Nov 09 -
-- We consider that U.K.-based tobacco manufacturer British American Tobacco PLC (BAT) is sufficiently cash flow generative to be able to maintain its credit metrics at levels we view as commensurate with an ‘A-’ rating.
-- Furthermore, BAT has expressed its commitment to maintain its credit metrics at these levels.
-- We are therefore raising our long-term corporate credit rating on BAT to ‘A-’ from ‘BBB+’ and affirming our ‘A-2’ short-term corporate credit rating on the company.
-- The stable outlook reflects our view that BAT is sufficiently profitable and cash flow generative to maintain metrics that are compatible with an ‘A-’ rating.
On Nov. 9, 2012, Standard & Poor’s Ratings Services raised its long-term corporate credit rating on U.K.-based tobacco manufacturer British American Tobacco PLC (BAT) to ‘A-’ from ‘BBB+'. At the same time, we affirmed our ‘A-2’ short-term corporate credit rating on BAT. The outlook is stable.
The upgrade reflects our view that BAT is sufficiently cash flow generative to be able to maintain its credit metrics at levels we view as commensurate with an ‘A-’ rating. In addition, the group has stated that it manages its financial profile in line with an unadjusted net-debt-to-EBITDA ratio of 1.5x-2.5x. This is compatible with an ‘A-’ rating in the context of BAT’s “strong” business risk profile.
Further support for the upgrade derives from the relatively consolidated nature of the tobacco industry. The four largest players (including BAT) comprise about 80% of the global market, excluding China. This means that there are not as many acquisition targets as in some other consumer goods sectors. In addition, BAT has significant financial flexibility. Its adjusted leverage was 1.7x at the end of June 2012, and adjusted funds from operations (FFO) to debt was 42%, both of which are comfortably compatible with an ‘A-’ rating. Moreover, BAT has maintained adjusted leverage of comfortably less than 3x for the past five years.
Under our base-case operating scenario, we believe that BAT’s revenues will grow by low single digits over the next few years, driven by product innovation, selective price increases, and sales mix improvements. This growth is despite continued pressure on volumes resulting from long-term declines in some of the group’s mature markets, and decreasing disposable incomes in some European countries. Regulatory changes, such as the plain packaging law in Australia, and unexpected excise tax increases can put additional pressure on volumes.
We believe that BAT will be able to increase its EBITDA margin modestly and gradually over the next few years as a result of both price increases and efficiency gains. Our view is consistent with BAT’s annual margin expansion target of 50-100 basis points. Based on these assumptions, we estimate that the group will generate FFO of GBP4.5 billion-GBP5.0 billion and discretionary cash of about GBP1 billion annually over the next few years. Taking into account our assumptions of spending on bolt-on acquisitions and a gradual increase in the amount of share buybacks, we project that BAT will be able to maintain metrics that at their minimum are compatible with an ‘A-’ rating. We consider adjusted debt to EBITDA of less than 2.5x and adjusted FFO to debt of more than 35% as compatible with an ‘A-’ rating.
The ‘A-2’ short-term rating reflects our opinion that over the short term, BAT should have ample internal liquidity, good cash flow characteristics, and significant access to the capital markets. We view BAT’s liquidity as “adequate” under our criteria. This means that we estimate that sources of cash will cover uses of cash by at least 1.2x over the next 12 months.
We estimate that liquidity sources comprise:
-- Cash and cash equivalents of GBP1.7 billion on June 30, 2012;
-- An undrawn GBP2.0 billion revolving credit facility due 2015; and
-- FFO of about GBP4.5 billion.
We estimate that BAT’s liquidity uses over the next 12 months comprise:
-- Short-term debt of GBP1.8 billion as of June 30, 2012.
-- Capital expenditure of about GBP700 million;
-- Dividend payments of about GBP2.5 billion; and
-- Share buybacks of GBP1.3 billion.
In addition, we consider the following factors to support of BAT’s “adequate” liquidity profile:
-- Widespread bond maturities. On June 30, 2012, the group’s average centrally managed debt maturity was seven years. This is unchanged from year-end 2011, and is within BAT’s five-year target. Less than 20% of the group’s debt matures in any one year. The group manages a residual portion its debt locally rather than centrally.
-- Significant headroom under BAT’s 4.5x interest coverage financial covenant, which most of its bank facilities include. There was about 50% EBITDA headroom under this covenant as of June 30, 2012.
-- Absence of downward rating triggers that would accelerate the maturity of a material amount of debt.