversified conglomerate with exposure to the defensive healthcare and fast-moving consumer goods sectors. Hemas also has a conservative approach to acquisitions and expansions and has lower leverage than Lion, supporting its higher rating.
Lion is placed four notches below the Distilleries Company of Sri Lanka PLC (DIST, AAA(lka)/Rating Watch Negative) – the country’s largest spirit manufacturer – reflecting DIST’s stronger market position as well as its stronger margins and lower leverage than Lion. The Rating Watch Negative reflects potentially higher financial risks following a September 2016 group restructure.
Sunshine Holdings PLC (A(lka)/Stable) and Richard Pieris & Company PLC (A(lka)/Stable) are rated one notch below Lion, reflecting their significant exposure to the structurally declining agriculture segment and lower EBITDA margins. Sunshine also faces regulatory risks in its pharmaceutical distribution division, which act as a short-term rating constraint.
KEY ASSUMPTIONS
Fitch’s key assumptions within the rating case for Lion include:
– revenue to recover with a 1.5-fold increase over FY18 and FY19
– EBITDAR margins to normalise at 24% over the next two years, but remain lower than historical levels of the high twenties due to heavy taxation on beer inhibiting volume and profitability
– excise duty on strong and mild beer to remain unchanged during FY18 and increase by over 5% on average during in FY19 and FY20
– capex at 12% of net revenue in FY18 then remain low at 2.5% on average over FY19 and FY20, as Lion’s production is only likely to ramp-up to FY16 levels of around 96 million litres in FY21
– no dividends during FY18, then reverting to historical levels
RATING SENSITIVITIES
Developments that May, Individually or Collectively, Lead to Negative Rating Action
– If Lion is unable to lower its adjusted net debt/operating EBITDAR to 3.0x by FY19
Developments that May, Individually or Collectively, Lead to Positive Rating Action
– We may revise the Outlook to Stable if there is a meaningful improvement in sales volume that leads to adjusted net debt/operating EBITDAR falling below 3.0x on a sustained basis
LIQUIDITY
Adequate Liquidity: Lion has a comfortable liquidity position, with an unrestricted cash balance of LKR7.6 billion as of FYE17 and unutilised credit lines of LKR5.1 billion to meet LKR4.5 billion of contractual maturities falling due in the next 12 months. Lion’s strong market position in the domestic beer industry and consistent access to bank funding because it is one of Sri Lanka’s largest listed corporates further support liquidity.
Of total gross debt of LKR18.9 billion as at end-March 2017, 41% relates to revolving loans – including the overdraft facility- and term loan facilities account for 34%. Lion had LKR3.9 billion of debentures in issue as at FYE17 (21% of total gross debt), with maturities ranging between FY19 and FY20. Debentures with a face value of LKR799.4 million were redeemed during FY17.
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