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BAT's business strengths manifest through its resilient profitability and cash generation, strong market position, and its broad geographic diversification. We believe cash flow generation will continue to be supported by rising incomes in emerging markets and by the group's relatively low capital intensity and strong brand equity, which acts as a barrier to entry. These strengths are partially mitigated by declining volumes and rising consumer price sensitivity in mature markets. Further rating constraints are the tobacco industry's exposure to shifts in regulatory framework, tobacco taxation, and litigation risks. On June 30, 2012, BAT had Standard & Poor's-adjusted debt of GBP10.7 billion, or about 1.7x EBITDA.
S&P base-case operating scenario
We estimate that BAT will be able to grow its revenues in the low single digits annually over the next few years. This will in our view be driven by demand from emerging markets such as Asia and Africa where disposable incomes are rising. In addition, gradual price increases, product innovation, and sales mix improvements should provide further support to the group's revenues.
This is despite potential volume pressures. Over the medium term we think that BAT's volumes will be put under pressure by a trend of declining smoking rates in some mature markets and weak demand from consumers in Southern European countries where unemployment remains high and disposable incomes are being squeezed. In addition, unexpected excise tax increases and regulatory changes--such as the Australian plain-packaging law that came into effect in December 2012--may put further pressure on volumes.
We believe that BAT will be able to improve its margins modestly and gradually over the next few years as a result of both price increases and efficiency gains. This view is supported by the company's annual margin expansion target of 50-100 basis points (bps). BAT's adjusted EBITDA margin was about 42% at the end of June 2012.
S&P base-case cash flow and capital structure scenario
Given our projections for revenue growth and modest margin expansion, 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 the minimum compatible with the current ratings. We consider adjusted debt to EBITDA of less than 2.5x and adjusted FFO to debt of more than 35% as compatible with the current ratings.
Our projections incorporate the risk of BAT's 42%-owned operating affiliate in the U.S., Reynolds American Inc. (BBB-/Stable/--) suspending a regular equity dividend to BAT for litigation-related reasons or otherwise. Specifically, we estimate that the impact of a hypothetical suspension of dividends would not be material.
Additional support to our leverage projection is our understanding that BAT manages its financial profile in line with an unadjusted net-debt-to-EBITDA ratio of 1.5x-2.5x. Moreover, BAT has maintained adjusted leverage of comfortably less than 3x for the past five years.
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 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.
The stable outlook reflects our view that BAT is sufficiently profitable and cash flow generative to maintain metrics that at their minimum are compatible with the current ratings--adjusted FFO to debt of more than 35% and adjusted debt to EBITDA of less than 2.5x--over the next few years. The outlook also incorporates our understanding that BAT is committed to adhering to a moderate financial policy that is compatible with the current ratings.
In light of our base-case operating scenario, downward rating pressure would most likely arise as a result of a change in financial policy rather than as a result of weak operating performance. Specifically, we could lower the ratings if BAT increased its level of spending on returns to shareholders and/or acquisitions such that adjusted leverage rose to more than 2.5x on an ongoing basis. We view a downgrade to be unlikely, given the large amount of discretionary spending required to reach adjusted leverage of 2.5x and our understanding that the group is committed to a moderate financial policy.
We could raise the ratings if the group committed to adjusted leverage of less than 1.5x. We currently view this as unlikely.
Related Criteria And Research
-- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
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