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Fitch Upgrades Altria's Ratings to 'A-' Outlook Stable
April 3, 2017 / 9:54 PM / 6 months ago

Fitch Upgrades Altria's Ratings to 'A-' Outlook Stable

(The following statement was released by the rating agency) CHICAGO, April 03 (Fitch) Fitch Ratings has upgraded Altria Group, Inc.'s (Altria) Long-term Issuer Default Rating (IDR) and long-term debt ratings to 'A-' from 'BBB+'. Altria's short-term ratings have been affirmed. Altria had approximately $14 billion of total outstanding debt as of Dec. 31, 2016. The Rating Outlook is Stable. A complete list of rating actions follows at the end of this release. The ratings upgrade reflects the fundamental change in the litigation environment, and Fitch's belief the risk for large pay-outs by U.S. tobacco companies has significantly decreased. Altria's ratings are supported by a strong competitive position anchored by its Marlboro brand, good pricing power, expanding margins and large dividends from ABI InBev that results in robust cash flows. These strengths are balanced against secular volume declines, regulatory pressures, litigation risk and large shareholder remuneration. KEY RATING DRIVERS Litigation Risk Has Moderated Fitch believes a fundamental change to litigation risk has occurred due to the settlement and/or dismissal of lawsuits including several class actions during 2016. As a result, Altria does not have a certified class action lawsuit outstanding. Thus, Fitch believes the risk of tobacco litigation court cases leading to major pay-outs by tobacco companies has significantly abated in the US market. Since October 2004, Altria has paid in aggregate judgments and settlements (including related costs and fees) totaling approximately $656 million (including interest) as of December 31, 2016. Engle progeny cases have also been materially reduced over time with roughly 2,600 state and federal cases remaining. In nine years of trial for 105 federal and state Engle progeny cases with 58 verdicts returned in favor of plaintiffs, Altria has paid $146 million (including interest). The company, like its competitors, has an experienced legal team that has stretched the resolution period of litigation by effectively using the appellate process. While continuing litigation risk remains above-average, uncertain and challenging, Fitch believes Altria's exposure to litigation is a manageable liability that should continue to diminish over time. Any judgements and settlement payments are expected to be relatively modest in relation to the company's substantial operating cash flows. Leading Market Positions Altria remains the industry leader in the U.S. cigarette market with its Marlboro franchise, and leading positions in moist smokeless tobacco (MST) with its Copenhagen brand and tipped cigars with Black & Mild. PM USA, the company's smokeable tobacco subsidiary, captures slightly more than one-half of the U.S. marketplace given Marlboro's strong brand equity with an approximate 44% share. The company's MST offerings, Copenhagen and Skoal, also hold slightly more than one-half of the domestic MST market on a combined basis and Black & Mild has an approximate 26% share. Altria's business profile is constrained by limited geographic diversification given their reliance on the U.S. market which heightens the company's exposure to a potential shock that could simultaneously affect all of the company's sales. Secular Volume Decline Altria, with approximately one-half of the U.S. cigarette marketplace, has significant exposure to the long-term secular volume declines. Fitch expects cigarette declines will increase to the mid 4% range during 2017 due to regulatory pressures despite a supportive macroeconomic environment. This is due in part to state excise tax increases in large population areas including California, which raised its tax by $2 to $2.87 at the beginning of April 2017, and Pennsylvania, which had increased its tax by $1 to $2.60 during 2016. Additional headwinds come from minimum age increases to 21 during 2016 in several areas including California. Increasing Profitability Driving Earnings Growth Altria's strong profitability benefits from consistent pricing power, reduced variable costs, improving operating efficiency related to productivity initiatives and growth in higher margin MST products that is driving improved operational leverage. Consequently, the strong operating performance has resulted in material margin expansion and earnings growth with EBITDA margins increasing by 360 basis points during the past two years to 47.5%. Fitch expects continued margin expansion to the 50% range by 2018. Altria's product portfolio is somewhat diversified with leading MST brands, various smoking alternatives and premium wine offerings. However, the smokeable tobacco business still generates around 86 to 87% of revenues and operating income respectively despite the broader offering. Within the smokeable segment, Altria has achieved at least modest sales growth in most years through strong digital capabilities, biannual price increases on key brands and innovation to brand architecture. RRPs Growth Potential Fitch sees Altria as well-positioned through its licensing agreement with Philip Morris International (PMI) in reduced risk products (RRPs) like iQOS. These products can deliver nicotine with reduced health risks compared to cigarettes and represent a smoking experience similar to that of traditional cigarettes. PMI filed its Premarket Tobacco Product Application with the FDA at the end of the first quarter that could enable commercialization of iQOS in the U.S. by late 2017 or early 2018. Fitch believe RRPs like iQOS could give Altria a material competitive advantage to win further market share and represents a powerful tool with protecting itself in the event of an accelerated rate of decline with demand for traditional tobacco products. Heavy Shareholder Returns Manageable Fitch expects Altria to maintain its shareholder-friendly posture through the ratings horizon, which includes dividend pay-outs around 80% (of adjusted EPS) supplemented with active share repurchasing. The company gains flexibility for heavy shareholder returns from limited acquisition opportunities and light capital spending. Altria increases its dividend yearly by 8% to 9% (currently topping $4 billion) and generally spends around $1 billion for share repurchases that is determined annually. Fitch sees the strategy as manageable at current cash flows and with leverage (total debt to EBITDA) consistently sustained well below 2x. Capital Structure Well Managed Altria has worked down $8.3 billion of high coupon notes (due in 2018, 2019, 2038, and 2039) issued for the U.S. Tobacco (UST) acquisition in 2009. Since 2012, the company re-financed and tendered for nearly $6 billion of the expensive debt, leaving a balance of approximately $2.5 billion as of December 31, 2016. As such, Altria's weighted average interest rate on its debt, all fixed rate, decreased to 4.9% in 2016 from 8.3% in 2011. Total debt was $14 billion at the end of 2016 with gross debt leverage of 1.4x. Fitch expects leverage will remain relatively consistent in the mid-1x range over the next few years, as the company maintains financial discipline while benefiting from strong operational performance. Altria's next significant long-term debt maturity is the balance of 9.7% unsecured notes ($863.6 million) due in November 2018. Variation in Criteria Fitch's special report titled Tobacco Companies - Ratings Navigator Companion, dated February 6, 2015, indicates that ratings for U.S. domestic-only companies are capped at 'BBB+'. This criteria variation recognizes that Fitch no longer believes a cap is appropriate given the fundamental change in litigation risk as discussed in the above commentary. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer in 2017 and 2018 include: --Consolidated revenue increases by a compound annual growth rate (CAGR) of between 1%-2% as cigarette volume declines revert closer to historical levels in the 4% range after moderating in 2015 and 2016. --Consolidated EBITDA and EBITDA margin approximately of $9.6 billion and 49%, respectively in 2017, growing to $10 billion and 50% in 2018; --Total debt to EBITDA of approximately 1.4x; --Free cash flow (FCF; operating cash flow, less CAPEX and dividends) in the range of $600 million to $700 million (approximate 3.5% margin) annually reflecting annual increases to dividends and capital intensity maintained around 1%; --Share repurchases of at least $2 billion in 2017; declining to the $1 billion range in 2018. RATING SENSITIVITIES Future developments that may, individually or collectively, lead to a positive rating action include: -- A further lessening of litigation risk; -- Mitigation of negative industry factors with an emphasis on the slowing or reversal of secular volume declines due to successful commercialization of reduced risk products; -- Leverage sustained below 1.5x; -- FCF margin sustained above 4%, reflecting a stable operating environment and relatively consistent shareholder remuneration policies; -- FFO fixed charge coverage above 6.0x. Negative: Future developments that may, individually or collectively, lead to negative rating include: -- A more aggressive financial strategy related to dividend, share repurchases and M&A causing leverage to be sustained above 2x (2017E: 1.4x); -- Substantial reversal in litigation environment, leading to expectations for an excessively large judgement; -- An unexpected adverse change in regulatory environment that significantly accelerates volume declines; -- A deterioration of operating profile due to pressure on organic profit, resulting from weak pricing power, volume declines and lack of cost realization, leading to FCF margin falling below 3% on a sustained basis; (2017E: 3.5% to 4%); -- FFO fixed charge cover sustained less than 5.0x (2017E: 8.8x). LIQUIDITY Liquidity remains solid at Dec. 31, 2016, with cash of $4.6 billion and full availability under a $3 billion five-year revolver due August 2020. Fitch expects cash balances will decrease as Altria returns a significant amount of cash to shareholders in 2017. Internal liquidity is provided by strong operating cash flows that have historically increased annually and were $3.8 billion in 2016, versus $5.8 billion in 2015 and $4.7 billion in 2014. Lower operating cash flows were due to the exceptionally high cash taxes associated with the cash received following the merger of SAB Miller with AB InBev and a $500 million pension contribution. Fitch expects operating cash flows will return to previous levels in 2017. Excess liquidity is important given Altria's annual payment to the Master Settlement Agreement (MSA) of approximately $4 billion each April. Altria's liquidity is further supported by the company's 10.2% share of AB InBev, which has a total market capitalization of approximately EUR175 billion and expected to provide annual dividends to Altria in the range of $700 million to $800 million. In October 2016, Altria expanded its share repurchase program to $3 billion from $1 billion authorized. During 2016, Altria repurchased $1 billion in shares and had $1.9 billion remaining under the program. Altria has indicated publicly that the company expects to complete the share repurchase program by the end of the second quarter of 2018. Given the excess cash, current leverage and depending on market conditions, Fitch anticipates that Altria could complete the program during 2017. FULL LIST OF RATING ACTIONS Fitch has upgraded the following corporate ratings for Altria: Altria Group Inc. (Parent) --Long-Term Issuer Default Rating (IDR) to 'A-' from 'BBB+'; --Guaranteed bank credit facility to 'A-' from 'BBB+'; --Guaranteed senior unsecured debt to 'A-' from 'BBB+'. Philip Morris Capital Corp. (a wholly owned subsidiary of Altria) --Long-Term IDR to 'A-' from 'BBB+'. Fitch has affirmed the following corporate ratings for Altria: Altria Group Inc.'s --Short-Term IDR 'F2'; --Commercial paper (CP) 'F2.' Philip Morris Capital Corp.'s ratings: --Short-Term IDR 'F2'; --CP 'F2'. The Rating Outlook is Stable. Contact: Primary Analyst William Densmore Senior Director +1-312-368-3125 Fitch Ratings, Inc. 70 W. Madison Street Chicago, IL 60602 Secondary Analyst Ellen Itskovitz, CFA Senior Director +1-312-368-3118 Committee Chairperson Monica Aggarwal, CFA Managing Director +1-212-908-0282 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --NPM Adjustments related to Master Settlement Agreement; --Affiliate dividend received from AB InBev is reflected in leverage metric calculations. 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