December 20, 2017 / 1:19 PM / in 10 months

Fitch Upgrades Pernod Ricard SA to 'BBB', Outlook Positive

(The following statement was released by the rating agency) LONDON/MILAN/MOSCOW, December 20 (Fitch) Fitch Ratings has upgraded Pernod Ricard SA's Long-Term Foreign-Currency Issuer Default Rating (IDR) and senior unsecured rating to 'BBB' from 'BBB-' and affirmed its Short-Term IDR at 'F3'. The Outlook is Positive. The upgrade reflects Pernod's significant deleveraging over the last two years. The scope for this to continue is reflected by the Positive Outlook. Although leverage metrics remained weak for the 'BBB' rating category at year-end June 2017 (FYE17), this is more than offset by the company's strong business profile and its demonstrated ability to maintain a healthy operating performance despite a difficult background in certain markets. Solid profitability and the sustainability of free cash-flow (FCF) generation at least around mid-single digits of sales add enough financial flexibility to Pernod's current rating. We expect headroom to continue to improve, and to be sufficient to absorb a potential acceleration in bolt-on M&A activity, which we assumed at up to EUR500 million annually in our projections. KEY RATING DRIVERS Strong Business Profile: Pernod's ratings reflect its number-two position in the global spirits industry, its geographically diverse operations and powerful brands in several international consumption categories. This results in operating performance resilience, healthy profitability and an ability to generate healthy FCF over the long term. Pernod's large exposure to emerging markets (FY17: 38% of sales) remains a driver of long-term organic sales growth, while a combination of pricing power of its higher-end exclusive products and its innovation capabilities supports revenues in the event of volume weaknesses. Solid Operating Performance: Fitch expects Pernod's organic sales growth to remain at healthy 4%-5% per annum over FY18-FY19 followed by moderation to 3% annually. This will stem from an improving operating environment in many emerging markets, including a return to growth in China and Brazil and accelerating growth in Russia. India is the company's second-largest country by sales globally and we expect sales growth to remain modest due to the demonetisation and to sales restrictions in the areas of major highways. Strong growth in other Asian markets should however offset this in the region. Volumes growth in western Europe and the US is likely to remain in the low single digits in the medium term due to high competition, but should be supported by ongoing premiumisation. Improving Profitability: Pernod's EBITDA margin improved by 40bp to close to 29% in FY17 thanks to its efficiency programme, an improving product mix and a positive FX impact. We expect the EBITDA margin to further improve to 30% by FY21. Profitability resilience is due to wide geographical diversification, pricing power and a strong brand portfolio, together with an active, market-tailored cost management, in particular in advertising and promotion spending. The company is in the middle of its efficiency programme for FY16-FY20, which in FY17 brought in EUR60 million of savings in profits and around EUR50 million from working capital. FCF Generation Recovery: We project FCF margin will remain strong at 6%-7% or EUR0.7-EUR0.8 billion a year in the next four years, supported by anticipated further profit gains and improving working-capital management. Pernod posted a second year of strong FCF in FY17 to EUR0.7 billion or 8% of revenue (FY16: 6.6%) on the back of better profits, lower interest costs and low working capital outflows (including balanced investments in ageing whisky and cognac inventories). Debt Burden to Decline Further: FFO adjusted net leverage dropped to 4.4x at FYE17 (FYE15: 6.0x) and we estimate a further reduction to below 4.0x by FYE19. The improved financial structure both currently and projected for FY18 justify the current rating upgrade to 'BBB'. In the absence of major M&A, we estimate that FFO adjusted net leverage could decline towards 3.5x by FY20 (equivalent to lease adjusted net debt to EBITDAR below 3.0x) which would be strong for the rating. Because of the company's strong business profile and its profitability levels, Pernod has the potential to be rated one notch higher at 'BBB+', still below industry leader Diageo ('A-') over the medium term. No Large M&A Assumed: Pernod has maintained a cautious approach to M&A over the last two years, but has still concluded a number of bolt-on acquisitions, in tandem with small divestments. Consumers' growing demand for new unique brands and craft features of spirits has resulted in the fast growth of new entrants in many developed markets. In our view, this has forced the large producers to prioritise bolt-on M&A transactions for the takeover of this type of entity over large deals to buy established brands. Given Pernod's improved balance sheet, we assume that it might look for these purchase opportunities more actively, and project expenditure of up to EUR500 million per year for small to medium-size acquisitions, instead of larger debt-funded transactions, which the rating has more limited headroom to absorb. DERIVATION SUMMARY Pernod's business profile and profitability are well-positioned in the 'A' rating category relative to peers such as Diageo (A-/Stable) and Brown-Forman (A/Stable). This is offset by Pernod's higher leverage and weaker financial flexibility which results in a lower rating of 'BBB'. We expect the company to generate strong cash flows with mid- to high single-digit FCF margin over the medium term. In absence of large M&A, this should result in further deleveraging, supporting a potential upgrade up to 'BBB+' in the event the company reaches leverage similar to industry leader Diageo. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - organic sales growth of about 5% in FY18 stabilising at around 3.0%-4% over FY19-FY21; - a 3% fall in revenue in FY18 due to FX, mostly due to US dollar, Chinese yuan and Indian rupee depreciation against the euro in 2017;. - EBITDA margin gradually increasing towards 30% (FY17: 28.8%) over the next four years, benefiting from the operating efficiency programme, premiumisation trends in many markets and the increasing share of more profitable Asian operations in group revenue; - FCF margin of 7%-8% over FY18-FY21 thanks to operating margin gains, improvements in working capital and moderate investments in ageing inventories (cognac and whisky) over the period; - moderate bolt-on M&A activity of EUR300 million in FY18 and EUR500m annually thereafter; - no change in dividend policy. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - FFO adjusted net leverage (adjusted for leases and factoring) sustainably below 3.5x (FY17: 4.4x) and/or lease adjusted net debt /EBITDAR below 3.0x - FFO fixed charge cover ratio above 5.0x on a sustained basis (FY17: 4.2x) - A condition for an upgrade would be maintaining FCF in the mid- to high single digits as a percentage of sales and preserving a top-three position in the industry. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action, i.e. a Downgrade - Evidence of weakening market position, operating efficiency and/or pricing power resulting in sustained weak sales growth and profit margins - FCF margin reduction towards the low single digits on a sustainable basis due to erosion of operating profitability, increased dividend distributions or material adverse FX movements - FFO adjusted net leverage (adjusted for leases and factoring) sustainably above 4.0x and/or lease adjusted net debt /EBITDAR over 3.5x - FFO fixed charge cover ratio under 4.0x - Material M&A spending if not offset by divestments or equity injections LIQUIDITY Sufficient Liquidity: Pernod had EUR2.4 billion liquidity available at FYE17, split between a EUR2.2 billion undrawn revolving credit facility due in June 2022 and EUR227 million in unrestricted cash and cash equivalents (based on Fitch's definitions) which compares with EUR677 million of reported cash. Together with our estimates of strong FCF of around EUR0.7 billion for FY18, this is enough to cover Pernod's debt repayments due in FY18 of EUR1.1 billion (EUR1.6 billion if adjusted for factoring). Contact: Principal Analyst Tatiana Bobrovskaya Director +7 495 956 5569 Supervisory Analyst Giulio Lombardi Senior Director +39 02 8790 87214 Fitch Italia SpA via Morigi 6 20123 Milan Committee Chairperson Pablo Mazzini Senior Director +44 20 3530 1021 Summary of Financial Statement Adjustments Fitch adjusts the company's net debt by adding back factoring lines (EUR557 million utilisation in FY17). In addition, Fitch adjusts working-capital cash movements by decreasing it by the year-on-year increase in outstanding factoring funding (EUR37 million in FY17) and decreasing cash flows from financing by the same amount. Interest expense in the income statement is increased by the assumed interest paid on factoring debt. Fitch deducts EUR450 million from readily available cash, as an estimate of the average extra use of bank facilities during the year in order to fund a peak-to-trough EUR800 million-EUR900 million swing in trade receivables (including factoring) between end-December and end-June. Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. Applicable Criteria Corporate Rating Criteria (pub. 07 Aug 2017) here Exposure Draft: Corporate Rating Criteria (pub. 14 Dec 2017) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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