Fitch Affirms Diageo at 'A-'; Outlook Stable

Wed Apr 24, 2013 11:31am EDT

(The following statement was released by the rating agency) MILAN/PARIS/LONDON, April 24 (Fitch) Fitch Ratings has affirmed Diageo plc's (Diageo) Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'A-' and Short-Term IDR at 'F2'. The Outlook on the Long-term IDR is Stable. Diageo's subsidiaries, Diageo Finance BV, Diageo Finance plc, Diageo Capital plc and Diageo Investment Corporation's senior unsecured ratings have also been affirmed at 'A-'/'F2'. Diageo's ratings continue to factor in its leadership in global spirits and its advantages over other players in terms of breadth of alcoholic beverage categories, the ownership of large, globally known brands as well as a presence across all pricing points, particularly premium and above. These aspects are contrasted by the agency's expectation that Diageo's rating headroom will remain constrained by M&A spending and other growth-related investments. KEY RATING DRIVERS: Healthy Operating Profile Diageo's strengths are reflected in a high EBITDA margin of over 30%, the resilience demonstrated by its sales and profits in FY09 and FY10, and its strong innovation capability, which contributed to improved performance in FY11 and FY12. In addition, Fitch views positively Diageo's geographical spread across North America, Western Europe and other markets, with an increasing contribution from high growth developing markets (40% of net sales at FYE12). Growth Markets Offset Europe Diageo derives over one-quarter of its profits from Europe, where weak consumer spending in Western and Southern Europe has been weighing negatively on its trading performance since FY09. Conversely, good organic revenue growth in North America and developing markets resulted in strong consolidated revenue growth of 6% in FY12 and a still good 5% in 9M2013, despite an industry slow-down in sales in Asia since the beginning of FY13. Fitch factors in positively the company's current investments on long-term growth in developing countries, including the shift of focus of advertising expenditure, although it expects a temporary dilutive margin impact from the increasing weight of developing countries. Weakness in Tequila from FY14 While tequila is a far smaller global category than whisky and vodka, it is an important constituent of the product offering in the US. Diageo's loss of the rights to distribute Jose Cuervo from FY14 is relevant from a strategic standpoint rather than the cause of a material profit reduction. Fitch believes it could lead Diageo to invest in the development of alternative brands, both in-house (including expanding Don Julio - a brand it manages through a joint venture, focused on the super-premium price point) but possibly also through M&A. Manageable Excise Duty Risk Governments in need of tax income or with policies intended to protect the health of citizens have increasingly been considering excise increases. Excise duties are related to alcoholic content and mostly affect lower-priced products. Therefore, demand for higher-priced products, such as those sold by Diageo, typically suffers less, as excises and VAT account for a lower proportion of their retail price. As a reference, in France taxes represent 84% of a 700ml bottle of vodka that retails for EUR13 but only 52% for a bottle retailing at EUR25. However, following increases of excise on spirits and beer since 2010 in Russia, Turkey and France, no increases are currently planned in major European markets or the US. Acquisition Risk Despite Diageo's uptick in M&A spending over 2011-2012, Fitch does not rule out the possibility of further transactions, be it on developing-world targets, or on products with scope for global roll-out. Diageo could evaluate a takeover of Beam, Inc. ('BBB'/Stable), an important spirits company which owns the major bourbon whisky portfolio and Sauza, the second largest tequila brand in the US. Gaining Sauza could help Diageo with retaining its leadership in tequila; however Fitch estimates that a debt-funded acquisition of Beam would cause a disbursement of well above Beam's current market value of USD8.6bn introducing a negative pressure on the company's rating. Minority Participations Additionally, Diageo has a number of minority participations which it mostly consolidates fully despite only having title to a proportion of their profits. Fitch believes Diageo is likely to invest in increasing some of its stakes in these strategic investments, which include United Spirits India. While these assets remain minor profit contributors, a step up in the use of acquisition structures with minority participations could absorb Diageo's rating headroom. Rating Headroom Testing Limits Over the next two years, Fitch expects cash from operations to be absorbed by higher working capital and capex outflows in relation to planned increases in whisky capacity, as well as a regular increase of dividend distribution in at least the high single digits. Therefore FCF should remain aligned with FY12's GBP500m (lower than FY10-FY11) despite the increase of profits. This provides some headroom within the current 'A-' rating and a degree of flexibility for bolt-on acquisitions despite Diageo's FY13 lease-adjusted net FFO leverage being likely to reach 2.9x (including the full consolidation of United Spirits). RATING SENSITIVITIES Positive: Future developments that could lead to positive rating actions include: - FFO adjusted net leverage (including put options) on a permanent basis below 2.5x - FFO fixed charge cover ratio above 8.0 x - Continuation of consistently positive, at least low-mid single digit organic revenue and profit growth - Free cash flow moving well above GBP600m - GBP700m Negative: Future developments that could lead to negative rating action include: - FFO adjusted net leverage (including put options) on a permanent basis above 3.0x - either as a result of shareholder distributions / acquisitions / business weakness - FFO fixed charge cover ratio below 6.0 x - Organic revenue and profit growth negative or expected to be negative for three successive six-month periods - Permanent EBITDA margin erosion by more than 150bps - 200bps caused by trading difficulties - Free cash flow below GBP300m - Materially adverse regulatory changes causing declines in global spirits consumption Contact: Principal Analyst Anne Porte Associate Director +33 144 29 91 36 Supervisory Analyst Giulio Lombardi Senior Director +39 02 8790 87214 Fitch Italia SpA Vicolo Santa Maria alla Porta, 1 20123 Milan Committee Chair Pablo Mazzini Senior Director +44 20 3530 1021 Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@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 Methodology', dated 8 August 2012, are available at www.fitchratings.com. Applicable Criteria and Related Research Corporate Rating Methodology here Additional Disclosure Solicitation Status 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 WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. 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