Fitch places Distilleries on rating watch negative

Fitch Ratings has placed Distilleries Company of Sri Lanka PLC’s (DIST) National Long-Term Rating of ‘AAA(lka)’ on Rating Watch Negative (RWN). 

The rating action follows a restructuring in the group. In August 2016, Melstacorp (MC), a 100% subsidiary of DIST, issued new shares to DIST for which the maker of alcoholic beverages paid with a Rs. 24.8 b promissory note. Shareholders of DIST are due to swap their shares for shares in MC on 30 September 2016, after which DIST will become a fully owned subsidiary of MC. 

The RWN reflects the potential for an increase in financial risks to DIST. Fitch believes that this, combined with the risk of higher dividends to MC could lead to a weakening in DIST’s credit metrics. Resolution of the RWN will depend on how the company manages the promissory note obligation and recapitalises the company. 

Fitch expects to resolve the RWN once we are able to fully assess DIST’s capital structure. Although the company plans to complete various transactions impacting its capital structure in the next three months, a resolution of the RWN could take longer than the t29ypical six-month period if these plans are delayed.

Key rating rivers

Rising Financial Risks: The financial profile of DIST has weakened as it now has a LKR24.8bn liability due to the purchase of new MC shares. However, there has been no cash outflow and the company is looking at several alternatives to meet this obligation, including a new share issue by DIST. Following the share swap, DIST will have a negative net asset position as it will write down its investment in MC. In addition, dividends to MC from DIST could also increase, which could put pressure on DIST’s rating. 

Likely to Raise Equity: DIST does not plan to borrow to meet the promissory note obligation and plans to raise new equity, which could contain DIST’s leverage within acceptable levels for its ‘AAA(lka)’ rating. However, if DIST borrows to meet the promissory note obligation, leverage as measured by net adjusted debt to EBITDAR could increase to above 3.0x. 

Historically Conservative Capital Structure: DIST has until now adopted a conservative capital structure as reflected in its low leverage of 0.8x at the end of the financial year to March 2016 (FYE16). The leverage calculation also takes into account group debt guaranteed by DIST. DIST’s borrowings are entirely short-term in nature and fund working capital requirements. Although the company may raise new equity to satisfy the promissory note, MC’s growth plans could rely on increased dividends from DIST, which will restrict DIST’s free cash generation. 

Resilient Business Profile: 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. As of the latest published statistics, DIST produced 67% of Sri Lanka’s hard liquor. We expect profitability to remain healthy with EBITDAR margin of over 35% in the medium term (41% in FY16), supported by DIST’s ability to pass on tax increases to the consumer. 

Key assumptions

Fitch’s key assumptions within the rating case for DIST expect revenue to grow by mid-single digits over the next three years and the EBITDAR margin to moderate to 37% by FY20.

Rating sensitivities

The resolution of the RWN will depend on the details of DIST’s capital structure, which could take longer than the typical six month period if its plans are delayed. This will also be dependent on the plans obtaining the necessary approvals from the shareholders and SEC. 

Negative: The Negative Watch could result in a downgrade if DIST increases its financial leverage to meet its promissory note obligation. The rating may be downgraded by multiple notches if DIST adopts a more shareholder-friendly distribution policy to its new parent, MC.