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Fitch Downgrades British American Tobacco to 'BBB'; Withdraws Reynolds American
August 4, 2017 / 3:08 PM / 4 months ago

Fitch Downgrades British American Tobacco to 'BBB'; Withdraws Reynolds American

(The following statement was released by the rating agency) MILAN/CHICAGO, August 04 (Fitch) Fitch Ratings has downgraded British American Tobacco plc's (BAT) Long-Term Issuer Default Rating (IDR) to 'BBB' from 'A-' and removed it from Rating Watch Negative. The Outlook is Stable. The agency has also affirmed Reynolds American Inc's (RAI) IDR at 'BBB' and withdrawn the rating. A full list of rating actions is shown at the end of this commentary. The downgrade follows the completion of the merger between BAT and its 42%-owned associate Reynolds American Inc. BAT now benefits from an enhanced geographic footprint, access to cash flows in different currencies, stronger scope to pursue its Next Generation Products strategy and further opportunities to improve its profit margins thanks to merger synergies. The transaction makes it the largest tobacco company globally. However, it will be burdened by increased leverage, which may remain high and not consistent with 'BBB' category rating medians over the rating horizon despite positive free cash flow (FCF) generation averaging GBP2 billion a year and our expectation that financial headroom should improve over the rating horizon. KEY RATING DRIVERS RAI and BAT Rating Equalisation: Fitch has analysed parent and subsidiary links between BAT and RAI following their merger and concluded that they are sufficiently strong to equalise the IDR for both entities at BAT's IDR of 'BBB'. BAT has provided a senior unsecured guarantee to RAI's bonds and RAI has established a guarantee that will benefit BAT's bonds. The two guarantees create pari passu status across all of the group's debt. We have analysed strategic and operational ties, in addition to legal links, between RAI and BAT under our parent-subsidiary methodology and believe that these are strong. RAI Deal Increases Leverage: BAT financed the acquisition price of the 57.8% it did not own by offering cash of USD24.5 billion (GBP16.6 billion) and a large equity component of USD25.1 billion. BAT also took on USD13 billion of RAI debt, which we treat as pari passu with its own debt. We calculate that BAT's consolidated funds from operations (FFO)-based net leverage will rise in 2017 on an annualised pro forma basis, to about 5.5x (equating to net debt/consolidated EBITDA of 4.0x-4.5x), up from 2016's 3.7x (2.9x), a level that, in isolation, we do not deem consistent with the 'BBB' category for the sector. Scope for Subsequent Deleveraging: BAT has historically targeted a net debt/EBITDA ratio of 1.5x-2.5x and proved, by using equity for the RAI transaction, that it values its investment-grade rating. Management stated that after the merger it intends to prioritise the allocation of cash flow to debt paydown, to reduce net debt/EBITDA to 3.0x by 2019. This leverage can only support a 'BBB' IDR, even though we estimate strong annual consolidated FCF of on average GBP2 billion and project that FFO adjusted net leverage should drop to 4.6x-4.8x by FY19. This considers BAT's pro forma strong business profile and profitability compatible with an 'A' category rating. Strong, Stable Business Profile: The ratings reflect BAT's position as the largest international tobacco company, with a 24% market share of the global market excluding China. BAT's operations are supported by the diversity of its portfolio of brands and of the countries it operates in. Post-merger BAT will combine a strong concentration in the profitable US market (over 40% of profits) with steady cash flow from Canada, western Europe, Australia and - we estimate - between 20% and 25% of profits from high-growth emerging markets. Scope for Profit Growth: The inclusion of RAI as a fully owned subsidiary will boost BAT's scope to continue to make progress on its cost rationalisation programmes and supports further improvements in its operating profit margin thanks to USD400 million annualised cost synergies to be achieved by the end of the third year following completion, and RAI's higher margin compared to BAT. Evolving US Tobacco Regulation: We view tobacco regulatory risk creates modest demand pressure in some markets but consider it manageable. For example, the US Food and Drug Administration announced it aims to cut maximum nicotine levels allowed in cigarettes. Stricter regulation could over time accelerate the secular decline of cigarette volumes consumed in the US (historically 3% to 4% a year), particularly if there is a stringent cap on nicotine levels. We do not believe this is likely, as a very low nicotine cap could either encourage people to smoke more or turn to the illegal market for stronger cigarettes. Overall, these plans could take time to turn into legislation, so we have not reflected them in our rating case. On the positive side for BAT, this would further promote the take-up of its Next Generation Products, including heat-not-burn and vaping products, where BAT is well positioned. Scope for Price Increases: The global tobacco industry excluding the Chinese market benefits from an oligopoly structure, with most national markets having essentially up to three companies commanding over 90% of volumes. In the US, RAI is the second-largest operator, and has a track record of consistent price increases that compensate for volume declines. The 'BBB' IDR is therefore supported by strong profitability, with the EBITDA margin trending to, if not exceeding, 45% over the rating horizon and solid FCF generation. DERIVATION SUMMARY BAT will have very high pro forma annualised net leverage for a 'BBB' rated tobacco company (compared to the 'BBB' FFO net leverage median of 3.5x; 'BB': 4.5x) of about 5.5x immediately following the merger. We project de-leveraging to a still relatively high 4.5x in 2019 (second full year). However, the company's operational profile supports a higher rating than those medians. BAT is the second-largest company in the US (after Altria Group Inc., rated 'A-') and internationally (after Philip Morris International Inc., rated 'A') but on a consolidated basis is now slightly larger than PMI and ahead of Imperial Brands PLC ('BBB'). BAT will retain similarly strong EBITDA margins to major tobacco peers and will have a strong FCF margin of 7%-8%. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - organic annual revenue and profit growth of low single digits; - GBP/USD exchange rate of 0.82; - acquisition synergies of GBP160 million in FY18; cumulative GBP346 million in FY19 and GBP404 million in FY20; - capex declining towards 3.2% of sales by FY20 - BAT dividend distribution/EBITDA reducing well below FY15 and FY16's 50% level over the rating horizon; - no share buybacks. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action A positive rating action is not envisaged over the coming two years given BAT's leverage burden, although the following developments may lead to an upgrade: - FFO adjusted net leverage dropping below 4.0x (corresponding to net debt/EBITDA of between 2.5x and 3.0x); - FCF margin remaining at least in the mid single digits as a percentage of sales; - FFO fixed charge coverage returning above 6.0x . Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - Insufficient annual FCF to generate steady deleveraging and reducing below GBP1 billion (or under 3% of sales); - No improvement in FFO adjusted net leverage over 2018-2020 and lack of visibility that it is trending below 5.0x; - FFO fixed charge cover dropping below 4.5x LIQUIDITY Strong Liquidity: The group has strong liquidity and access to bond markets with, as of end-2016 no more than 10% of total debt maturing in any 12-month period over the coming 10 years, cash balances averaging GBP1.5 billion to GBP2 billion and a GBP3 billion committed revolving bank facility due May 2021 and undrawn as at 31 December 2016. The company has arranged a USD25 billion bridge facility to fund the RAI transaction and also has bank commitments to increase its revolving credit facility to GBP5.7 billion. Under the bridge facility BAT intends to refinance - most likely in the bond markets - USD20 billion in the short aftermath of closing, which we think is achievable. FULL LIST OF RATING ACTIONS British American Tobacco plc --Long-Term IDR: downgraded to BBB from 'A-'; Stable Outlook and off Rating Watch Negative --Short-Term IDR: affirmed at 'F2'; off Rating Watch Negative --Senior unsecured long-term rating: downgraded to BBB from 'A-'; off Rating Watch Negative B.A.T. International Finance (BATIF) --Senior unsecured long-term rating: downgraded to BBB from 'A-'; off Rating Watch Negative --Senior unsecured short-term rating: affirmed at 'F2'; off Rating Watch Negative B.A.T. Netherlands Finance B.V. --Senior unsecured long-term rating: downgraded to BBB from 'A-'; off Rating Watch Negative Reynolds American Inc --Long-Term IDR: affirmed at BBB, Stable Outlook; off Rating Watch Positive and withdrawn --Short-Term IDR: affirmed at 'F2'; off Rating Watch Positive and withdrawn --Senior unsecured long-term rating: affirmed at BBB; off Rating Watch Positive R. J. Reynolds Tobacco Company --Long-Term IDR: affirmed at BBB, Stable Outlook; off Rating Watch Positive and withdrawn --Senior unsecured long-term rating: affirmed at BBB; off Rating Watch Positive In accordance with Fitch's policies the issuer appealed, which resulted in a rating action that is different than the original rating committee outcome. Contact: BRITISH AMERICAN TOBACCO Principal Analyst Marialuisa Macchia Associate Director +39 02 879087213 Supervisory Analyst Giulio Lombardi Senior Director +39 02 879087214 Fitch Italia S.p.A. Via Morigi 6 20121 Milano Committee Chairperson Pablo Mazzini Senior Director +44 20 3530 1021 REYNOLDS AMERICAN INC. and RJ REYNOLDS TOBACCO COMPANY Secondary Analyst Ellen Itskowitz Senior Director +1 312 368 3118 Primary Analyst Bill Densmore Senior Director +1 312 368 3125 Fitch Ratings, Inc. 70 W. Madison Street Chicago, IL 60602 Committee Chairperson Pablo Mazzini Senior Director +44 20 3530 1021 Summary of Financial Statement Adjustments for British American Tobacco plc - Due to exchange control regulations in the countries where this cash was held at end-December 2016, Fitch has treated GBP157 million as restricted cash. -Preferred dividends and minorities cash adjustment: We added GBP745 million dividends received from associates (net of dividends paid to minorities) in our computation of FFO in FY16. Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Additional information is available on www.fitchratings.com. 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