"Fitch views the high and frequent increases in top-line taxes on spirits as a regulatory risk, which has created a large illicit spirits market," the rating agency said in a statement.
"However, the rating factors in the agency's expectation that DIST will benefit in the longer term, as the consumption of legal alcoholic beverages gradually replaces illicit spirits in line with rising per capita income levels in the country.
"However, the agency notes that regulations such as the ban on advertising also impede the natural growth of the legal alcoholic beverages industry to an extent."
The full statement is reproduced below:
Fitch Rates Distilleries Company of Sri Lanka 'AAA(lka)/Stable'
Fitch Ratings-Colombo/Singapore-20 December 2012: Fitch Ratings has assigned a 'AAA(lka)' National Long-Term rating to Distilleries Company of Sri Lanka PLC (DIST). The rating Outlook is Stable.
DIST's rating is driven by its market leadership in the domestic alcoholic beverages (spirits) industry, the relatively inelastic demand for spirits through economic cycles, high entry barriers stemming from the regulatory ban on advertising and licensing constraints (which favour established manufacturers over new entrants), and future growth prospects for the industry amid Sri Lanka's post-war development.
Fitch views the high and frequent increases in top-line taxes on spirits as a regulatory risk, which has created a large illicit spirits market. However, the rating factors in the agency's expectation that DIST will benefit in the longer term, as the consumption of legal alcoholic beverages gradually replaces illicit spirits in line with rising per capita income levels in the country. However, the agency notes that regulations such as the ban on advertising also impede the natural growth of the legal alcoholic beverages industry to an extent.
DIST accounted for a 65% share of local alcoholic beverages produced in 2011 through legal channels, including nearly 80% of Arrack volumes - the major product consumed. The company's brand portfolio is diverse and caters to varying tastes of consumers. However, a majority of DIST's beverage sales are driven by its 'Extra Special Arrack' product, which is targeted at the price conscious consumer. Relatively resilient demand for spirits has helped DIST sustain and improve group EBITDAR margins (FY12 ending March: 33%; FY07: 12.5%), despite frequent increases in top-line taxes by the authorities.
A sustained increase in financial risk, as measured by an increase in the group's financial leverage (defined as lease adjusted debt net of cash / operating EBITDAR, excluding debt at its licensed finance company subsidiary) is a key medium-term risk, and could result from potential debt-funded acquisitions or a substantial weakening in DIST's group EBITDAR margins.
DIST is also exposed to foreign currency risk on any US dollar denominated debt unless adequately hedged, due to the group's limited foreign currency related earnings (approximately 8% of group EBITDAR at FY12). However, Fitch notes that the group's exposure to foreign currency risk through the planned US dollar term loan of approximately USD11m is manageable.
WHAT COULD TRIGGER A RATING ACTION?
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
- Consolidated financial leverage increasing over 1.5x on a sustained basis (end-September 2012: 0.74x annualised),
- Consolidated Fund Flow from Operations coverage of interest and fixed charges such as operating lease rentals weakens to below 4.0x (end-September 2012: 4.03x), on a sustained basis.
- A structural change in the domestic alcoholic beverages industry which 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.