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Fitch Affirms Imperial Brands at BBB; Stable Outlook
June 22, 2017 / 3:50 PM / 5 months ago

Fitch Affirms Imperial Brands at BBB; Stable Outlook

(The following statement was released by the rating agency) LONDON/MILAN, June 22 (Fitch) Fitch Ratings has affirmed Imperial Brands PLC's Long-Term Issuer Default Rating (IDR) and senior unsecured ratings of 'BBB', as well as its Short-Term IDR of 'F3'. A full list of rating actions is provided at the end of this commentary. The affirmation of Imperial's ratings reflects Fitch's confidence regarding the continuation of its deleveraging, the resilient and strong cash-flow generation, and a renewed commitment to a prudent financial policy. These aspects offset the weak organic growth in the financial years to September 2016 and 2017 (FY16 and FY17), a modest drain on cash flow from a new phase of marketing and cost rationalisation investments and the adverse effect on net debt the pound's depreciation. The weakening of sterling against the dollar and the euro during 2016 has delayed the reduction in leverage that we expected when in March 2016 we changed our Outlook to Stable from Negative. KEY RATING DRIVERS Temporary Profit Contraction: Imperial's revenues and profit have been reduced in organic terms in 1H17 by considerable price and marketing investments, largely aimed at defending its market share in its key markets. We believe these investments should deliver returns during the balance of FY17 and result in moderate profit growth in FY17, thanks also to currency translation benefits from the company's overseas operations. Thereafter we expect modest profit growth in the low single digits. The company's EBITDA margin (calculated against the company's economic net revenue of GBP8.0 billion) remains among the highest in the industry at 47% in FY16 (FY15: 46%). Operating Efficiency: The company intends to spend GBP750 million over the next four years to reduce complexity, drive operational efficiencies and secure additional global procurement benefits. This should help deliver additional savings of GBP300 million annually by 2020 on top of the previously announced GBP300 million savings that the company is targeting by FYE18 at a cost of GBP600 million. These resources will be deployed to further support the business. Deleveraging Path: We project that Imperial's lease adjusted net debt/funds from operations (FFO) should decline to approximately 3.7x in FY18 having fallen to 4.6x in FY16 from a peak of 5.1x in FY15. Compared to our expectations of March 2016 when we changed our Outlook to Stable, this deleveraging path is delayed by over one year due to adverse currency movements that affected Imperial's FY16 net debt position. The maintenance of a Stable Outlook is aided by FCF generation and from management's track record of prioritising debt repayment. Consistent Free Cash Flow: In FY16 Imperial's free cash flow (FCF) grew to a strong GBP980 million, representing a healthy 12.3% of economic revenues. We expect FCF to fall to approximately GBP800 million pa over FY17-FY18 as we assume a progressive increase in dividend distributions by 10%. Nevertheless, this remains very healthy FCF which supports continued deleveraging. Management Commitment: Net debt increased by GBP1.7 billion in FY16, mostly due to the adverse impact of sterling weakness. However, management's intention to continue to prioritise paying down debt, together with the announced capital discipline and management policy of cash allocation underlines the company's willingness to protect its credit metrics. US Turnaround: Imperial's strategy in the US centres around a relaunch of the Winston brand, which had suffered a long-term decline in volume before its acquisition by Imperial. Encouragingly in FY16, Winston's market share improved by 23bp, thanks to new packaging and advertising together with optimised retailer agreements. Part of Imperial's marketing investments during 1H17 were directed at repositioning Winston to a more affordable pricing point and should result in a further volume recovery. Manageable Regulatory Changes: The first notable implementations of plain packaging in Europe are taking place in 2017 in the UK and France. We believe that part of Imperial's pricing investments of 1H17 have been directed at maintaining an overall competitive profile in the UK market ahead of the introduction of plain packaging and addressing the likely reduction of pricing power that tends to result from restricted branding differentiation. This early reaction to the regulatory change should enable Imperial to defend its market share in the profitable UK market. Overall, Fitch continues to view the impact of regulatory restrictions on the tobacco industry, including the revised European Union Tobacco Product Directive (EUTPD), of smoking bans, cabinet display bans, graphic health warnings on consumption, and plain packaging, as broadly manageable. However, plain packaging could in the longer term lead to erosion of pricing power for the more premium brands and a reduction in the new generation smokers. In Europe, the strength of Imperial's portfolio in the lower priced segment helps it cope with this challenge. DERIVATION SUMMARY In comparison to its peers, Imperial Brands is mainly a European operator, although now with a larger US presence and with a strong presence in the medium- and low-priced segments. Its lower rating than its peers' - British American Tobacco (A-/RWN) and Philip Morris International (A/Negative Outlook) - reflects more limited geographic diversification and higher leverage. At the same time, Imperial's creditors benefit from a more conservative shareholder distribution policy, which gives Imperial the highest free cash-flow margin in the industry. Imperial's 'BBB' is at the same level as Reynolds American Inc, which has seen a spike in leverage from the 2015 merger with Lorillard but which only operates in the more protected environment of the large and oligopolistic US market. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Revenue growth by +3% in FY17, aided by favourable FX of +1% onwards; - EBITDA margin gradually growing from 47% towards 50% over the forecasts horizon; - dividends per share increasing by 10% pa; - no further material M&A; - capex of GBP250 million pa; - tax rate of 20% for FY17; - average exchange rates: GBP/EUR 1.18 (FY16: 1.28); GBP/USD 1.25 (FY16: 1.42) RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - In light of the company's current stretched financial profile, we do not foresee any rating upside in the short term. However, future developments that could lead to positive rating action include: - the trading environment in Imperial's territories is not permanently challenged by widespread introduction of plain packaging legislation or by an accelerated substitution of traditional cigarettes by other products; - FFO net leverage below 3.0x and FFO fixed charge cover ratio above 5.0x; - EBITDA margin above 48% (FY16: 47%); - maintenance of current financial policy. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - Another M&A transaction or a change in shareholder distribution policies preventing FFO net leverage from returning to a sustainable level of around 3.5x (FY16: 4.6x) - FFO fixed charge cover ratio below 4.0x (FY16: 5.4x) - Annual FCF margin below 5% (FY16: 12.3%) on a sustained basis. LIQUIDITY Adequate liquidity: At FYE16, Imperial had GBP0.8 billion of unrestricted cash (as defined by Fitch) and undrawn committed facilities of GBP4.7 billion. The cash decreased in FY16 as a result of a major bond repayment; but liquidity is sufficient to meet short-term debt of GBP1.3 billion due in FY17. The majority of debt is composed of bonds issued by the wholly owned issuing vehicle Imperial Brands Finance PLC and guaranteed by Imperial Brands PLC and by the sub-holding and UK operating subsidiary Imperial Tobacco Ltd. FULL LIST OF RATING ACTIONS Imperial Brands PLC - Long-Term IDR; affirmed at BBB, Stable Outlook - Short-Term IDR; affirmed at F3 - Senior unsecured, affirmed at BBB. Imperial Brands Finance PLC - Senior unsecured, affirmed at BBB Contact: Principal Analyst Marialuisa Macchia Associate Director +39 02 879 087 213 Supervisory Analyst Giulio Lombardi Senior Director +39 02 879 087 214 Fitch Italia S.p.A. 20123 Milano, Via Morigi, 6 Committee Chairperson Raymond Hill Senior Director +44 20 3530 1079 Summary of Financial Statement Adjustments Restricted Cash: the restricted cash figure for Imperial Brands as of FY16 is GBP426 million, being the sum ofGBP134 million for collateral for derivatives and GBP292 million as an estimate of the average restricted cash for operations. Dividends to minorities/from associates: as per Fitch's methodology we included in the calculation of FFO dividends received net of dividends paid (a net GBP23 million outflow). Capitalisation of long-term leases: we applied a multiple of 8x as the company is UK based. Media Relations: Adrian Simpson, London, Tel: 203 530, Email: adrian.simpson@fitchratings.com. 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