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Fitch Maintains British American Tobacco on Rating Watch Negative
April 26, 2017 / 4:32 PM / in 8 months

Fitch Maintains British American Tobacco on Rating Watch Negative

(The following statement was released by the rating agency) LONDON/MILAN, April 26 (Fitch) Fitch Ratings has maintained British American Tobacco plc's (BAT) Long-Term Issuer Default Rating (IDR) and senior unsecured ratings of 'A-' as well as its Short-Term IDR of 'F2' on Rating Watch Negative (RWN). A full list of rating actions is shown at the end of this commentary The ratings remain on RWN pending the completion of the agreed proposal by BAT's board to merge with its 42% owned associate Reynolds American Inc. (RAI). Fitch is likely to downgrade BAT's IDR by two notches on the back of the company's post-merger profile, which will benefit from an enhanced geographic footprint but will be burdened by increased leverage. The process of approvals is proceeding well and the company expects to complete the transaction during the third quarter of 2017. Should however the transaction be called off, Fitch would reassess whether this could lead BAT to adopt a more aggressive financial policy or whether its leverage on a standalone basis, which is currently high for the current 'A-' rating, could continue its recent steady decline. KEY RATING DRIVERS RAI Deal Increases Leverage: Based on the terms of the proposal agreed by BAT's and RAI's Boards in January 2017, BAT plans to finance the acquisition price of the 57.8% it does not own by offering cash of USD24.5bn (GBP20 billion) and a large equity component of USD25.1 billion. BAT will also take on USD10.3 billion of RAI's debt, which it will treat as pari passu with its own debt. We calculate that BAT's consolidated funds from operations (FFO)-based net leverage could rise in 2017 on a pro forma basis, when the transaction should close, to over 5.5x (equating to net debt/consolidated EBITDA of between 4.0x and 4.5x in 2017), up from 2016's 3.7x (2.6x based on net debt/ EBITDA). Scope for Subsequent Deleveraging: BAT has historically targeted a net debt/EBITDA ratio of between 1.5x to 2.5x and it is proving, by utilising equity for the RAI transaction, that it values its investment-grade rating. Management confirmed that following the merger it intends to prioritise the allocation of cash flow to paying down debt, and so expect to reduce net debt/EBITDA to 3.0x by 2019. We estimate strong annual consolidated FCF of on average GBP1.5 billion and project that FFO adjusted leverage should drop to between 4.5x and 5.0x (equal to approximately 3.5x net debt/EBITDA) by the financial year to December 2019 (FY19). However, this level of leverage can only currently support a 'BBB' IDR. This takes into account BAT's pro forma strong business profile and profitability, which are compatible with an 'A' category rating. Strong, Stable Business Profile: The ratings continue to reflect BAT's position as a leading international tobacco company, with the prospect, after the merger, of becoming the largest industry player 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. Following the merger, BAT will combine a strong concentration in the profitable US market 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 support further improvements in its operating profit margin thanks to USD400 million targeted synergies and RAI's higher margin than BAT's. Attractive US Tobacco Industry: We calculate that as a result of the merger with RAI, BAT would derive 45% of its profits from the US market. The US cigarette industry remains in secular decline, typically in a range of 3% to 4% per year in terms of cigarette volumes, but the industry benefits from an oligopoly structure with essentially three players commanding over 90% of volumes. RAI is the second largest, and has a track record of consistent price increases that compensate for volume declines. Lower Tobacco Litigation Risks: Fitch believes the risk of tobacco litigation court cases leading to major payouts by tobacco companies has significantly abated in the US market. In our view the plan to ban menthol cigarettes - which generate more than 50% of RAI's revenues - seems less likely now. However, the risk of this adverse regulatory event has not fully disappeared and its materialisation could affect BAT's profits in the US following the merger in the coming years. DERIVATION SUMMARY In a post-RAI merger scenario, BAT would have an initially very high pro forma annualised net leverage of over 5.5x for a 'BBB' rated tobacco company ('BBB' FFO adjusted net leverage median is 3.5x; 'BB' is 4.5x) and this would fall in 2019 (second full year) below 5.0x. The company's operational profile supports a higher rating than those medians. BAT would remain the3 second-largest player in the US (after Altria rated 'A-') and internationally (after PMI rated 'A' with Negative Outlook). However, on a consolidated basis, BAT would become slightly larger than current industry leader PMI. It will continue to enjoy similarly strong EBITDA margins compared to major tobacco peers and have a very strong FCF margin (post dividends) of between 6% and 8%. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - BAT acquires full control of RAI for USD24.4 billion (GBP20 billion) cash in 2H 2017; - BAT assumes USD13 billion (GBP10.6 billion) of RAI debt; - organic annual revenue and profit growth in the low single digits for both the BAT and RAI businesses - USD/GBP exchange rate of 0.82; - capex as percentage of pro forma sales averaging 3.7% over 2017-2020; - acquisition synergies of GBP160 million in FY18, GBP346 million in FY19 and GBP404 million in FY20 RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action Subject to BAT not proceeding with a merger with RAI, Fitch would affirm the IDR at the current level based on the following parameters: - FFO adjusted net leverage below 3.0x; - FCF margin recovering above 3%, reflecting a stable operating environment and more conservative shareholder remuneration; - FFO fixed charge cover staying above 6.0x. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action Upon conclusion of the merger Fitch would downgrade BAT's rating by up to two notches in the following circumstances: - the expectation that BAT's FFO adjusted net leverage will remain above 3.5x for over two years; - FFO fixed charge cover under 6.0x (2015: 6.1x). LIQUIDITY Strong Liquidity: The group currently has strong liquidity with, over the coming 10 years, no more than 10% of total debt maturing in any 12-month period, cash balances averaging GBP1.5 billion to GBP 2 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 to GBP6 billion its RCF. Under the bridge facility it will need to refinance - most likely in the bond markets - USD15 billion over the first two years since closing and USD5 billion within three years from closing, which we think is achievable. FULL LIST OF RATING ACTIONS British American Tobacco plc: --Long-Term IDR: maintained at 'A-' on RWN --Short-Term IDR: maintained at 'F2' on RWN --Senior unsecured long-term rating: maintained at 'A-' on RWN B.A.T. International Finance (BATIF) --Senior unsecured long-term rating: maintained at 'A-' on RWN --Senior unsecured short-term rating: maintained at 'F2' on RWN B.A.T. Netherlands Finance B.V. --Senior unsecured long-term rating: maintained at 'A-' on RWN Contact: Principal Analyst Marialuisa Macchia Associate Director +39 02 8790 87 213 Supervisory Analyst Giulio Lombardi Senior Director +39 02 8790 87 214 Fitch Italia S.P.A. Via Morigi 6 20123 Milan Committee Chairperson Pablo Mazzini Senior Director +44 20 3530 1021 Summary of Financial Statement Adjustments - 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. Additional information is available on 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 Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: Additional information is available on Applicable Criteria Criteria for Rating Non-Financial Corporates (pub. 10 Mar 2017) here Additional Disclosures Solicitation Status here#solicitation Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. 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