DIST is the market leader in the manufacture of alcoholic beverages locally through its arrack and other spirits products, accounting for 61% of local alcoholic beverage production (measured in proof litres) and 79% of arrack production in 2011.
The second-largest spirits manufacturer accounted for just 10.4% of 2011 arrack production.
DIST’s beverage product portfolio is diverse across price points, placing the company in a strong position to cater to varying customer preferences and tastes. However, a majority of DIST’s beverage revenues stem from its mass-market-oriented products.
Positive price elasticity of demand has allowed the group to pass on frequent tax increases on alcoholic beverages to consumers with only a limited (and typically short-term) negative impact on consumption. Fitch views this as the key business strength of the company, which operates in a highly regulated industry.
Local regulations limit the issuance of new retail licenses and restrict advertising, impeding the growth of the formal industry as well as the ability of new entrants to gain market share. Fitch believes, however, that the regulator is unlikely to impose rulings that could significantly curtail domestic alcoholic-beverage production, given the industry’s significant contribution to government revenue (2012: Rs 60.1 billion (US$ 471million) or 5.9% of government revenue1).
Net leverage (operating lease-adjusted debt net of cash/operating EBITDAR) sustained above 1.5x (end-9 million FY13: 1.15x annualised), or funds from operations coverage of fixed-charges (including interest and rent) sustained below 4.0x (end-9 million FY13:4.42x), or a structural weakening of DIST‟s competitive position, could result in a downgrade. Net leverage and fixed-charge coverage is calculated to exclude financial services sector debt and interest expenses.
Cash and unutilised bank lines of Rs 1.0 billion and Rs 4.95 billion, respectively, at end-9 million FY13, can be used to pay down Rs 4.1 billion of term debt due in 2013, while good access to local bank funding will facilitate refinancing. We expect DIST to generate positive free cash flow (FCF, after cap-ex and dividends) in the medium term which could help the company deleverage further.
A majority of group debt (Rs 11 billion at FYE12) was short term and revolving in nature. Of this, over RS 8 billion was used to buy stakes in Aitken Spence PLC (SPEN, 39.8% ownership) and acquire 3.6% of John Keells Holdings PLC (JKH, AAA(lka)/Stable), which exposes DIST to moderate refinancing risk in Fitch’s view. We expect DIST‟s working-capital cycle to remain healthy, and expect an estimated Rs 3 billion-Rs 4 billion of working-capital-related debt to be rolled over in the normal course of business.
DIST has been able to sustain moderate volume and revenue growth in the face of high and frequently increasing average selling prices (ASPs) driven largely by the increase in taxes on production volumes. Fitch expects production volume growth to moderate in 2013, driven by higher ASP‟s as the company will probably pass on the frequent tax increases in 2012. However, over the longer term, Fitch expects volume growth to remain in the mid- to high- single digits, and to broadly track Sri Lanka’s per capita income growth.
DIST is the clear industry leader in the manufacture of spirits, accounting for over 61% of alcohol volumes produced in Sri Lanka or 40.3 million proof litres in 2011. For comparison, the second-largest manufacturer, also the largest brewer - Lion Brewery Ceylon PLC - accounted for 13.7% of volumes (estimated at nine million proof litres), while the third-largest producer had a market share of just 10.2% (6.7 million proof litres). Among its products, DIST produced 39.2 million proof litres of arrack, which accounted for 79% of domestic arrack volumes. Sri Lankan Arrack (made from a blend of coconut extract and rectified spirits) is the dominant alcoholic beverage consumed in the country through legal channels. DIST is also the third-largest manufacturer of foreign blends in the country, with production volumes of 1.1 million proof litres in 2011 or a market share of 27%2.
DIST‟s spirits portfolio is diversified across price points. As the incumbent spirits manufacturer, DIST‟s local brands are well entrenched among consumers. This, together with its strong distribution network, and regulations that ban advertising, strengthens its leading market position further. However a majority of its beverage revenues stem from its low-priced mass- market oriented products. DIST is also the sole distributor of global brands for Pernod Ricard S.A. (BBB−/Stable) in Sri Lanka. However, total foreign brands only accounted for about 2% of beverage-sector revenues in FY12.
With rapid urbanization in post-war Sri Lanka, the consumption of ‘soft’ liquor, particularly beer, has increased, and is likely to grow faster than the overall spirits industry. Fitch views this as a long-term business risk for DIST. Nevertheless, soft liquor production accounts for just 11% of aggregate alcoholic beverage volumes produced in 2011. The ban on advertising and constraints on expanding distribution networks are likely to limit a considerable change in the consumption dynamics of spirits versus beer over the medium term.
The local alcoholic beverage industry is highly regulated, governed by the National Authority on Tobacco and Alcohol products (NATA) Act No. 27 which was passed in 2006. Regulation includes banning the public display of trademarks, advertising, and other forms of promotion.
However, displaying the trademark on the product, as well as a notice detailing prescribed dimensions and pricing of products in retail outlets is not considered a violation of these rules.
The regulator has also limited the issuance of new retail licenses. Manufacturing also requires a license.
The impact of high taxes on consumption is partially offset by the relatively inelastic demand for spirits. Taxes on arrack and locally manufactured foreign blends have grown at a CAGR of 15% and 13%, respectively, between 2008 and 2013. In FY11 and FY12, taxes were increased six times, by a two-year Compound Annual Growth Rate (CAGR) of 27%.
Taxes, which are levied at point of production prior to sale, constitute a significant working capital burden on alcoholic-beverage producers, accounting for 68% of DIST’s gross revenue, and 33% of group payables in FY12, and pose a barrier to new entrants.
Heavy taxation and the consequent increase in average selling price impedes demand for legally produced spirits, and encourages the existence of a large illicit spirits market. Demand for illicit liquor stems primarily from the lower-end consumers who may fluctuate between legal and illicit channels in line with macroeconomic cycles. However, illicit liquor is known to pose a greater health hazard than legally manufactured spirits which limits its growth as per capita income increases. The authorities have also increased policing of illicit liquor manufacturers to a greater extent over the years.
Overall, Fitch expects the growth in Sri Lanka’s per capita income to help drive greater use of legal channels. Furthermore, DIST’s particularly strong mass-market (low price) products are also likely to limit the cannibalisation of its market share from illicit alcohol.
DIST expects M&A activity to be lower than in the past. The group has used strong free cash flow generation from its beverages sector to acquire companies, including the state-owned Sri Lanka Insurance Corporation (SLIC) in FY03 - the largest local composite insurer, Apollo Hospitals Limited in FY07 (through SLIC), and Pellawatte Sugar Industries in FY11, all of which were subsequently reacquired by the State in FY10 and FY12, respectively. More recently, in FY12 the company used debt to finance a Rs 11.24 bullion investment in SPEN and JKH.
A substantial increase in contributions to DIST‟s profits stemming from higher-risk businesses could introduce greater volatility in operating cash flows and materially alter the group’s business risk profile, while debt-funded acquisitions could weaken the group’s credit metrics at least in the near term. Fitch treats such occurrences as event risks and will review the group’s ratings as and when any such events are announced.
At FY12, other segments accounted for 16% of gross revenues and 12% of DISTs
consolidated pre-tax profits (excluding associate earnings). The Diversified division, which is made up of mainly DISTs financial services investments, was the largest contributor to profit before tax and associates apart from Beverages in FY12 at 10.7%, followed by Telecom (1.2%) and Plantations (0.3%).
Over the medium term, DIST is likely to focus on expanding its financial services, which include a licensed finance company - Melsta Regal Finance Limited, and a general insurer - Continental Insurance Lanka Ltd. Both these businesses are subject to minimum regulatory capital thresholds and are likely to require capital injections from DIST in line with expected asset growth.
At end-December 2012 Melsta Regal Finance and Continental Insurance had assets of Rs 734.3 million and Rs 1.27 billion, respectively. Melsta Regal’s total regulatory capital adequacy ratio was 154% given that it is a start-up, and well above the regulatory floor of 10%, while the solvency ratio for Continental Insurance as at end-October 2012 was 1.72x (above the regulatory threshold of 1.0x), potentially reducing the possibility that equity injections are required in the near term.