March 2017 ASHA PHILLIP SECURITIES LTD SRI LANKA MELSTACORP LIMITED: MELS.N Key Statistics Base case price target appeals “BUY” CSE Ticker MELS.N Share Price(3-March-17) LKR 63 No.of issued shares (m) 1,165 Inelastic nature of liquor products together with Market Cap. LKR m 75,751 increasing trend of per capita alcohol consumption Free Float 43% would lead MELS to mark topline based growth. We 52-week H/L LKR 54.9/69.50 expect MELS to record c.14% gross income CAGR Avg.daily vol.(000' shares,1yr) 201.93 over FY17-21E driven by solid market positioning of Avg.daily turnover(USD 000') 212.65 beverage business and high growth trajectory of MRF Source: MELS AR’s, CSE & CNI. We believe BALA and LB to gradually recover from loss making status to support group EBT margins Share Price Movement to sustain at c.9-10% levels. We believe unutilized debt capacity and large cash inflows of MELS would 140% facilitate substantial CAPEX requirements elsewhere 120% 100% leaving overall dividend payout largely unchanged. In 80% our opinion MELS is currently undervalued at LKR 63 60% perIncome share Points price. Our base case SOTP evaluation 40% 20% estimates LKR 66 per share intrinsic value. This is 0% further backed by our base case market based valuation which calculates LKR 70 per share value. MELS to record c.14% gross income CAGR ASPI S&P MELS We believe MELS’s beverage arm would continue its Source: CSE/APSL estimates market leadership position in domestic hard liquor industry. Besides increasing ASP’s, we assume price Margins points Share Price Performance inelasticity would support volume growth of alcohol. Further, growing general insurance business of CNI 3m 6m 12m and increasing loan book of MRF would overcome MELS 10% -3% 21% possible income contraction in Plantations and Telco S&P 2% -1% 9% arms. ASPI -2% -6% -1% EBT Margins to sustain at 9-10% levels Source: CSE/APSL estimates HealthyCF/Div/Financial growth potential points of diversified segment with relatively high margins aided by rising contribution of Summary Financials SPEN profits would help MELS to post increased group EBT margins over FY17-21E. LKR 000" FY16 FY17E FY18E FY19E We establish LKR 66-73 valuation range for MELS Net Revenue 33,840 39,920 45,172 50,813 Our Base case SOTP valuation results in LKR 66 per Gross Profit 15,452 18,868 21,305 23,890 share intrinsic value which is c.5% upside to the EBITDA 10,824 13,286 14,681 15,988 current market price. This is further backed by our EBIT 8,390 10,596 12,135 13,549 market based valuation which estimates LKR 70 per share value reflecting c.11% upside. EBT 8,188 10,344 11,863 13,209 Table of ContentTable of Contents EAT 5,613 7,393 8,272 9,058 EPS 4.82 6.34 7.10 7.77 Source: MELS AR’s, APSL estimates Analyst: Sandun Kulathunga MELSTACORP LTD APSL RESEARCH Table of Contents MELS TO RECORD 14% GROSS INCOME CAGR OVER FY17-21E 3 DIST: BEVERAGE ARM CONTINUES TO DOMINATE INCOME GENERATION 3 INELASTIC NATURE OF DEMAND TO STABILIZE VOLUMES DESPITE INCREASING PRICES 4 PLANTATIONS CONTINUES TO WITNESS DECLINE: BALANGODA PLANTATIONS 7 LANKA BELL: THE TELCO ARM YET TO RECOVER FROM LOSSES 8 UPSIDE POTENTIAL TO TOP-LINE GROWTH 9 DOWNSIDE RISKS TO REVENUE EXPECTATIONS 9 EBT MARGINS TO SUSTAIN AT 9-10% LEVELS OVER FY17-21E 10 GOVERNMENT EXCISE DUTY CONTINUES TO ACCOUNT FOR OVER 2/3 OF BEVERAGE GROSS REVENUE 10 DIST: BEVERAGE SEGMENT MARGINS TO SETTLE AT 9%-10% LEVELS OVER FY17-21E 11 SPEN: ASSOCIATE PROFITS TO MAKE SIGNIFICANT CONTRIBUTION TOWARDS GROUP EARNINGS 11 DOWNSIDE RISKS FOR MARGIN EXPANSION 12 HIGHER CAPEX REQUIREMENTS TO LIMIT DIVIDEND INCREASES BESIDE SOLID FREE CASH FLOWS 13 UNUTILIZED DEBT CAPACITY PROVIDES VITAL ADVANTAGE OF FLEXIBLE OUTPUT EXPANSIONS 14 RETURN ON SHAREHOLDER’S FUNDS YET TO RECOVER FROM GRADUAL DECLINE SINCE FY11 14 WE ESTABLISH A VALUATION RANGE OF LKR 66-73 FOR MELS SHARES 15 MULTIPLES BASED VALUATION 17 SHARE PRICE PERFORMANCE 18 SRI LANKAN ALCOHOL INDUSTRY 19 GOVERNMENT TAX MECHANISM 20 INDUSTRY GROWTH DRIVERS: 21 PER CAPITA INCOME 21 TOURIST ARRIVALS 21 COMPANY OVERVIEW 22 SEGMENTAL ANALYSIS 23 BOARD OF DIRECTORS 25 TOP FIVE SHARE HOLDERS 25 CORPORATE HOLDING STRUCTURE 26 SWOT ANALYSIS 27 GROUP SUMMARY FINANCIALS 28 Page | 2 MELSTACORP LTD APSL RESEARCH MELS to record 14% gross income CAGR over FY17-21E We expect MELS would record c.14% income CAGR over FY17-21E Besides beverage mainly backed by Beverage business which is expected to post a healthy business being the 15% gross income CAGR over FY17-21E. Further, growing general major revenue insurance business of Continental Insurance and growth potential of generator, financial Melsta Regal would collectively translate to c. 12% gross income CAGR over the same period. Besides sings of growth in Telecommunications, arm continues to Plantations and Diversified segments, we conservatively assume zero grow at healthy growth in terms of income contribution. levels. MELS’s gross revenue to grow at 14% CAGR over FY17-21E supported by its solid Beverage Business LKR Mn 200,000 150,000 100,000 50,000 - FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY19E FY20E FY21E Total Gross Revenue Beverage: Gross Beverage: Net Source: DIST AR’s, APSL estimates DIST: Beverage arm continues to dominate income generation We believe Beverage segment would continue to dominate income contribution by marking c.15% gross income CAGR over FY17-21E. Beverage business currently accounts for c.89% of group gross revenue and 72% of group net revenue. Further we expect a steady demand growth for Alcoholic products and gradually increasing Average Selling Prices (ASP) Beverage Business to post a solid 15% CAGR over FY17-21E driven by both volume and ASP growth LKR Mn LKR Per 1L 200,000 3,500.00 3,000.00 150,000 2,500.00 2,000.00 100,000 1,500.00 50,000 1,000.00 500.00 - - FY15 FY16 FY17E FY18E FY19E FY20E FY21E Beverage: Gross ASP: Per Litre Source: DIST AR’s, APSL estimates Page | 3 MELSTACORP LTD APSL RESEARCH Inelastic nature of demand to stabilize volumes despite increasing prices Despite predicted 10% increase in ASP’s over the explicit forecasting Per capita liquor period, we believe hard alcohol industry as a whole would continue to consumption of Sri grow at a healthy CAGR of c.8% during FY17-21E cf.13% CAGR over Lanka has grown to FY13-16. Price inelasticity of products due to addictive nature of alcohol 4.5 Liters in 2015 would ensure both industry growth and MELS’s market share driving from 3.7 Liters in overall revenue up. 2010.Increasing trend Special Arrack continued to score the highest contribution by accounting of Per Capita income for c.68% of total hard alcohol industry volumes while MELS Special and healthy growth in Arrack business represented c.80% of total Special Arrack industry tourism industry volume as of FY16. Total Coconut & Processed Arrack market showed a would support solid volume growth by FY16, accounting for c.17% of total hard alcohol industry wide volume industry volumes cf.11% in FY13. MELS’s Coconut & Processed Arrack growth. business represented c.46% of total Coconut & Processed Arrack industry volume as of FY16.Hence the gradual shift of product mix towards Coconut & Processed Arrack puts pressure on MELS which is Entry barriers in currently capitalizing on Special Arrack business. Molasses Arrack and terms of legal Country made foreign liquor accounted for c.15% of MELS’s beverage compliance, sales in terms of volume as of FY16. Economies of Scale Considering Sri Lankan Special Arrack being in the maturity levels of of being the largest market, we believe the total market would grow at a moderate 4% CAGR player of the market over FY17-21E. However, we expect a solid 11% volume CAGR for and health concerns Coconut & Processed Arrack for which Sri Lanka is the largest producer over illicit-substitute in volume terms. Further we notice the demand for Molasses Arrack (c. alcohol products 2% Market Share for MELS as of FY16) and Country made foreign liquor would help MELS to (c. 20% Market Share for MELS as of FY16) would continue to gradually protect market share contract over FY17-21E. Beverage Segment volumes to grow at an overall 5% CAGR over FY17-21E Volume: Litres 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000 - FY13 FY14 FY15 FY16 FY17E FY18E FY19E FY20E FY21E Special Arrack Coconut & Processed Arrack Country Made Foreign Liquor Molasses Arrack Source: Department of Excise of Sri Lanka AR15, APSL estimates Page | 4 MELSTACORP LTD APSL RESEARCH Strong brand name and wide distribution network to secure market We believe MELS leadership position would maintain the market leadership Despite inability to involve in active advertising in Sri Lanka due to legal position in Special constrains, MELS has been able to secure the market leadership position Arrack business by of the Hard Liquor industry. MELS accounted for c.81% share of Special securing c.80% Arrack market and c.46% share of Coconut and Processed Arrack market market share. as of 2016. We believe MELS would be able to maintain its current share of market in Special Arrack business over FY17-21E. However, we expect a gradual Increased completion decline in MELS’s volume wise market share of Coconut & Processed in Coconut & Arrack business by five percentage points (5pp) from 46% in 2016 to 41% Processed Arrack in 2021E.