Distilleries Company of Sri Lanka PLC Equity Research Initiation Coverage

Leveraging on inelastic consumption growth BUY Arrack has been a lifestyle alcoholic beverage in Sri Lanka over many years while LOLC SEC Valuation LKR 291.30 experiencing an inelastic demand from a strong habitual consumption amongst Sri Lankans. 12M Tgt Price (excl.dividend) LKR 264.80 DIST being the market leader since its inception supplying Arrack to the local market, we Share Price LKR 216.00 expect the company to reap benefits from the expected per capita income rise backed by Upside/(Downside) 35% inelasticity of the industry and measures taken by 2016 Budget to curtail down illicit and Risk Level Medium illegal liquor. Excessive levies on liquor producers will also barricade small scale liquor (refer page 22 for recommendation) producers to operate in the industry while benefiting DIST. Share Details Investment Considerations Bloomberg Ticker DIST SL Inelastic proxy for consumption growth: Local liquor industry has been a resilient CSE Sector Beverage, Food & Tobacco GICS Sector Consumer Staples performer historically, despite continuous tax hikes. With expected GDP per capita income Market Cap (LKR Mn) 64,800 rise and demand inelasticity, we expect liquor consumption to post modest 1.7% CAGR in Issued Quantity (Mn) 300 medium term while mitigating the risk of possible consumption downturn based on price 30-day avg T/O (LKR Mn) 12.71 hikes. We believe that illicit/illegal liquor consumption to be cut down on tight regulatory Beta (6 months) 1.02 measures while big players will benefit on increased volumes. Accordingly, DIST being the leading Arrack producer could leverage on inelastic consumption growth of Arrack and record strong performance in bottom-line. Investment Fundamentals LKR Bn 12MTrail. 2016(F) 2017(F) 2018(F) Revenue 30.8 31.8 33.8 35.3 DIST, undisputed market leadership: With 67% market share, we estimate to increase its Net Profit 6.9 5.5 7.9 8.4 market share to historical averages (70% by FY18) while Sri Lanka's alcohol consumption S/H's Equity 64.8 69.5 76.2 83.4 and 'budget 2016' to regulate the industry will augur well with DIST in regaining its lost Total Assets 91.9 97.9 105.2 112.8 market share. Proved business acumen of the owner/chairman of the group will contribute to ROA (%) 7 6 8 7 be a key factor in group maintaining its market leadership. ROE (%) 11 8 11 11

'DCSL Arrack', strong brand name attached to local consumers: DCSL has been able to Price Multiples PE (X) 8.90 make a strong foothold in local households through its strong brand name 'DCSL Arrack', PBV (X) 1.06 giving competitive advantage for DIST to stand above the competition. Price to Sales (X) 2.18 Divdend Yield (%) 1.50 Budget 2016 trending positive for DIST: We believe that Budget 2016 will generate positive results for DIST in medium to long run while making the industry more concentrated Price Behavior with few large players. We also expect illicit and illegal liquor consumption to be reduced 330 310 noticeably upon effective implementation of budget proposals, giving a market advantage for LKR 290 270 DIST. 250 230 210 190 Strong balance sheet and low gearing to allow for investments: The Group is fairly low 170 150 geared and hence can conveniently leverage up for prospective investment opportunities. 26-Jan-15 26-Apr-15 26-Jul-15 26-Oct-15 26-Jan-16 DIST Share Price ASI movement (adjusted to DIST base price) SPEN, a sweetener on DIST's value: DIST has an associate investment in Aitken Spence PLC, Per Share Details as at 30.09.2015 (LKR) a blue chip conglomerate owning one of largest locally owned hotel chains having high Earnings per share (trailing 12m) 24.27 profitability. SPEN contributes 23% to DIST valuation. Net Asset Value per share 209.51 Sales per share (trailing 12m) 99.29 Dividend Per Share (trailing 12m) Other businesses: We expect Telco and plantation sectors to drag down DIST's ROEs while 3.25 Business Nature DIST's other diversify businesses to grow in line with GDP growth of the country. Distilleries Company of Sri Lanka PLC the leading hard liquor producers in Sri Lanka.It produces different types of Arrack Valuation products and imports other types of liquor products. It also We assume a cost of equity of 14.34% for our valuation which is a 6% premium on 3 year has other diversified businesses in various industries. treasury bond rate(GOSL), taking into consideration the equity market risk. Accordingly, We have valued the counter using SOTP approach and derived the value of a share at LKR 291.30. Shareholder Details At the current value, counter is trading at a discount to our valuation. We give a Buy Milford Exports Ceylon Lt 41% recommendation for DIST. Lanka Milk Foods Cwe Ltd 13% Yaseen Muzaffar Ali 7% Salient Sections of the Report Shareholders below 5% 33% Inelastic proxy for consumption growth (pg.2)|DIST, undisputed market leadership (pg.4)| Source:CSE, Bloomberg, LOSEC Research DCSL Arrack, a strong brand name (pg.6)|Budget 2016 trending positive (pg.7)| Strong Analyst (s) balance sheet (pg.9)| Telco & Plantation (pg.10)| SEPN, a sweetener on DIST's value (pg.12)| Gayan Rajakaruna Valuation (pg.13)|Sensitivity (pg.15)| Earnings risk comment (pg.15)|Appendices (pg.16 ) +94 117 880837 [email protected] 26 January 16 Recommendation Guidance, Important Disclosures and Analyst Certification: Page 25 Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Inelastic proxy for consumption growth

Distilled alcoholic beverages have become a lifestyle product amongst the male population of the Island nation since 1505 from western colonisation. Today, alcohol industry has become a matured and profitable industry due to Arrack is a lifestyle consistent demand for alcoholic beverages. The beverage segment of DIST which accounts for 66% of group's topline product with consistant and approx. 86% of the bottom-line as at FY15 dominates the market since its inception and supplies high quality demand alcoholic products, predominantly Arrack to local consumers.

In the last decade, Sri Lanka's Arrack consumption has seen a modest growth of 1.4%. This could be largely due to the Arrack consumption to increased penetration of illicit & illegal liquor products to the society and disproportionate growth of taxes compared lag economic growth with disposable income rise.

We estimate recorded Arrack consumption for next 3 years to be inline with 1.7% CAGR by considering expected per

Beverage, Food & Tobacco capita income growth (avg.12%), potential shift from cheaper liquor to legal products on rise of disposable income and curtailing the availability of illicit liquor through tight regulatory controls. Accordingly, we estimate a 3.8 litres Consumer Staples 3.8 litres per capita per capita Arrack consumption by 2018 and it could reach to 4 litres by 2020. There is a positive correlation between Arrack consumption by GDP per capita income growth with arrack consumption pattern, however the correlation can be affected from a mix 2018 shift from local arrack products to foreign hard/soft liquor products when income rises and lifestyle getting improved accordingly.

Graph 01: Arrack consumption maintains a modest growth Graph 02: Correlation of per capita income growth and of 1.4%-1.7% arrack consumption is positive Lr (Mn) USD 90 20% 6,000 35%

80 30% 15% 5,000 70 25% 4,000 60 10% 20% 50 5% 3,000 15% 40 10% 30 0% 2,000 5% 20 1,000 -5% 0% 10

- -10% - -5% 2005 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2010 2011 2012 2013 2014 2015 2016 2017 (F) (F) (F) (F) (F) (F) Per capita income (USD) Arrack consumption YoY growth Arrack consumption (lr) YoY Growth Average GDP per capita YoY growth

Source:Excise Department, WHO, LOLC SEC Estimates Source:Excise Department, WHO, LOLC SEC Estimates, Dept. of Statistics Industry outlook is positive for big players Based on WHO, Sri Lanka's unrecorded alcohol (illicit) consumption is ~40%. By considering a declining trend of number of offences recorded under Excise Dept/NATA, we believe that illicit liquor trade carried out by small Illicit liquor consumption manufactures have been gradually declined over the years. Recorded alcohol consumption of the country is relatively accounts ~40% of total higher than several neighbouring countries and the avg. of South Asia and South-East Asia and also greatly tilted consumption towards to hard liquor (85%) over soft liquor. We expect DIST will benefit from this positive outlook in regaining its lost market share during last three years.

Table 01: Sri Lankans prefer spirits over beer and wine Country Total per Recorded per Beer Wine Spirits capita capita alcohol con. alcohol con. Sri Lanka 3.7 lr 2.2 lr 13% 0% 85% Maldives 1.2 lr 0.7 lr 29% 29% 41% Nepal 2.2 lr 0.2 lr 48% 1% 51% India 4.4 lr 2.2 lr 7% 0% 93% Source:CSE, Bloomberg, LOSEC Research Myanmar 0.7 lr 0.1 lr 83% 6% 12% Thailand 7.1 lr 6.4 lr 27% 0% 73% South Asia Avg 2.1 lr 1.0 lr 33% 5% 45% South-East Asia 2.5 lr 1.8 lr 40% 15% 42% World 6.2 lr 4.7 lr 35% 8% 50% * This is based on 2010 data Source:WHO 2 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Inelastic proxy for consumption growth (cont…)

Demand inelasticity to augur well with DIST's revenue growth

Historically, alcohol industry has seen a demand inelasticity, despite increasing retail prices followed by regular excise duty increases. We expect that our estimate on modest Arrack consumption growth to be further backed by price inelasticity which was witnessed previously while enabling DIST to pass down incremental taxes without significantly deteriorating sales volume. We expect any possible volume decline due to unbearable taxes in coming years to be off set by positive measures introduced by budget 2016 which will enable DIST to regain lost volumes in Demand inelasticity to the recent past. keep sales volume stable despite price increases We derived the existing 'net' and 'gross' selling price per Arrack litre based on historical revenue and production quantity of the company subjected to duties. Net selling price per litre is estimated with 3% CAGR for FY16-18 considering the existing net price, past average growth, expected rise of inflation and premium added over peers (currently LKR 10-20 per bottle). With 2016 budget proposal, topline tax on net selling prices estimated to be increased to avg. 250% from current average level of 202% and we believe that impact of this increase to be reflected by beginning of FY16/17.

Graph 03: Avg. price of 1 lr of Arrack to be LKR 1606 by 2017 Graph 04: People consume Arrack despite price increases LKR per lr Lr (Mn) 1,800 90 1,600 85 1,400 1,200 Price increases has seen minimal 80 impact on consumption 1,000 800 75 600 70 400 200 65 - 2009 2010 2011 2012 2013 2014 2015/162016/172017/18 (F) (F) (F) 60 LKR 648 676 846 959 1,058 1,250 1,332 1,575 1,606 Weighted avg. excise duty per arrack lr per lr (F) Weighted avg. selling price per arrack lr (incl. taxes) Arrack consumption(lr) (F) (F) Weighted avg. selling price per arrck lr (excl. taxes) Linear (Arrack consumption(lr))

Source:Excise Department, LOLC SEC Estimates Source:Excise Department, LOLC SEC Estimates

Source:Excise Department, WHO, LOLC SEC Estimates, Dept. of Statistics DIST caters to 71% of DIST plays a crucial role while catering to 71% of total Arrack consumption in 2014. After making LKR 6bn total Arrack consumpion investment in FY15, now it is fully equipped with modern blending and bottling plant to facilitate a greater capacity.

2 | LOLC Securities Limited 3 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

DIST, Undisputed market leadership

DIST has been operating as the market leader in Sri Lankan hard liquor industry amidst intense competition from other licensed liquor manufactures and the continuous influx of illicit liquor to the market. Based on the annual hard liquor production, DIST has been able to maintain an average 75% market share since 2006. However during last three years, market share of DIST has seen a dip from 76% to 67% and could be largely due to significant infusion of DIST dominates with cheaply priced illegal liquor to the market by certain licenced manufacturers and consumers opting for lower priced avg.75% market share products despite the difference in quality. Such manufacturers have been capable of pricing their products at a discount to the market price through cost savings gained on evading excise and import duties.

Graph 05: DIST has a dominant market share on production Graph 06: Hard liquor market share of top 3 players in 2014 Proof Lr (Mn) 60 85% 55 11% 14% 80% 50 8% 45 75% 40 35 70% 30 25 65% 20 60% 15 67% 10 55% 5 0 50% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 (F) (F) (F) Total production excl. DIST - Proof lr IDL DIST Rockland Other DIST production - Proof lr

Source:Excise Department, LOLC SEC Estimates Source:Excise Department, LOLC SEC Estimates

Though Sri Lanka's recorded Arrack consumption is less volatile historically, there is a drop in last two years which seems to be due to increasing illicit liquor (unrecorded liquor) in the market and price sensitive customers shifting to such liquor in based on disproportionate retail price increases in parallel to their income growth. However we believe Disproportionate taxes that total hard liquor consumption including both recorded and unrecorded consumption to be remained with a on alcohol beverages modest growth of 1% - 2% range due to demand inelasticity for alcoholic beverages. compared with income

Source:Excise Department, LOLC SEC Estimates growth DIST's share on recorded Arrack consumption has registered a drop from 81% to 71% as a result of the drop in recorded Arrack consumption and consumers shifting from DCSL Arrack to other local Arrack brands who have significantly under-priced their products by dodging excise duties and channelling them to retail liquor shops run by same manufactures.

Graph 08: Gvt. imposes more taxes on liquor than peoples' Graph 07: DIST's market share on Arrack consumption income growth Proof Lr (Mn) 60 90% 30%

85% 50 25% 80% 40 75% 20%

30 70% 15% 65% 20 10% 60% 10 55% 5% 0 50% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0% (F) (F) (F) 2010 2011 2012 2013 2014 2015 (F) 2016 (F) 2017 (F)

DIST arrack sales - proof lt Total arrack consumption - proof lr Per capita income YoY growth Excise duty per lr YoY growth DIST share on consumption Average Avg. per capita income growth Avg. per capita excise duty growth

Source:Excise Department, LOLC SEC Estimates Source:Excise Department, LOLC SEC Estimates * Arrack consumption given in bulk litres has been converted to proof litres

3 | LOLC Securities Limited 4 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

DIST, Undisputed market leadership (cont…)

DIST's and its subsidiary Periceyl Ltd. liquor products are mainly classified as Special Arrack, Coconut & Processed Arrack, Molasses Arrack and locally made foreign liquor. In Special Arrack segment, DIST has 82% market share in 2014 while Coconut & Processed Arrack segment secured 47% market share in 2014.

Graph 09: Special Arrack accounts for over 85% of total production volume Proof Lr (Mn) 45 93% 92% 40 91% 90% 35 89% 30 88% 87% 25 86% 85% 20 84% 15 83% 2007 2008 2009 2010 2011 2012 2013 2014 Special Arrack Coconut & Processed Arrack Molasses Arrack

Country Made Foreign Liquor % Special Arrack on total production

Source:Excise Department, LOLC SEC Estimates

Market share forecast of DIST

In terms of hard liquor consumption, the industry has seen a modest growth of 1.4% since 2005 due to the stagnant Source:Excise Department, LOLC SEC Estimates Gvt. to support on consumers' purchasing power on liquor led by disproportionate excise duty increase. During last 3 years, hard liquor curtailing illicit/illegal industry saw a decline in recorded production and consumption largely due to populating illegal and illicit liquor liquor significantly. There could also be a slight impact from substitution effect of beer, deteriorating hard liquor consumption. However, we believe that steadfast loyalty towards liquor consumption along with Gvt. support on curtailing down illicit/illegal liquor will enable DIST to compete in the legitimate alcoholic beverage business with more equal term.

DIST's market share to We estimate that DIST will be able to regain lost sales volume during next three years based on tightened government reach 70% by FY18 policies to regulate liquor industry which will lead to deteriorate small players' share in the industry and to concentrate it with few large players (refer page 07). Further small manufactures will lose pricing advantage created on untaxed/low-taxed ethanol and liquor, enabling DIST's products to be more price competitive and thereby increasing sales volumes. Thus we estimate DIST's market share to reach 70% by FY18 from 67% recorded in FY15. Competetive advantage Specially company's leadership; Mr. Harry Jayawardena has shown a strong business acumen over the years to on its leadership maintain the market leadership in the highly profitable industry, even during the adverse environments.

Source:Excise Department, LOLC SEC Estimates

4 | LOLC Securities Limited 5 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

"DCSL Arrack" a strong brand name attached to Sri Lankan consumers

We believe that strong brand name of Distilleries which has been built over last couple of decades is the greatest strength of the company for its continued success. DCSL has been able to make a strong foothold in Sri Lankan households through its strong brand name "DCSL Arrack" while its unique taste and affordable "kick-per-buck" have DCSL amongst most made an inerasable image amongst Sri Lankan consumers. Proving its brand strength, DCSL has been honoured valuable brands within top fifteen most valuable brands (Brand value - LKR 9602 Mn) and one of the most valued corporate entities of the country.

Diagram 01: DCDL has a strong brand image and diverse portfolio of Arrack products

Source:Excise Department, LOLC SEC Estimates

Source:DIST Annual Report 2015

National Authority on Tobacco & Alcoholic (NATA) Act prohibits advertising and promoting alcoholic brands which has created a platform for DIST to stay resilient amidst hefty competition since peers also can not promote their DIST has a regulatory brands or products through any form of media while DIST has already been maintaining well established and reputed advantage brand name over the years. This will naturally be an entry barrier for new comers as well preventing them to promote their products. Accordingly, this regulatory barrier will essentially create a competitive edge for DIST over its peers to dominate the industry.

Table 02:Most valuable brands of food & beverage sector in Sri Lanka

Company Rank Brand Value Brand (USD Mns) Rating NEST 7 139 AA- CARG 8 122 AA LION 10 114 AA- DCSL 13 67 A- CCS 22 35 AA- HARI 50 8 A- KFP 54 6 A+ BFL 63 5 BB LMF 66 5 BBB CONV 72 4 A-

Source: Brand Finance

5 | LOLC Securities Limited 6 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Budget 2016 trending positive for DIST

*Minimum excise duty of LKR 250 mn per month

Budget 2016 has proposed to impose a minimum excise duty of LKR 250 mn per month (LKR 3 Bn/year) from liquor manufactures which will adversely affect small manufactures while benefiting big players like DIST. In 2014, DIST accounted 66% out of total duties of LKR 52.55 bn paid for hard liquor while 11% came from small manufacturers whose contribution were less than LKR 3 Bn per year. However, assuming that what is declared by them holds true, most of the small players are likely to be wiped out from the industry upon implementation and 11% to be even out 16 out of 20 licenced amongst top few players. arrack producers pay below LKR 250 mn per However reality may deviate from the estimates as there is a considerable volume of illegal supply which are not month taxed/disclosed and thus paying below this threshold eroding Gvt revenue though they have the capacity pay proper tax amount. Upon effective implementation, a policy of this nature will enable such illegal players to pay more taxes in the future and thereby preventing them to price liquor products way below the market rate. However as per various sources, there is a court case pending against this and may not come to effect in short term. But current Gvt is considered to be aggressive on revenue collection and thus we believe this policy to be gradually effective with some amendments and eventually leaving the industry more concentrated with big players.

Graph 10: Small liquor producers account only 11% of total Graph 11: Small manufactures with 11% market share pay duty payment below LKR 250 mn

11% 11%

9% DIST+Periceyl

International Dist. Top 3 contributors

14% Rockland Contributors

89%

Source:Excise Department Source:Excise Department

*Single annual licence fee of LKR 50 mn

It was proposed to impose a flat annual license fee of LKR 150 mn for liquor manufacturers irrespective of volume could adversely affect the small companies who do not have a strong scale of production volume. However as per Small liquor producers "Excise Ordinance Notification No.983", this fee has been brought down to LKR 50 mn per annum. We believe that have to increase price to new fee is more affordable for medium size and big firms while small liquor manufacturers to find ways absorb this absorb incremental cost incremental cost.

*Foolproof sticker - positive for DIST upon effective execution

As per budget proposal 2016, every tax paid liquor bottle must be labelled with a fool-proof sticker enabling a visual Foolproof sticker to identification for the excise officers in identifying the tax paid liquor bottles. The decision is favourable to DIST, but curtail illicit liquor while unregulated liquor being curtailed down, we believe that the execution should be effective and free from systematic loopholes to get rewards.

6 | LOLC Securities Limited 7 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Budget 2016 trending positive for DIST (cont…)

*Annual manufacturing license fee of LKR 150 mn for each distillery

Gvt proposed to increase the annual manufacturing license fee for each distillery owned by the manufacturer to LKR 150 mn through 'budget 2016'. Subsequently, as per "Excise Notification No.983", it has been reduced to LKR 100 mn. However, this is not effective yet and as per Excise Department and "Daily Mirror on 26.12.2015" and few other Proposed license fee for publications indicated that the Gvt. is to withdraw this decision due to the plea made by liquor producers based on each distillery may not be possible collapse of many liquor manufacturing companies if this was implemented. Accordingly, it is likely that this implemented will not be effective and thus we have not factored the negative impact to our valuation.

If this becomes effective, DIST may have to pay LKR 300 mn for two distilleries. We believe that DIST and other players will accordingly increase price to pass cost to consumers.

*Income tax rate to be reduced from 40% to 37.5%

2.5% decline in corporate With the introduction of 30% corporate tax rate and 25% of surtax for liquor industry, the total effective income tax tax will be estimated as 37.5%. This will be a 2.5% drop from the existing rate of 40% enabling DIST to have a positive impact on its bottom-line. However it remains high compared to other industries which is 15%-30%.

*Increased custom and excise duties on foreign liquor, beer and imported ethanol

Gvt has increased the total tax burden (mainly on custom import duty) of imported foreign liquor from LKR 1850/lr to LKR 2500/lr while adding further 70% as excise levy. This will make foreign liquor further costly and consumers will tend to shift to country made foreign liquor or Arrack supporting local producers like DIST to gain market share.

On a negative note, company has to incur an additional cost due to increased import duties on ethanol (from LKR 300/lr to LKR 400/lr), since 50% of ethanol required for DIST's production is imported while the rest is produced DIST's cost of production locally. Production cost will be further affected due to Rupee depreciation as ethanol cost accounts to 40% of cost of will increase production. Thus we estimate that cost of production of one proof lr of Arrack to record a 4% CAGR over next three years from the current weighted avg. cost of LKR 303 in order to absorb expected cost increase.

Source:Excise Department

*Imposing higher percentage of excise duties on beer over hard liquor

Percentage growth of excise duties imposed on strong and mild beer based on 'October and November 2015 price Beer to take a greater hit revisions' are considerably above those on hard liquor. Thus beer manufactures will be pushed to increase prices at a from budget 2016 higher percentage compared to liquor manufactures to reflect the revised taxes, which could negate beer demand and substitution effect on hard liquor.

Graph 12: Excise duty growth % of beer is greater than Arrack 45% 40% 35% 30% 25% 20% 15% 10%

5% Excise Excise duty growth% 0% Nov-14 Oct-15 Nov-15 Arrack Foreign liquor Mild beer-alcohol vol.<5% Strong beer-alcohol vol.>5%

Source: Excise Department, Parliament Gazettes 7 | LOLC Securities Limited 8 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Strong balance sheet and low gearing to allow for investments

DIST has been able to generate strong free cash flow balances and gearing has continued to be below 23% over last three years which will open up further avenues for raising debt to venture into new projects. We don't expect any DIST maintains strong significant debt financing in years ahead since a LKR 6 Bn investment for a blending and bottling plant has been cash base and low already made and expect DIST to maintain the same low level of gearing for next three years. Its cash balance gearing (combined with cash in hand and short-term investments) by FY15 is LKR 6.5 bn which is significant compared to most of the Sri Lankan corporates. Thus DIST has appeared to be a self-financed business during previous years while indicating its capability of internal capital formation for capital investments.

Graph 13: DIST has a low gearing ratio and sound asset base Graph 14: Low gearing over listed peers LKR Mn 120,000 Gearings ratio are below 30% 180% 25% and declining 110,000 160% 100,000 25% 140% 90,000 80,000 20% 120% 70,000 100% 60,000 15% 80% 50,000 40,000 10% 60% 30,000 40% 20,000 5% 20% 10,000 - 0% 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2010 2011 2012 2013 2014 2015 (F) (F) (F) Cash and cash equivalents Total Assets Gearing DIST LION BREW

Source: Bloomberg, LOLC SEC Estimates Source:DIST Annual Report, Bloomberg

Out of the largest companies in terms of asset base (excluding bank, finance & insurance sector), DIST has been amongst the top ten listed companies.

Graph 15: Total asset value comparison

240 220 200 180 160 140 120 100 80 60 40 20 0 JKH CARS BUKI VONE SLTL DIAL DIST HAYL SHL BREW LION

Source:DIST Annual Report, Bloomberg

8 | LOLC Securities Limited 9 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Telecommunication and Plantation sectors, dragging DIST's ROEs

DIST's full owned subsidiary "Lankabell Private Ltd." mainly operates in fixed telephony and broadband segments of the country which are intensely competitive and dominated by two telecom giants SLTL and DIAL. It has been pioneering CDMA technology in local market with 25% market share in fixed lines and has recently introduced its 4G LTE network on a bandwidth of 25 MHz in the 2.3 GHz spectrum which is the most sought after brand in the Asian region. Lanka Bell's fixed telephony market share is Lanka Bell's fixed telephony (CDMA) segment has seen a continuous decline of its market (subscriber base) over the deteriorating past three years due to consistent market growth of SLTL through its economies of scale and rapid growth of mobile telephony usage over fixed lines in Sri Lankan households . Thus we believe that fixed line segment of Lanka Bell will continue to see pressure on performance.

Graph 16: Lanka Bell's CDMA market share is dropping Graph 17: Fixed broadband market is growing

70% 3,000,000

60% 2,500,000 50% 2,000,000 40% 1,500,000 30% Fixed broadband 1,000,000 Source:DIST Annual Report, Bloomberg 20% subscribers growing by 19% CAGR 10% 500,000

0% - 2012 2013 2014 2009 2010 2011 2012 2013 2014

SLTL DIAL Lanka Bell Fixed Mobile YoY Growth

Source:SLTL & DIAL annual reports, TRCSL, LOLC SEC Estimates Source:SLTL & DIAL annual reports, TRCSL, LOLC SEC Estimates

Lanka Bell could see a potential in its data business through 4G LTE network as the country has seen a rapid growth of internet usage over the years. Proving market's growth potential, fixed broadband subscribers have increased at Lanka Bell has potential 19% CAGR since 2010. However, Lanka Bell has a uphill task of capturing a strong market share to make a recovery in growing data business from loss territory as other two leading players, DIAL and SLTL aggressively operate to increase their share of data market.

Plantation sector

Plantation sector of DIST entails Balangoda Plantations PLC (BALA), a subsidiary with 43.23% ownership and Madulsima Plantations PLC (MADU), an associate business with 45.9% holding. BALA recorded a loss of LKR 95 mn by FY15 and LKR 310 Mn loss has already been incurred for 9MFY16, signalling a possible performance decline in Negative outlook of years ahead. MADU also follows a similar loss making pattern while deteriorating the contribution from associate plantation industry businesses to the Group. With the down turn of global tea prices and increase in cost of production on wage increases curtails growth prospects of plantation sector workers, we expect plantation sector to generate negative earnings and thus affecting DIST's bottom-line in FY16,17 and 18. Source:DIST Annual Report, Bloomberg

9 | LOLC Securities Limited 10 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Telecommunication and Plantation sectors, dragging DIST's ROEs

Graph 19: Tea export price decline and cost of production Graph 18: BALA and MADU has incurred losses increase make losses for plantation companies LKR Mn 300 20% 30% 15% 200 20% 10% 100 10% 5%

- 0% 0% 2010 2011 2012 2013 2014 2015 (9M) 2009 2010 2011 2012 2013 2014 2015 (100) -5% -10% -10% (200) -20% -15% (300) -20% -30% (400) YoY Growth of tea export price (LHS) YoY Growth of cost of production (LHS) BALA MADU Margin per kg (RHS)

Source:BALA & MADU Annual Reports, Bloomberg Source: CBSL Annual Report, LOLC SEC Estimates

Diversified sector will reduce dependency on Arrack business

Diversified business segment of the Group has been yielding positive earnings for last four years with a 33% CAGR of PBT. Its contribution to the total revenue is 18% and 6% to Group's earnings. Group's restructuring program to consolidate subsidiaries and associates under Melstacrop has seem to be paid off well in terms of improved financial performance and enhancing the contribution from non-alcoholic sector while reducing the Group's dependency on Diversifed segment to liquor business. grow with GDP growth Diversified segments contains variety of businesses under 19 subsidiaries while Insurance (Continental Insurance), Financial Services (Melta Regal), Leisure (Herittance Negambo) and power generation (Bogo Power) being the key Source:SLTL & DIAL annual reports, TRCSL, LOLC SEC Estimates contributors of the segmental performance. This segment is highly diversified, we expect the segmental performance to improve in par with the economic growth (GDP) potential of the country.

Graph 20: Diversified segment to grow inline with expected GDP growth LKR Mn 4,500 14% 13% 4,000 12% 12% 11% 11% 12% 3,500 11% 10% 3,000 9% 2,500 8%

2,000 6% 6% 1,500 5% 4% 1,000 2% 500

- 0% 2010 2011 2012 2013 2014 2015 2016(F) 2017(F) 2018(F) Diversified revenue GDP growth % of segment contribution to revenue

Source:DIST annual reports, LOLC SEC Estimates

10 | LOLC Securities Limited 11 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Aitken Spence PLC - A sweetener on DIST's value

DIST has invested in Aitken Spence (SPEN) as an associate business owning 43.07% of this blue chip diversified conglomerate with main exposure to tourism through Aitken Spence Hotel Holdings PLC (AHUN). With post war tourism boom in Sri Lanka along with tourism growth in Asian region, SPEN has been able to generate 9% average SPEN is one of the largest annual earnings growth during last five years mainly through its high profitable hotel business. Currently, its tourism blue chip conglomerate segment account for 75% of its net earnings and rest is derived from various businesses in power, logistic and services industries.

Graph 22: Earnings composition of SPEN's business Graph 21: SPEN's tourism segment has superior profitability segments

14 2% 12 10%

10 13% 8

6 Source: CBSL Annual Report, LOLC SEC Estimates 4

75% 2

- AHUN CONN AHPL JKHL SHOT

AHUN CONN AHPL JKHL SHOT Tourism Maritime & Logistics Strategic investments Services

Source: Bloomberg Source: SPEN's Annual Report 2015

We expect SPEN to post a 20% average earnings growth in next three years for equity holders which will be largely AHUN's room inventory driven by the growing number of tourist arrivals inline with ongoing capacity expansion of its tourism segment, will increase from 2141 despite political turmoil of Maldives resulting to see a earnings decline in last two quarters. AHUN's room capacity to total of 3145 will increase from 2141 to total of 3145 by 46% by 2018 and we estimate 75% earnings contribution derived from tourism segment for next three years.

Graph 23: Tourism segment of SPEN to grow with industry Graph 24: AHUN's room inventory to reach 3145 rooms by growth in Sri Lanka & Maldives 2018 and continue to be the second largest hotelier LKR Mn # of rooms 2,500 50% 3500 45% 3145 rooms by 2018 3000 2,000 40% 35% 2500 1,500 30% 25% 2000 1,000 20% 15% 1500 500 10% 5% 1000 0 0% 2010 2011 2012 2013 2014 2015(E) 500 Earnings YoY Tourist arrival growth in Sri Lanka 0 YoY tourist arrival growth in Asia & Pacific AHUN CONN AHPL & JKHL CHOT SHOT

Source: SLTB, Ministry of Tourism Maldives Source: Company annual reports, LOLC SEC Estimates

SPEN 's growth to DIST carries SPEN its book at LKR 7.45 Bn. We expect SPEN to generate superior earnings as a diversified holding continue, adding value backed by tourism growth potential in the region and expected GDP growth in Sri Lanka and thereby add significant to DIST value to DIST in years ahead.

11 | LOLC Securities Limited 12 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Valuation

We have used the 'Sum of the Parts' (SOTP) approach in deriving the valuation for DIST. Accordingly we estimate total valuation for the company at LKR 87.37 billion. We assume a cost of equity of 14% which is 6% premium to 3 year Sri Lanka Govt Treasury Bond Yield. A risk premium of 6% has been taken considering the equity market risk in CSE. We have taken a mid-term growth (4-6 years) of 3% and a free cash flow terminal growth (>6 years) of 1% of valuing beverage segment. Accordingly, we value the share at LKR 291.30 which is a 35% discount to the current price of the share. At the current share price, DIST is trading at forward PE of 8.2X and a forward PBV of 0.9X.

Sensitivity of valuation for Terminal Growth and Cost of Equity is indicated below and sensitivity of key assumptions are evaluated separately in proceeding section.

Table 03: Valuation Sensitivity Matrix

Cost of Equity Share price in LKR 12% 13% 14% 15% 16% 0.5% 241 234 227 221 216 0.8% 281 269 259 250 243 1.0% 320 304 291 280 270

Rate

Growth Growth 1.3% 359 340 324 309 297 Terminal 1.5% 398 375 356 339 324

Source:CSE, Bloomberg, LOLC SEC Estimates

Table 04: SOTP Valuation of DIST Source: SPEN's Annual Report 2015 Segment Equity value (LKR Mn) Value per Share (LKR)

Beverages 48,754 163 Plantation 521 2 Telecommunication 4,684 16 Diversified 5,612 19 Associate Investments: SPEN 20,238 67 MADU 667 2 Investments on financial assets 17,654 59 Cash 2,048 7 Group's debt (adjusted for NCI) (12,810) (43)

Total Equity Value of DIST 87,369 291

Source:LOLC SEC Estimates

Table 05: Peer Comparison

Name Market Cap (USD Mn) PE (x) PBV (X) Dividend ROE % Yield % Distilleries Co Of Sri Lanka (Sri Lanka) 450 9.43 1.03 1.50 11.17 Lion Brewery Ceylon Plc (Sri Lanka) 300 26.68 4.86 0.74 19.65 Ceylon Beverage Holdings Plc (Sri Lanka) 110 18.52 3.54 1.06 20.68 Source: Company annual reports, LOLC SEC Estimates Radico Khaitan Ltd (India) 220 30.04 5.79 0.72 21.80 Hite Jinro Co Ltd (South Korea) 1608 55.08 1.46 3.62 2.59 Takara Holdings Inc (Japan) 1552 26.40 1.30 1.31 5.11 Luzhou Laojiao Co Ltd-A (China) 4476 30.74 2.92 3.81 9.51 Thai Beverage Pcl (Thailand) 11667 15.65 3.87 3.72 26.17

Source:CSE, Bloomberg, LOLC SEC Research

12 | LOLC Securities Limited 13| LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Valuation (cont…)

In valuing DIST, we applied Sum of the Parts (SOTP) analysis approach based on several valuation techniques in valuing respective segments of SOTP model which is illustrated in Table 04.

Beverage segment We have valued the beverage segment by applying the Residual Income method, applying a 14.34% required rate of return which comprised with 8.34% risk free rate and a market risk premium of 6%. We have estimated a 3% medium term residual income growth (4 -6 years) of the beverage segment by applying a discount to the expected per capita income growth and considering stable profit making ability inherited in the hard liquor industry. 1% terminal growth rate has been applied by considering the flat growth rate of arrack consumption in valuing the beverage segment. Accordingly, we valued the segment at LKR 48,754 Mn while generating a LKR 163 per share.

We have estimated already paid total super gain tax liability and factored in FY16 earnings which has resulted a considerable drop in net earnings estimated for FY16. Effective corporate tax of 37.5% has been applied in forecasting net earnings of the beverage segment.

Plantation Balangoda Plantation (BALA) is largely in to tea plantation and therefore we valued the segment based on PBV multiple method by considering the sector average PBV derived from selected set of counters which are predominantly into tea plantation. We valued Madulsima Plantations (MADU-associate business) in the same manner adjusting it for Melstacrop's stake.

Telecommunication For telecommunication segment, we have applied EV/EBITDA multiple method discounted to the average EV/EBITDA of two listed players (SLT & DIAL). We used a 20% discount to the average EV/EBITDA considering Lanka Bell's market share drop, loss making scenario over last three years and SLT & DIAL dominance in local data business.

Diversified Diversified segment of DIST has been into many business segments and Melstacrop Limited operates as the holding entity of these widespread businesses. We believe that this business segment has similar characteristics of holdings companies listed under diversified sector of CSE. Accordingly we valued the segment based on PE multiple method considering sector average PE. We adjusted the derived equity value for DIST's effective ownership of Browns Beach Hotel.

Investments on financial assets Short term and long term financial assets are valued on the estimated market value as at December 31, 2015.

Associates: SPEN Source:LOLC SEC Estimates In valuing SPEN, We used market multiple method and applied an average of weighted average 'Hotel' and 'Diversified' sectors PE and PBV multiples for its trailing 12M earnings for common equity holders and for the current book value. We expect a 75% to 25% earnings mix from both hotel and diversified segments and weighted sector multiples accordingly. In deriving weighted hotel sector multiples, we selected only leading hoteliers who hold hotel chains locally and overseas. We adjusted the DIST's ownership of 43.07% for the average value derived from both multiples and derived the value of DIST's stake of SPEN as LKR 20,238 Mn.

Source:CSE, Bloomberg, LOLC SEC Research

13| LOLC Securities Limited 14 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Summarized Sensitivity of Assumptions

Graph 25: GDP per capita growth sensitivity: Medium Graph 26: Currency sensitivity on beverage seg.: Medium LKR LKR 298 296 296 294 294 +2% 292 292 +1.5% 290 290 288 -2% -1.5% 288 286 284 286 282 284 280 278 282 -1% 0 1% -1% 0 1% Change of GDP per capita income growth forecast USD:LKR forecast

Source:LOLC SEC Estimates Source:LOLC SEC Estimates

Graph 27: Corporate tax sensitivity on beverage seg.: Medium Graph 28: Tourist arrivals sensitivity on SPEN: Medium LKR LKR 296 298 296 294 +2% +1% 294 292 292 290 -1% -2% 290 288 288 286 284 286 282 280 284 278 -1% 0 1% -1% 0 1% Change of corporate tax on liquor forecast Change of average tourist arrival growth rate forecast

Source:LOLC SEC Estimates Source:LOLC SEC Estimates Earnings Risk Comment Sri Lankan liquor industry is exposed to considerable regulatory risk due to regular import and excise duty hikes to increase Gvt's tax revenues. As a result, licensed liquor manufactures are often compelled to increase selling prices by passing incremental costs to consumers to maintain their margins. To a certain extent consumers will not be price sensitive due to drinking necessity, however when price rises become greatly disproportionate to disposable income growth, price sensitive consumers tend to shift to low priced soft and illicit liquor products.

Currently, industry has an entry barrier from regulation. If Gvt. decided to liberalize the industry, it will lead the industry to be more competitive and deteriorating market share of the existing players. Further, inline with country's growth if Gvt removed hefty taxes and import restrictions enforced on foreign liquor enabling Sri Lankans to consume high quality foreign liquor, DIST as the market leader will face a significant risk of losing its market share.

As a national initiative if the Gvt enforces restrictions on liquor supply to the market or a complete halt of liquor production and consumption due to rising health implications and religious/social pressure for such closure, DIST as the largest player will certainly plunge to liquidating position. But tobacco and liquor industry being the second highest contributor to the Gvt. revenue makes it a highly unlikely enforcement.

Longer term demographic and lifestyle changes could also affect future earnings of DIST as liquor is highly correlated with social & cultural acceptance . Over the years, Sri Lankan elderly and female population have been growing over young males lowering demand for hard liquor. Elderly people do not tend to consume liquor on for better health while females would not consume liquor on cultural norms. Some religions have stricter principles on liquor consumption which will essentially create a risk of deteriorating demand when their population is growing at a higher rate. However, we foresee these demographic changes as more long term driven and somewhat distant from medium term impact. As part of lifestyle changes, a considerable increase in soft liquor (beer and wine) consumption is also witnessed in the recent past along with rise of disposable income, creating a substitution effect on hard liquor. We believe that the DIST's market share to be protected from this shift due to demand inelasticity and brand loyalty towards 'DCSL Arrack'.

In summary, We don't see a much risk of losing a substantial market share of DIST in short to medium term, despite regular Gvt. tax hikes which will be soften by consumption inelasticity. Therefore with expected modest growth of the liquor industry, we are confident that DIST will not run into significant risks in medium term.

14 | LOLC Securities Limited 15 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Appendices

Table 06: Return comparison S&P SL 20 DIST ASI Index LION % Index 3 months -21.45 -10.67 -13.82 -14.29 6 months -23.19 -12.95 -18.98 -13.04 YTD -12.20 -8.22 -9.02 -14.29 1 year -6.49 -13.51 -19.48 -12.20 Source:CSE, Bloomberg Graph 29: Share Price Movement 5,000,000 Volume Price 350 Highest Price at 11.05.2015: LKR 310.20 4,000,000 3 Year Lowest Price as at 05.04.2013: LKR 160 SMAVG (50) SMAVG (100) 300

3,000,000 250 Rs 2,000,000 200 Source:LOLC SEC Estimates Volume 1,000,000 150

- 100

100.00 RSI (14) 75.00 50.00 25.00 0.00 1/26/13 7/26/13 1/26/14 7/26/14 1/26/15 7/26/15 1/26/16 Source:CSE, Bloomberg

Graph 30: PE Chart Graph 31: PBV Chart

14.0 1.6

12.0 1.4

Source:LOLC SEC Estimates 10.0 1.2

8.0 1.0

6.0 0.8

4.0 0.6 1/26/13 7/26/13 1/26/14 7/26/14 1/26/15 7/26/15 1/26/16 01/26/13 07/26/13 01/26/14 07/26/14 01/26/15 07/26/15 01/26/16 PE ratio Highest Average Lowest PBV ratio Highest Average Lowest

Source:CSE, Bloomberg Source:CSE, Bloomberg

Graph 32: Price per Sales Graph 33: Dividend Yield

3.5 2.1 1.9 3.0 1.7 2.5 1.5 1.3 2.0 1.1 0.9 1.5 0.7

1.0 0.5 1/26/13 7/26/13 1/26/14 7/26/14 1/26/15 7/26/15 1/26/16 1/26/13 7/26/13 1/26/14 7/26/14 1/26/15 7/26/15 1/26/16 Price to Sales ratio Highest Average Lowest DIST dividend yield Highest Average Lowest

Source:CSE, Bloomberg Source:CSE, Bloomberg

Graph 34: CSE PE Chart Graph 35: CSE PBV Chart

16.0 1.8 15.0 1.8 14.0 1.7 13.0 1.7 1.6 12.0 1.6 11.0 1.5 10.0 1.5 9.0 1.4 1/26/13 7/26/13 1/26/14 7/26/14 1/26/15 7/26/15 1/26/16 8.0 01/26/13 07/26/13 01/26/14 07/26/14 01/26/15 07/26/15 01/26/16 ASI PBV ratio Highest Average Lowest ASI PE ratio Highest Average Lowest

Source:CSE, Bloomberg Source:CSE, Bloomberg 15 | LOLC Securities Limited 16 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Table 07: Financial Summary Forecast Figures in LKR Mn (31st March) FY 13 FY 14 FY 15 FY 16 (E) FY 17 (F) FY 18 (F) Income Statement Gross Revenue 65,790 63,186 66,765 77,387 94,918 99,504 Net Revenue 28,766 28,983 28,693 31,841 33,838 35,257 Cost of Revenue (15,898) (15,219) (16,234) (16,966) (18,159) (19,167) Gross Profit 12,869 13,764 12,459 14,876 15,678 16,090 Operating Expenses (6,190) (6,084) (5,568) (6,160) (6,599) (6,947) Operating Income 7,059 7,680 7,302 9,054 9,452 9,553 Share of profit of equity accounted invt 1,292 1,440 1,391 1,506 1,752 2,236 Pretax Income 8,084 9,494 9,728 11,272 11,750 12,232 Income Tax Expense (2,826) (3,263) (3,254) (3,662) (3,749) (3,748) Net Profit att. to shareholders 5,140 6,122 6,553 5,485 7,907 8,386

Balance Sheet Cash & Near Cash Items 4,843 3,924 6,505 5,789 6,815 7,803 Accounts & Notes Receivable 1,601 4,017 3,300 3,652 3,892 4,055 Inventories 6,140 4,436 4,984 5,195 5,575 5,884 Total Current Assets 21,469 21,755 23,791 23,638 25,284 26,744 Total Long-Term Assets 57,078 61,987 68,898 74,271 79,897 86,050 Total Assets 78,547 83,742 92,689 97,909 105,181 112,795 Accounts Payable 1,276 941 1,210 1,261 1,353 1,428 Other Short-Term Liabilities 21,771 22,719 22,368 22,690 22,945 23,130 Total Current Liabilities 23,047 23,660 23,577 23,951 24,298 24,558 Total Long-Term Liabilities 2,787 2,489 4,287 4,465 4,660 4,875 Total Liabilities 25,834 26,148 27,865 28,416 28,958 29,433 Share Capital 300 300 300 300 300 300 Retained Earnings & Other Equity 47,678 53,336 60,704 65,373 72,103 79,241 Total Equity 52,713 57,593 64,824 69,493 76,223 83,361 Total Liabilities & Equity 78,547 83,742 92,689 97,909 105,181 112,795

Cash Flow Statement Net Income 5,140 6,122 6,553 5,485 7,907 8,386 Depreciation & Amortization 1,700 1,540 1,575 1,990 2,168 2,330 Changes in Non-Cash Capital (832) (2,666) (1,598) (511) (528) (397) Cash From Operations 5,054 4,823 4,693 6,964 9,547 10,318

Capital Expenditures (2,594) (4,812) (10,271) (4,000) (4,000) (4,000) Increase in Investments (270) (1,636) - 575 (2,043) (2,247) Cash From Investing Activities (3,154) (7,251) (3,851) (4,931) (7,794) (8,483)

Dividends Paid (891) (898) (975) (816) (1,176) (1,248) Change in Long Term Borrowings (686) (965) 1,086 178 195 215 Cash from Financing Activities (1,486) (1,800) 154 (316) (726) (848) Net Changes in Cash 414 -4,229 996 1,716 1,026 988

Source:CSE, Bloomberg, LOLC SEC Estimates

16 | LOLC Securities Limited 17 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Table 08: Forecast Ratios FY 13 FY 14 FY 15 FY 16 (E) FY 17 (F) FY 18 (F) Profitability Ratios GP Margin (%) 45% 47% 43% 47% 46% 46% NP Margin (%) 18% 21% 23% 17% 23% 24% ROE (%) 11% 11% 11% 8% 11% 11% ROA (%) 7% 7% 7% 6% 8% 7% Earnings per share (LKR) 17.13 20.41 21.84 18.28 26.36 27.95 Dividend per Share (LKR) 3.00 3.25 3.25 2.72 3.92 4.16

Credit Ratios Total Debt/Equity Ratio (%) 23% 25% 23% 22% 20% 19% Interest Coverage (X) 4.3 6.3 10.5 9.2 8.1 7.1 Total Assets/Equity (X) 1.6 1.6 1.5 1.5 1.5 1.4 Net Debt/EBIT (X) 0.9 1.2 1.3 0.9 0.8 0.8

Liquidity Ratios Current Ratio (X) 0.9 0.9 1.0 1.0 1.0 1.1 Quick Ratio (X) 0.7 0.7 0.8 0.8 0.8 0.8 Asset Turnover Ratio (X) 0.4 0.3 0.3 0.3 0.3 0.3 Net Asset Value per share (LKR) 160 179 203 219 241 265

Growth Ratios Revenue Growth YOY% 7% 1% -1% 11% 6% 4% Earnings growth YOY% -7% 19% 7% -16% 44% 6% Total Assets YOY% 7% 7% 11% 6% 7% 7% Total Debt YOY% -10% 20% 3% 4% 3% 3%

Investment Ratios PE Ratio (X) 9.72 9.95 11.01 11.81 8.20 7.73 Price to Book Value (X) 1.04 1.14 1.18 0.99 0.89 0.81 Dividend Yield (%) 1.80% 1.60% 1.35% 1.26% 1.82% 1.93%

Source:CSE, Bloomberg, LOLC SEC Estimates

Source:CSE, Bloomberg, LOLC SEC Estimates

17 | LOLC Securities Limited 18 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Company

Distilleries Company of Sri Lanka PLC (DIST) is the market leader in the beverage industry with avg. 75% volume market share of domestic hard liquor market while also maintaining a diversified portfolio of other business operations. In its beverage business category, the company distils, manufactures and distributes liquor products for the local market. Other business operations entail plantation, telecommunication, insurance and other financial services, power generation, logistics, textiles, business process outsourcing (BPO) services, media and tourism. DIST operates under state-of-the-art fully automated bottling plants and pot and patent distillation units located in four strategic regions in Seeduwa, Kandy, Kalutara and Badulla and an island wide distribution network consisting of a large fleet of vehicles coupled with massive warehouse facilities.

DIST is currently headed by Mr. Harry Jayawardena who is a prominent business personnel in Sri Lanka. DIST is one of the largest cap counters in the Colombo Stock Exchange (CSE) with the market capitalisation of LKR 68700 Mn (USD 474 Mn) and it is the only listed player operating in the hard liquor manufacturing sector.

History of DIST

Excise Department of Ceylon which was initially created in 1913 as the enforcement authority to distribute and sell liquor products in Sri Lanka branched out into the distillation and manufacture of liquor products. The State Distilleries Corporation which was incorporated in 1974 took over this venture while the Excise Department realigned its operation as a monitory body. Under a government policy decision made in 1989, the State Distilleries Corporation was converted into a limited liability company. Subsequently, the transfer of ownership took place at CSE in 1992 enabling the company to stand out as a private entity. After this privatisation, the company saw a significant turnaround in terms of production volumes, process efficiencies and superior financial performance while making DIST to become the largest distiller in the country.

Financial Snapshot

Source:CSE, Bloomberg, LOLC SEC Estimates Graph 36: DIST's net revenue breakdown Graph 37: DIST's PBT breakdown LKR Mn LKR Mn 25,000 40% 12,000 250% 35% 10,000 200% 20,000 30% 25% 8,000 20% 150% 15,000 15% 6,000 100% 10% 10,000 4,000 5% 50% 0% 2,000 5,000 -5% 0% -10% - 2010 2011 2012 2013 2014 2015 - -15% (2,000) -50% 2010 2011 2012 2013 2014 2015 Beverages Plantation Associates profit Diversified Telecommunication Diversified Telecommunication Plantation YoY growth Beverages YoY growth

Source: Annual Reports, Bloomberg Source: Annual Reports, Bloomberg

Beverage segment represents the majority of Group's revenue and profitability while registering 66% and 86% contribution by FY15 respectively. Revenue generated from the beverage segment has seen a considerable growth from 2010 to 2013 and then seen a slightly drop in during last two years mainly due to decreasing volumes and shrinking market share as a result of excessive taxes and large influx of cheaper liquor to the market.

However, the segment has been able to increase their PBT during last three years due to operational efficiencies and the streamlined cost structure. Despite of 10% and 12% revenue contribution from plantation and teleco segments, both have incurred losses during FY15. Diversified segment has managed to yield average 7% contribution to Group's PBT over last four years while associate businesses were able to generate positive earnings for the Group with 35% CAGR over last five years. DIST has been operating as a crucial contributor to Gvt. revenue while paying LKR 41 bn to the state by way of taxes.

18 | LOLC Securities Limited 19 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

DIST Business Segments

DIST's core business entails distilation and distribution of beverage products including sevral varieties of coconut based arrack, locally manufactured foreign liquor and imported foreign liquor varieities. Over the years, DIST has also succesfully diversified in to other industires such as telecommunicarion, plantation, telecommunication, financial services, textile, IT and leisure.

Beverage segment

This segment accounts 66% of Group's revenue and 86% of profit before tax as of FY15 and currently operates under three sub segements.

Cocunut and processed arrack: DIST offers cocunut arrack and special arrack brands such as Old Arrack, White Label Arrack, Blue Lable Arrack, Double Distilled Arrack, Extra Special, Pure Cocunut Arrack, etc. Sri Lankan cocunut arrack is believed to be one of the purest, naturally derived alcoholic bevereges in the world distilled through a natural fermentation process.

Locally manufactured foreign liquor: This segment is largerly managed by Periceyl (Pvt) Ltd, a joint venture between DIST and France-based Pernod Ricard in 1996. Periceyl manufactures and distributes locally manufactured foreign liquor and Arrack via DCSLs extensive distributor network. Periceyl’s flagship brands include Galerie Napoleon French Brandy, Franklin Brandy, Black Opal Arrack - the unique premium arrack, and Flinton Gin, Balmora Rum, Petroff Vodka and House of Tilbury Whisky .

Imported foreign brands: Periceyl also distributes the world renowned range of wines and spirits, which are owned by Group Pernod Ricard France, such as Royal Salute, Chivas Regal, The Glenlivet, Ballantines whiskies, Martell Cognac, Absolut Vodka, Beefeater Gin, Havana Club Rum, Jacob’s Creek, Long Mountain , Montana wines and G.H. Mumm and Perrier Jouet champagnes.

Diversified Businesses

DIST's diversified business have been restructured under Melstacorp Limited which holds 19 direct and indirect subsudiries and 2 associated companies. This has enabled Distilleries Company to more focus on the beverage segment whilst Melstacorp to provide greater focus on diversified businesses and investments.

Plantations: This segment mainly engeges in cultivation and processing tea and rubber via Balangoda Plantation PLC(BALA), an entity of which DIST has an effective ownership of approx. 58%. Plantation segement accounts for 10% of DIST's net revenue in FY15. It has 23 Estates is over 13,000 hectares comprising of Sri Lanka’s most fertile tea and rubber Estates.

Telecommunication: This segment accounts for 12% of DIST's net revenue in FY15 and operates in the fixed telecommunication and broadbrand sectors via its subsidiary Lanka Bell. Lanka Bell is the second largest fixed line operator in Sri Lanka with a subscriber base in excess of 1.2 million. Lanka Bell has 62 own branch offices islandwide along with the customer reach through over 600 retail outlets around the country.

Other diversified businesses (excluding associate companies): DIST's other diversified businesses mainly engages in insurance (Continental Insurance), financial services (Melsta Regal Finance), auto mobile servicing and Source: Annual Reports, Bloomberg logistics (Melsta Logistics), textile (Texpro), BPO and KPO services (BellVantage) , leisure (Browns Beach Hotel PLC) and media (Splendor media) industries. Divesified segment accounts 18% of DIST's net revenue in FY15.

Associate companies: The Group's two associate investments include 43.07% ownership of Aitken Spence PLC (SPEN) which is a leading diversified conglomarate in Sri Lanka and 45.9% stake of Madulsima Plantations PLC which is mainly in to tea cultivation and processing. SEPN is amongst the largest cap counters in CSE with a capilisation of LKR 35.9 Bn and predominatly does businesses in hotel and tourisum industries locally and overseas.

19 | LOLC Securities Limited 20 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

DIST Shareholding Distribution (as at 30. 09.2015)

Shareholder No. of shares % Stake Milford Exports (Ceylon) (Pvt) Limited 124,470,500 41.5% Lanka Milk Foods (CWE) Limited 37,961,500 12.7% Mr. Muzaffar Ali Yaseen 22,418,512 7.5% Commercial Bank of Ceylon PLC/L.E.M.Yaseen 13,050,000 4.4% Melstacorp Limited 8,650,732 2.9% HSBC International Nominees Ltd- Morgan Stanley And Co INTL P 4,400,000 1.5% HSBC INTL NOM LTD – SSBT – Wasatch Frontier Emerging Small COU 4,230,100 1.4% Commercial Bank of Ceylon PLC/M.A.Yaseen 4,000,000 1.3% Caceis Bank Luxembourg S/A Barca Global Master Fund LP 3,713,286 1.2% Lahugala Plantation (Private) Limited 3,695,560 1.2% Mrs. Shantha Marie Chrysostom 2,847,500 0.9% Northern Trust CO S/A National Westminister Bank PLC as Trust C/O Standard Chartered 2,800,000 Bank 0.9% BNYM SA/NV – Blackrock Frontiers Investment Trust PLC 2,628,568 0.9% Citigroup Global Market Limited Agency Trading Prop Securi 2,622,188 0.9% Mrs. Lorraine Estelle Marlene Yaseen 2,456,000 0.8% BNYM SA/NV – Consilium Frontier Equity Fund L.P. 2,208,189 0.7% 7 Stassen Exports Limited 2,114,200 0.7% HSBC INTL Nominees Ltd-SSBT-Frank Russel Investment Company 2,044,036 0.7% Mr. Don Hasitha Stassen Jayawardena 1,882,833 0.6% HSBC International NOM Ltd- MSCO-Route One Fund 1, L.P. 1,839,153 0.6% Other 49,967,143 16.7% Total 300,000,000 100.0%

Graph 38: Shareholder structure 1 (as at 31.03.2015) Graph 39: Shareholder structure 2 (as at 31.03.2015)

Individuals 19% Non-Resident 23%

Institutions 81% Resident 77%

Source: Annual Report FY14/15 Source: Annual Report FY14/15

Corporate governance structure

As one of the most respected Sri Lankan entities, DIST is managed by a skilled and experienced Director Board while 33% of Directors being functioned as Independent Non Executive Director (NEDs). There are three Executive Directors and one Non-Independent Non-Executive Director representing the Board. DISTs Group operations are subjected to regulations of various governing bodies including Excise Department, NATA, CBSL , TRCSL, IBSL, CSE & SEC, Central Environmental Authority, etc.

However, DIST is significantly dependant on its influential Chairman/Managing Director Mr. Harry Jayawardena while his family operates as a controlling shareholder of the company with an effective ownership of 52.1%. Company's dependence on an individual in driving the business could have a negative impact in good corporate governance while company could run in to a significant risk at the absence of his contribution.

Graph 40: Composition of EDs and NEDs

Non Independent NEDs 17% EDs 50% Independent NEDs 33%

Source: Annual Report FY14/15 20 | LOLC Securities Limited 21 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Key Management (Source: Company Annual Report 2014/15)

Name of Director Profile Mr. D. H. S. Mr. Harry Jayawardena is one the most successful and prominent business magnates in Sri Jayawardena Lanka. He was elected Chairman of the DCSL Group in 2006 after serving as its Managing Chairman / Managing Director for almost two decades. He heads many successful ventures in diversified fields of Director business. He is the founder Director and the present Chairman / Managing Director of the Stassen Group of Companies. He is a former Director of Hatton National Bank PLC. and former Chairman of Ceylon Petroleum Corporation and SriLankan Airlines. Mr. Jayawardena is the Honorary Consul for Denmark and was the only Sri Lankan honoured with the prestigious “Knight’s Cross of Dannebrog’ by Her Majesty, Queen Margrethe II of Denmark, for his significant contribution to the Danish arts, sciences and business life. He has also been awarded the title, “Deshamanya” in recognition of his services to the Motherland, since November 2005.

Mr. C. R. Jansz Mr. C. R. Jansz has many years of experience in Logistics and in Documentation, Insurance, Executive Director Banking and Finance relating to international trade. He is the Chairman of DFCC Bank PLC and DFCC Vardhana Bank. He serves on the Board of Melstacorp Limited, Balangoda Plantations PLC., Lanka Bell Limited and several other companies of the Distilleries Group. He is also a Director of Lanka Milk Foods (CWE) PLC. and its subsidiaries.

Mr. N. de S. Deva Aditya Mr. Niranjan Deva Aditya, is an aeronautical engineer, scientist and economist, is a Independent Non- Conservative Member of the European Parliament elected from the SE England. He is the Executive Director Vice President of the Development Committee; ECR Coordinator and Conservative Spokesman for Overseas’ Development and Co-operation.

Capt. K. J. Kahanda Captain Kahanda joined the Company in 1993 as Regional Manager (Central Region) and (Retd.) was appointed a Director in December 2006. Being a former officer of the Sri Lanka Army, Executive Director he spearheaded the re-organisation of the operations of the Central Region since privatisation. He specialises in logistics, distribution and security matters, and is also a Director of G4S Security Services (Pvt) Ltd. and Pelwatte Distilleries (Pvt) Ltd., a subsidiary of the Group. Source: Annual Report FY14/15 Dr. Naomal Balasuriya Dr. Naomal Balasuriya, a medical doctor turned-entrepreneur is internationally sought Independent Non- after as a life changing motivational speaker. His professional expertise ranges from Executive Director medicine, military, management, marketing, mentoring to motivational speaking. He holds both the Master of Business Administration (MBA) and CIM (UK) qualifications.

Mr. D. Hasitha S. Mr. Hasitha Jayawardena holds a Bachelor’s Degree in Business Administration BBA (Hons) Jayawardena from the University of Kent in the United Kingdom. Mr. Jayawardena joined Stassen Group Non-Independent Non- in February 2013. Executive Director

Source: Annual Report FY14/15 21 | LOLC Securities Limited 22 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Liquor industry in Sri Lanka

The Sri Lankan coconut arrack is believed to be one of the purest, naturally derived alcoholic beverages in the world distilled through a natural fermentation process. In ancient times, toddy extracted from coconut trees was a very popular beverage amongst Sri Lankans. After Britain took possession of what is now Sri Lanka (then Ceylon) in 1802 Arrack became popular as a alcoholic beverage and was named as "Ceylon Arrack". Ceylon arrack was produced from ‘toddy’, fermented juice of the coconut palm, extracted by cutting the flowers from the tree and hanging a bucket below the cut to gather the free-flowing sap. Local alcohol industry currently consists of recorded hard liquor and soft liquor along with illicit liquor production. Further toddy production through Coconut, Palmyrah and Kithul tree can also be seen in Sri Lanka. Despite the availability of different types of arrack categories, Special Arrack is more preferred among the consumers due to the affordable "kick-per-buck".

During the recent years there have been a number of changes implemented with regard to alcohol policies in Sri Lanka which were more at a disadvantage to the liquor industry. Further Sri Lanka's demographic differences such as region, culture and societal perception on drinking play a major role in shaping the direction of local liquor industry. Majority of Sri Lankans are Buddhists and they take a pledge to prevent alcohol consumption, even though Buddhism does not impose such a religious rule. However there is about 9% Muslim population who are strictly prohibited from alcohol consumption. Further, Sri Lankan women usually do not consume hard or soft liquor as they perceive it as an unacceptable social habit while greatly discouraging their husbands, fathers and sons from consuming alcohol.

According to Excise department, 24 licensed liquor manufacturers operates in Sri Lanka where 13 players manufacture Molasses Arrack, 12 produce coconut and processed arrack and 17 players produce special arrack. There are 3 malt beer manufacturers and 2 wine manufacturers operating in the soft liquor industry.

Distilleries Company of Sri Lanka (DIST) is the only listed hard liquor manufacturer and Ceylon Beverage Holdings and Lion Brewery Ceylon are the listed players in soft liquor industry.

Table 09: Financial performance comparison of listed companies operating in alcohol industry Counter Price(LKR Market Cap Y/E Net NAV(LKR per ROE% ROA% PER PBV Dividend per Share) (LKR Mn) Profit(LKRMn) Share) Yield % DIST 229.00 68,700 6,553 203 11.4 7.5 10.0 1.1 1.4 LION 551.00 44,080 1,330 99 17.9 5.3 36.1 5.0 0.6 BREW 800.00 16,790 659 188 17.8 2.6 22.3 3.8 1.1

Source: Bloomberg

Table 10: Selected "beverage, food and tobacco" sector indicators Graph 41: Comparison of alcohol consumption

Indicator Value

PER 17.12 PBV 14.35 Toddy Dividend Yield 2.49%

Source: LOLC SEC Estimates

Graph 42: Alcohol consumption as a % of population Soft liquor

34%

Hard liquor 66%

- 20 40 60 80 100 120 140 Lr Millions 2014 2013 2012 Consumers Non concumers

Source: NATA Source: Excise Department

*Company overview, DIST shareholding distribution, Composition of Eds and NEDs, Key management, History, SWOT analysis, Industry analysis are taken from the extracts of websites, Annual reports, Bloomberg and LOSEC research materials. 22 | LOLC Securities Limited 23 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

SWOT Analysis

Strengths

Market leader in the hard liquor industry in Sri Lanka with a history of over 100 years. Mr. Harry Jayawardena, a influential and prominent business personnel backing DIST as Managing Director Strong brand image along with strong distribution network Strong balance sheet and low gearing allowing DIST's for investments

Weaknesses

Company is significantly dependant on Mr.Jayawardena's direction of driving the business Telecom and plantation sectors erode Group's profitability Company still awaits compensation from the Gvt takeover of its Sri Lankan insurance stake and Pelwatte Sugar Industries stake

Opportunities

Price inelasticity of demand for alcohol products Increase per capita income and growth of tourist arrivals leading to a higher demand for alcohol Unfavourable implication from budget 2016 for small liquor manufacturers will deteriorate their market share and support big players to capture it

Threats

Continuous increase in selling prices due to regular increases of taxes making liquor products expensive for consumers Cultural, religious and social pressure on curtailing alcohol consumption Inefficiencies in executing rules and regulations related to curbing illicit and illegal liquor Rupee depreciation leading to increase ethanol cost

Industry Analysis

Bargaining power of suppliers Company collects toddy from local toddy suppliers and pay a fair rate if suppliers meet required quality standard. Currently there is no scarcity of toddy and hence we see toddy suppliers bargaining power as "Low". Companies import ethanol mostly while big players like DIST produces sugar based ethanol locally to cover part of their requirement and use it for blending. Currently, global ethanol alcohol prices are experiencing a price drop, and thus liquor manufactures can obtain a cheap supply. Hence bargaining power of ethanol suppliers could be considered as "Low".

Bargaining power of customers Buyers are seen as price takers in the industry as sellers set the price of products passing price hikes as a result of excise duties changes to buyers. Consumers tend to buy liquor products amidst increased prices, however after some point when prices become unaffordable they become price-sensitive and shift to illicit and illegal products at a cheaper rate. Thus we view bargaining power of customers as "Medium".

Threat of substitutes Substitutes for the industry can be in the form of alcoholic and non alcoholic beverages such as beers, wine, soft drinks and fizzy drinks. There has been witnessing a significant threat from beer as beer consumption is growing at a rapid phase over arrack consumption. But we believe that most of the beer consumers tend to drink hard liquor as well while mitigating the substitution effect. Threat of substitutes of the industry could be considered "Medium".

Threat of new entrants Alcohol Industry is highly regulated and obtaining manufacturing licences are very difficult and costly. Gvt also maintains tight controls on not issuing new licences. However threat from new entrants is significant in the illicit segment of the industry where illegal institutional and individual brewers enter and exit the market frequently. Thus we view threat of new entrants as "High" for alcohol industry.

Existing Rivalry Source: Excise Department Rivalry among industry players are High since the market is crowed with 24 licenced companies. In addition there is a significant competition from beer companies like LION. Competition from illicit manufactures are also intense as they are capable of offering products significantly below normal prices.

23 | LOLC Securities Limited 24 | LOLC Securities Limited Initiation Coverage: Distilleries Company of Sri Lanka PLC | 26 January 16

Recommendation Guidance

BUY – expected return > 10% in excess of benchmark return SELL – expected return less than benchmark return HOLD – expected return between 0% and 10% in excess of benchmark return Investment Horizon: 3 years

12 months target price (12M Tgt Price) is based on the expected capital appreciation of the share excluding dividend.

Benchmark Interest Rate: Average Weighted Fixed Deposit Rate (AWFDR) published by Central Bank of Sri Lanka.

Risk Level Evaluation

High: Maximum price volatility to be up or down more than 50% monthly Medium: Maximum price volatility to be up or down between 25% - 50% monthly. Low: Maximum price volatility to be up or down less than 25% monthly. Risk Level is calculated taking the historical standard deviation measures.

Financial Glossary

EPS = Earnings per Share ROA = Return on Assets (adjusted net profit/average total assets) ROE = Return on Equity (adjusted net profit/average total equity) CAGR = Compound Annual Growth Rate ((End Value/Start Value) ^ (1/number of years) -1) GP= Gross Profit EBITDA= Earnings before interest, tax, depreciation and amortization PBT= Profit before tax PAT= Profit after tax NP= Net Profit PBV= Price to book value ratio PE= Price to earnings ratio

Analyst certification: The Analyst(s) who is/are responsible for compiling or co-compiling this research and whose names appear as the analyst(s) of the research certify that the views expressed in this research accurately reflect the personal view of the analyst(s) about the subject securities and issuers and/or other subject matter as appropriate and has taken reasonable care to achieve and maintain independence and objectivity in making any recommendations. No part of the compensation received by the analyst(s) was, is or will be directly or indirectly related to specific inclusion of specific recommendation or views in this research. On a general basis analyst’s performance appraisal may be influenced by quality of the content and efficacy of the research. The analyst(s) who is/are responsible for compiling or co-compiling this research and whose names appear as the analyst(s) receive compensation based on overall revenues of LOLC Securities Limited and its holding company (Lanka ORIX Company PLC – LOLC Group), which may include brokerage revenue from transactions involved with the securities mentioned in this research.

General Disclaimer: LOLC Securities Limited is a company incorporated in Sri Lanka and licensed by the Securities and Exchange Commission of Sri Lanka to operate as a stockbroker/stock dealer in Sri Lanka. LOLC Securities Limited is a trading member of Colombo Stock Exchange. This research is based on information from sources that LOLC Securities Limited believes to be reliable. Whilst reasonable care has been taken to ensure accuracy of the information presented in the research, LOLC Securities Limited does not give a guarantee on the accuracy of the information presented in the paper nor will take the responsibility on investment decisions taken based on the information provided by the research and hence LOLC Securities Limited nor its employees accepts any liability whatsoever for any loss arising from investments decisions taken using the information provided in this paper. The reader also should note this paper does not give recommendations to any particular category of investors and investor should consult investment advisors for further clarifications regarding risks involved in investing in equity market. Investing in securities has inherent risks with no guaranteed return and price may be subjected to significant volatilities. No part of this report should be considered as a solicitation to buy or sell any security or product or to engage in or refrain from engaging in any transaction. LOLC Securities Limited or its employees may or may not hold positions in the securities discussed in the research and the information provided in the research should not be construed as a buy or sell instruction for any securities mentioned in the research, Unless otherwise specifically mentioned. This research is intended for general use for clients of LOLC Securities Limited and must not be copied in whole or in part or distributed to any third party for commercial use without permission from LOLC Securities Limited. If the reader is not the intended recipient please inform LOLC Securities Limited immediately by return email to [email protected]. LOLC Securities Limited’s other staff including sales people, traders and other professionals may provide oral or written market commentaries or trading strategies to our clients which reflect opinions which are contrary to the opinions expressed in this research which may be influenced by different circumstances.

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