Fitch Ratings has affirmed Sri Lanka-based Lion Brewery (Ceylon) PLC's National Long-Term Rating at 'A+(lka)'. The Outlook is revised to Stable from Negative. Fitch has also affirmed the National Long-Term Rating on Lion's outstanding senior unsecured debentures at 'A+(lka)'.

The Outlook was revised to Stable because we expect Lion to be able to maintain leverage (defined as lease-adjusted debt net of cash / operating EBITDAR) at less than 3.0x over the medium term. Lion was able to improve its net leverage to 2.7x as of 31 March 2018 (FYE18) from 6.3x at FYE17, helped by the recovery in sales volume and operating profitability. The recovery was underpinned by a revision in excise taxes, which was announced in the Sri Lankan government's budget on 9 November 2017. The revised regime taxes alcoholic beverages with lower alcohol content at reduced rates compared to spirits. 

Fitch rates Lion on its standalone strength due to weak linkages between Lion and its ultimate parent, Carson Cumberbatch PLC, in line with Fitch's Parent and Subsidiary Rating Linkage criteria. Lion's 'A+(lka)' rating reflects its leading market position in the domestic beer industry, which is protected by stringent regulation, a well-established brand and extensive retail coverage. However, the domestic excise tax regime on alcoholic beverage sales changes frequently, which inhibits the industry's profitability. 

KEY RATING DRIVERS

Recovery in Sales Volume: Fitch expects Lion's sales volume to improve in the medium term after excise duties were revised to tax manufacturers of hard liquor at higher rates than beer and wine makers. The Sri Lankan government reduced excise taxes on strong beer by 33%, mild beer by 39% while raising that on hard liquor by 2%, effective from 10 November 2017. Previously, excise duty per unit of alcohol of strong beer was 10% higher than that of hard liquor, which depressed Lion's sales volumes from November 2015 to October 2017, when the previous tax regime was in effect.

Balance Sheet to Strengthen: We believe that Lion's net leverage will remain below 3.0x, the level at which Fitch would consider negative rating action, in the medium term. This is mainly due to improving profitability and likely reduction in capex as the company has adequate brewing capacity to meet growing demand over the medium term. Fitch expects Lion's leverage to continue to improve from the FYE18 level, giving it more headroom for its 'A+(lka)' rating. 

Improving EBITDAR Margin: Fitch expects Lion's EBITDAR margins to improve by around 100bp in FY19, from 27% in FY18, and to stabilise at around 29% from FY20, supported by better sales volume and operating conditions. Lion's EBITDAR margin recovered significantly in FY18 from a low of 19.5% in FY17 when manufacturing was halted temporarily due to floods and Lion had to import inventory at a higher cost. The margin recovery was driven by the company's efforts to recoup some of the lost sales volumes and operational efficiencies that reduced costs. 

Lion's sales volumes and profitability were also helped by the change in the excise tax regime in November 2017.However, margins may be somewhat constrained in the near term because of the depreciating Sri Lanka rupee, which raises the cost of the one-third of Lion's key production inputs that are likely to be imported. 

Market Leadership Position: Lion is the largest beer manufacturer in Sri Lanka, with significant market share in the domestic strong beer market. During FY18, Lion consolidated its market leadership by regaining the shelf space it lost in FY17 due to the temporary halt in production following floods in May 2016. Lion's strong market share is supported by its entrenched brand and widespread retail coverage, with access to 2,800 retail outlets around Sri Lanka. The company's market position is protected to some extent by regulations in the form of stringent restrictions on advertising and limited issuance of new retail licenses. 

High Regulatory Risk: Domestic alcoholic beverage producers face frequent revisions to excise duties, which cause significant operating cash flow volatility. In 2015, the government increased the excise duties on alcohol twice, which led to tax on strong beer overtaking the tax on hard liquor on an equivalent-alcohol basis. This situation was reversed after 24 months, which resulted in hard liquor taxed at 38% more than both strong and mild beer on an equivalent-alcohol basis. We believe any further tax increases will be gradual considering the importance of the industry to government coffers. Excise duties from alcoholic beverage makers made up 7% of government tax revenue in 2017. 

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 previously 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 the manufacturing of personal care and homecare products. 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 Distilleries Company of Sri Lanka PLC (DIST, AAA(lka)/Stable) - the country's largest spirit manufacturer - reflecting DIST's considerably larger operating scale and dominant market position in spirits, which are more widely consumed domestically than beer. DIST has substantially stronger EBITDA margins than Lion as well as lower leverage. 

Richard Pieris & Company PLC (A(lka)/Stable) is rated one notch below Lion, reflecting its weaker business risk profile due to significant exposure to the volatile agriculture segment.

KEY ASSUMPTIONS

Fitch's Key Assumptions Within Our Rating Case for the Issuer
- Revenue to recover with a 23.4% increase in FY19; growth to moderate to a mid-single-digit rate on average over the next three years. 
- EBITDAR margin to modestly improve to 28.3% in FY19 and to stabilise at around 29.0% in the next three years.
- Excise duty on strong and mild beer to remain unchanged during the next two years and increase by around 5% on average during in FY21 and FY22.
- Capex at 4.3% and 8.0% of net revenue in FY18 and FY19, respectively then falling to 2.1% on average over the next two years, mainly for maintenance.
- Dividend of LKR300 million per annum to shareholders in line with historical levels. 

RATING SENSITIVITIES

Developments that May, Individually or Collectively, Lead to Positive Rating Action
- A sustained reduction in Lion's lease-adjusted debt net of cash/EBITDAR to below 1.5x

Developments that May, Individually or Collectively, Lead to Negative Rating Action
- An increase in Lion's lease-adjusted debt net of cash/EBITDAR over 3.0x for a sustained period 

LIQUIDITY

Comfortable Liquidity Position: Lion had a comfortable liquidity position at end-March 2018, with unrestricted cash and cash equivalents of LKR8.1 billion and unutilised credit lines of LKR7.8 billion to meet LKR8.9 billion of debt maturing in the next 12 months. Lion's relatively defensive cash flows and consistent access to bank funding as one of Sri Lanka's largest listed corporates further supports liquidity.