Fitch places Distilleries on negative watch over restructuring

Fitch Ratings has placed Distilleries Company of Sri Lanka PLC’s (DIST) national long-term rating of ‘AAA(lka)’ on rating watch negative (RWN) following the group restructuring that is currently being completed. 
In August 2016, Melstacorp (MC), a 100 percent subsidiary of DIST, issued new shares to DIST for which the maker of alcoholic beverages paid with a Rs.24.8 billion promissory note. 

The shareholders of DIST are due to swap their shares for shares in MC on September 30, 2016, after which DIST will become a fully-owned subsidiary of MC.
According to Fitch, the rating action 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. 
The rating agency said the resolution of the negative rating watch will depend on how the company manages the promissory note obligation and recapitalises 
the company.
According to Fitch, the financial profile of DIST has weakened as it now has a Rs.24.8 billion 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.
“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,” Fitch noted.
According to Fitch, 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. 
As Fitch pointed out, 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.
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 percent of Sri Lanka’s 
hard liquor. 
“We expect profitability to remain healthy with EBITDAR margin of over 35 percent in the medium term (41 percent in FY16), supported by DIST’s ability to pass on tax increases to the consumer,” Fitch noted.