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July 15 (The following statement was released by the rating agency)
Fitch Ratings has revised the Outlook on Imperial Tobacco Group PLC's (Imperial)
Long-term Issuer Default Rating (IDR) to Negative from Stable and affirmed the IDR and senior
unsecured rating at 'BBB'. The Short-term IDR has been affirmed at 'F3'. The senior unsecured
ratings of the debt of Imperial's subsidiaries, Imperial Tobacco Finance PLC and
Altadis Emisiones Financieras have also been affirmed at 'BBB'.
The rating actions follow the announcement by Imperial that it intends to
acquire for USD7.1bn (GBP4.2bn) the assets that US tobacco companies Reynolds
American Inc. and Lorillard Inc. ('BBB'/Stable) will divest once they complete
the transaction they announced today. Fitch views positively the enlargement of
Imperial's US operations but at the same time notes that failure to enhance the
cash flow generation and profit growth capability of its core European business
would seriously impair credit metrics. The revision of the Outlook to Negative
reflects the combination of on-going challenges being faced by the existing
operations of Imperial and the anticipated increase of leverage resulting from
KEY RATING DRIVERS
Stronger Operating Profile
The acquisition will significantly enhance Imperial's US business, giving it a
number 3 position with a cigarette market share of 10% (currently 3%), a more
substantial portfolio that would be well diversified by pricing point, and a
national-reaching distribution platform. This should benefit Imperial's access
to shelf space and its negotiating power with retailers, as well as its existing
cigarette and cigar portfolio. Imperial will also acquire the number 1
e-cigarette brand in the US, blu. This will strengthen its ability to compete in
the EU e-cigarette market. Consequently, we expect Imperial's profitability and
diversification to grow and its reliance on the EU to reduce to approximately
55% of operating profits (63% in FY13).
Weak EU Market
The company's operating profile started to deteriorate in 2013 due to its
heavier-than-peer exposure to the declining EU tobacco market. Fragile consumer
spending in southern Europe and the increase in illicit trade affected
Imperial's consolidated volume performance to a point where price increases were
only just able to offset volume declines. In FY13 consolidated volumes dropped
by 7%, tobacco net revenues declined by 1% and total adjusted operating profit
grew by just 1% in organic terms. Performance in 1H14 worsened with tobacco net
revenue and adjusted operating profit down by 5% and volumes dropped by 8%
compared with 1H13. We therefore believe there is a risk that for some time
Imperial may not be able to defend its overall profits in this environment.
Strategy to Tackle Existing Business
Management is enacting several initiatives to tackle these challenges and
strengthen the existing business which, if successful, would support Imperial's
credit risk profile. These include a stock optimisation and a cost
rationalisation programme, brand migration and working capital initiatives. The
major part of the 1H14 underperformance is deliberate and linked to the
implementation of the stock optimisation programme which will consequently
curtail FY14 profit growth. Management also forecasts cash inflows from its
working capital initiatives in FY15 and FY16.
Execution Risks in Existing Business
While these key initiatives are in support of Imperial's long-term goals, they
carry execution risks, especially when benefits will only start to feed through
fully in FY15, when completion of the acquisition is expected to take place.
Failure of these initiatives to deliver successful results and to support an
improvement of credit metrics ahead of the completion of the transaction could
lead to a downgrade.
Moderate Risks to US Strategy
Although the integration risk of the acquired assets in the US is not high, we
believe there could be some execution risk to Imperial's growth ambitions.
Imperial expects to improve profits and increase its market share over time. We
believe market share increases are achievable but there is a risk this could be
at the expense of price. In addition, Imperial will gain two menthol brands -
Kool and Salem in the US. Although menthol cigarettes enjoy a less severe volume
decline rate compared with traditional cigarettes, we note the on-going debate
over their possible ban.
Leverage Beyond Rating Guidance
Lease adjusted net debt/FFO rose in FY13 to 4.1x and Fitch projects leverage
could peak at above 4.5x in FY15 (at closing of acquisition) before reducing
only to approximately 3.7x in FY17, a level still above the threshold compatible
for the 'BBB' rating. Our net debt figure now includes an adjustment of
approximately GBP400m to cash in order to exclude cash held in countries from
which repatriation is slow or restricted, or that forms collateral. However,
should Imperial deliver the benefits of its different initiatives to enhance
cash flow generation and return to profit growth as planned over FY15 to FY17,
there is a chance that leverage will reduce more quickly and that the Outlook
will be revised back to Stable.
Top Four Tobacco Company
The IDR continues to reflect Imperial's position as one of the four largest
global tobacco players (possibly moving from fourth to third place following the
transaction) and benefits from a portfolio of mid- to low-priced cigarette
brands and make-your-own products, which provides advantages in the high-price
environments of its core markets. This is despite it being less geographically
diversified than the bigger global players British American Tobacco (A-/Stable)
and Philip Morris International Inc (A/Stable). Imperial's 'BBB' IDR reflects
its size, brands and strength in the consolidated global tobacco industry, with
strong positions in the cash-generative UK, German and French markets.
Negative (Downgrade to BBB-): Future developments that could lead to a negative
rating action include:
-Failure by existing business to maintain at least low single digit organic
revenue growth in FY15.
-Failure by existing business in executing the recovery of EBITDA margin back to
2013 level (42.5%; calculated against FY13 economic revenues of GBP14.7bn) in
-FFO net leverage remaining persistently above 3.5x even after the second full
year of closing (FY17 in our projections).
-Fixed charge cover ratio below 4.0x.
-Annual FCF margin dropping below 3%.
Positive (revision of the Outlook to Stable): Future developments that could
lead to a positive rating action include:
-FFO net leverage dropping below 3.5x.
-FFO fixed charge cover ratio above 4.0x.
-Evidence showing the recovery of standalone business with EBITDA margins
improving and trending towards 43%.
-Sustainable FCF generation of at least GBP600m over FY14 and FY15.