Nov 08 - Fitch Ratings has upgraded British American Tobacco p.l.c.'s (BAT) Long-term foreign currency Issuer Default Rating (IDR) and senior unsecured ratings to 'A-' from 'BBB+'. The Short-term IDR has been affirmed at 'F2'. The Outlook is Stable. In addition, the senior unsecured long-term rating of debt issued by BAT's subsidiaries, British American Tobacco Holdings (The Netherlands) B.V., B.A.T. International Finance p.l.c. and B.A.T. Capital Corporation, has been upgraded to 'A-' from 'BBB+'. The short-term rating has been affirmed at 'F2'.
The upgrade reflects the strengthening of BAT's credit metrics since leverage peaked in 2008 combined with the gradual reduction of litigation risk, as well as scope for maintaining a conservative capital structure. These aspects are contrasted by the continuing regulatory pressure on tobacco companies, which constrains their ability to deliver volume growth.
BAT's gross debt has dropped from a peak of GBP12bn at YE08 to GBP9.9bn at YE11, despite the resumption of share buybacks last year. BAT's funds from operations (FFO) grew by an impressive 45% between 2008 and 2011, despite some deceleration in the ongoing process of trading up by consumers in developing markets. BAT's net lease adjusted debt to FFO stood below 2.0x at YE11 (FY08: 3.0x) - a level that the agency views as sustainable over the medium term despite the possibility of a mild step up in share buyback activity and some bolt-on acquisitions.
Fitch notes that litigation risk for US tobacco manufacturers has significantly reduced over time. In the past, the agency applied a discount of approximately one notch to BAT's rating to reflect the chances of an adverse ruling against BAT's associate Reynolds American Inc. (RAI) leading to the disappearance of the majority of dividends from associates (currently accounting for over 10% of BAT's consolidated FFO) and, in an extreme event, a spillover of litigation to BAT itself. This discount has reduced over time and the agency now believes it is no longer justifiable.
The gradual shift of litigation in the US from class actions and other cases pursuing large payouts to cases where the plaintiffs are individuals marks the move into a more manageable environment for tobacco manufacturers. Although Fitch does not exclude some pay-outs, in the agency's opinion, these are unlikely to compromise RAI's generous and consistent dividend distributions to BAT.
Contrasting the improvements on the litigation front, the agency acknowledges mid-term scope for increasing pressure on tobacco companies from the step up of regulatory efforts. These include cabinet display bans and smoking bans. While these initiatives tend to mostly affect consumption, the industry retains strong pricing power and a track record of delivering sustainable revenue growth from price and product mix.
In addition, BAT has improved profitability through cost rationalisation measures, system standardisation and productivity savings. These have significantly contributed to BAT's operating EBIT margin increase by 500 basis points over 2008-2011 to 35.5%. This outcome was well ahead of BAT's target of improving overall margin by 50 to 100 bp per annum. The agency expects the profit margin to continue to broadly improve at this latter pace.
Australia's plain packaging legislation could affect pricing power but material adverse effects on industry players will take time to materialise and only if the legislation is replicated by other jurisdictions. While the latter is possible, in Fitch's view its probability remains remote.
In addition, the company benefits from a growing contribution to revenues from developing markets. However, Fitch believes this could increase volatility of profits due to the currencies in which they are generated.
WHAT COULD TRIGGER A RATING ACTION?
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
- FFO based net leverage above 2.0x
- FCF (adjusted by working capital swings) falling below GBP500m as a result of litigation or dividend distributions
- Fixed charge cover under 6.0x
Positive: Provided that litigation and regulation risks remain manageable, upward rating pressure could materialise in the event of:
- FFO based net leverage lower than 1.0x - 1.2x
- Fixed charge cover above 10.0x
- FCF above GBP1.5bn and FCF margin at least in the high single digits
- Further improvement in Operating EBIT margin above 38%