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Fitch Affirms Diageo at 'A-'; Outlook Stable
October 23, 2017 / 2:38 PM / 2 months ago

Fitch Affirms Diageo at 'A-'; Outlook Stable

(The following statement was released by the rating agency) MOSCOW/LONDON, October 23 (Fitch) Fitch Ratings has affirmed Diageo plc's Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'A-'/'F2' and its Short-Term IDR at 'F2'. The Outlook is Stable. Fitch also affirmed the senior unsecured ratings on Diageo's subsidiaries, Diageo Finance BV, Diageo Finance plc, Diageo Capital plc and Diageo Investment Corporation, at 'A-'/'F2'. The rating affirmation reflects Diageo's improved operating performance, recovery of free cash flow (FCF) to a strong level of over 5% of revenue, and the stabilisation of its leverage metrics. Over the last two years Diageo has regained market momentum thanks to its strong marketing, distribution and innovation capabilities. At the same time, the resumption of share buybacks as a tool to maintain the company's capital structure within its target range of 2.5x- 3x net debt to EBITDA confirms that any extra cash flow generation is likely to remunerate shareholders rather than protect creditors. KEY RATING DRIVERS Improving Operating Performance: Diageo is now better positioned in our view to meet its target of mid-single-digit sales growth organically for the medium term thanks to stepped-up innovation, marketing and distribution efforts, and improving prospects for the market environments of many of countries in which it operates. In fiscal year ended June 2017 (FY17) Diageo's operating performance continued to improve (4% organic growth in revenue compared with around zero in FY14-FY15) with stronger sales growth across all its markets of operation. This stemmed both from management's initiatives to revive major brands and from an improving market environment in many regions. Stronger Performance in Core Region: We expect Diageo to deliver positive organic sales growth of up to 3% in the medium term in North America, which was responsible for 51% of its profit in FY17. Over FY16-FY17 Diageo succeeded in reviving its performance in this core market, with organic sales growth at 3% annually (FY15: -1.5%). This resulted from continuing share gains in North American whiskies (which account for around 25% of region's sales) and a return to growth for scotch in FY17. Challenges Remain: We continue to monitor Diageo's performance in categories and regions where it is exposed to challenges, such as economies with weak consumer spending environments (eg Russia, Brazil and Venezuela) or subject to sales restrictions (India). Challenges also remain for Diageo in US vodka. In FY17, Diageo's performance in the country was affected by a sales drop in its super-premium vodkas and a loss of market share for its important Smirnoff brand. This, together with high competition and continued demand for craft spirits, particularly in the US, is likely to continue to challenge Diageo's ability to increase its sales as fast as the market. Recovered Cash Flow Generation: We expect Diageo to maintain solid FCF generation of GBP0.7 billion-0.8 billion (after dividends) annually over FY18-FY21. This should stem from our assumption of a further 50bp improvement in EBITDA margin over FY18-FY21 due to the continued change in sales mix toward higher-priced products and the ongoing productivity programme. Diageo has raised its target for the programme (launched in FY15) to GBP700 million in savings (GBP500 million initially) and 175bp in operating margin (100bp) following a strong FY17, with two-thirds reinvested in the business by FYE19. We also expect the gains in FY17 from more efficient working-capital management to continue. Potential Return to Acquisitive Mode: Diageo confirmed with the USD700 million (around GBP520 million) acquisition of Casamigos - a super-premium tequila brand - in FY18 that it is continuing to look out for bolt-on acquisitions to strengthen its portfolio, after having prioritised cash preservation during FY15-FY16. This also follows large divestments of non-core assets in FY15-FY16 of around GBP2 billion. Its reduced leverage and improved cash generation mean we expect Diageo will consider potential bolt-on acquisitions to cover some products/price segment gaps in its brands portfolio. In our model we assume GBP200 million annually (in addition to the purchase of Casamigos) for bolt-on M&A. Share Buybacks Limit Deleveraging: Diageo announced a GBP1.5 billion share buyback in FY18, after strong results and debt leverage reduction in FY17, partly thanks to favourable currency effects on profit and cash flow. We estimate this will return FFO adjusted net leverage to 3.0x (FY17: 2.7x). Our forecasts of Diageo's financial performance indicate that large share-buybacks (up to GBP1.5 billion a year) are likely to continue over FY19-FY20 to keep net debt to EBITDA closer to the lower end of the company's targeted range of 2.5x-3.0x (FY17: 2.0x) We estimate that Diageo's FFO adjusted net leverage will stay mildly above 3.0x over the medium term. Strong Business Profile: Diageo's strengths are reflected in a high EBITDA margin of around 30%, its wide portfolio of brands and its consistent record of product and marketing innovation. Diageo's wide geographical footprint with a healthy revenue split between developed (around 58% in FY17) and emerging markets enhances long-term sales and profit growth prospects, although it exposes the company to some volatility in operating performance. DERIVATION SUMMARY Diageo has the strongest business profile relative to its major peers such as Brown-Forman Corporation (A/Stable), Pernod Ricard S.A. (BBB-/Stable) and Becle, S.A.B. de C.V. (BBB+/Stable). This stems from Diageo's materially larger scale and its strong and highly diversified brand portfolio both by product categories and pricing segments. Diageo also has more widespread geographical coverage, with leading market positions in most regions. This is offset by Diageo's historically higher leverage than Brown-Forman and Becle, which drags the group's IDR toward the lower border of the 'A' category. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - organic annual sales growth of low-mid-single digit over FY18-FY21; - EBITDA margin gradually improving by about 50bp and at around 33% over FY18-FY21; - moderate increase in maturing inventories and stable capex at around GBP600 million annually over FY18-FY21; - annual dividend growth of 5% over FY18-FY21; - GBP200 million bolt-on spending a year over FY18-FY21 in addition to USD700 million spending on Casamigos in FY18; - annual share buyback spending of up to GBP1.5 billion over FY19-FY20, which in the event of bolt on M&A would be reduced proportionately. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -Operational profile remaining strong, as indicated by annual organic revenue and profit growth consistently in the low to mid-single digits -FFO adjusted net leverage sustainably below 2.5x -FFO fixed-charge coverage ratio above 8x on a sustained basis - FCF margin above 5% of revenue Future Developments That May, Individually or Collectively, Lead to Negative Rating Action -FFO adjusted net leverage permanently close to 3.5x (FY17: 2.7x) as a result of shareholder distributions, acquisitions, or business weakness -FFO fixed charge cover ratio below 6.0x (FY17: 8.1x) -Protracted decline in revenue and profit as a result of weakened pricing power or diminished acceptance of Diageo's products, for example due to increased competition -FCF margin below 3.5% of revenue (FY17: 8.4%) LIQUIDITY Adequate Liquidity: At 30 June 2017 Diageo had GBP0.9 billion of unrestricted cash and cash equivalents on balance sheet, and GBP2.1 billion long-term undrawn committed bank facilities, providing comfortable back-up in relation to peak use under its USD8 billion US commercial-paper programme, its EUR2 billion European commercial-paper programme and to its short-term debt maturities. Fitch has adjusted Diageo's cash balance by GBP300 million, representing the average of its annual peak-to-trough working-capital fluctuation, with a peak in December and a low point around June. Contact: Principal Analyst Tatiana Bobrovskaya Director +7 495 956 5569 Supervisory Analyst Giulio Lombardi Senior Director +39 02 8790 872 14 Fitch Italia SpA 6, Via Morigi 20123 Milan Committee Chairperson Pablo Mazzini Senior Director +44 20 3530 1021 Summary of Financial Statement Adjustments Restricted Cash: Fitch has assumed GBP300 million (FY16: GBP400 million) of restricted/not readily available cash to reflect higher intra-year working capital needs. Dividends received/paid to/by associates: Fitch calculates FFO by adding dividends received from JVs/associates net of dividend paid to minorities (a net GBP140 million inflow in FY17). 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