MRO Magazine

Fitch Assigns First-Time ‘BBB’ Ratings on Reynolds American Inc.; Outlook Stable


May 9, 2016
By Business Wire News

NEW YORK

Fitch Ratings has assigned a Long-Term Issuer Default Rating (IDR) of ‘BBB’ and a Short-Term IDR of ‘F2’ to Reynolds American Inc. (Reynolds). The Rating Outlook is Stable. The ratings apply to $13.5 billion of debt at March 31, 2016. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

–Reynolds’ June 2015 acquisition of Lorillard, Inc. (Lorillard) strengthened Reynolds position as the second-largest cigarette company in the U.S. and enhanced the company’s share of higher margin premium cigarettes, including faster-growing menthol brands.

–Reynolds has reduced total outstanding debt by a notional amount of roughly $4.1 billion since the acquisition was completed, representing roughly a 0.7x gross leverage (total debt to EBITDA) turn based on Fitch’s expected 2016 EBITDA of $5.7 billion. Fitch expects the company will reduce leverage to the publicly stated goal of 2.5x by the end of 2016. Fitch views Reynolds’ long-term gross leverage target of between 1.5x – 2.5x as consistent with a ‘BBB’ rating.

–Solid liquidity is provided internally from solid operating cash flow generation that Fitch expects to exceed $2.5 billion in 2016 and continue to grow over the forecast period. Liquidity is further supported by cash of $4.4 billion and full availability under a recently extended $2 billion five-year revolver due Dec. 2020, as of March 31, 2016. Excess liquidity is important given Reynolds’ annual payment to the Master Settlement Agreement (MSA) that is expected to average around $3.0 billion over the next three years.

–Positive action to current credit ratings is restrained by key factors in the mature industry, specifically secular volume declines, high litigation exposure, and rising regulatory risks including the potential for an eventual restriction or ban on the sale of menthol cigarettes.

KEY ASSUMPTIONS

Fitch’s key assumptions within the rating case for Reynolds include:

–2016 – 2019 Revenue CAGR of 6.1%, as the RJR Tobacco segment posts double digit gains in 2016, benefitting from full year of Newport brand in 2016. Low single digit top line increases for the remainder of the forecast period as secular volume declines return closer to historical averages of 3% – 4%, partially offset by pricing and market share improvement.

–Expansion of EBITDA operating margin of 200 – 300 bps from current levels around 43% over forecast period due to portfolio mix benefits and realization of cost synergies.

–Shareholder dividends of 75% of net income in 2016, increasing to 80% of net income for 2017 – 2019.

–$500 million of 2016 debt maturities paid down with cash on hand. Remaining debt maturities refinanced, except $250 million of incremental debt issued in 2019 to help finance share repurchases discussed below.

–Resulting gross leverage of 2.2x – 2.3x throughout the forecast period.

–Share repurchases of $110 million in 2016 and $125 million in 2017, offsetting share dilution to maintain British American Tobacco p.l.c. (BAT) ownership stake at roughly 42%; $750 million of additional share repurchases are modeled in each of 2018 and 2019.

RATING SENSITIVITIES

Future developments that may individually or collectively, lead to a positive rating action include:

–Mitigation of negative industry factors with an emphasis on the slowing or reversal of secular volume declines;

–Reynolds fully offsetting cigarette volume pressures with meaningful portfolio diversification;

–Significantly reducing litigation risk, most notably the Engle progeny exposure;

–A commitment to a conservative financial strategy demonstrated by lower dividend pay-outs and a commitment to maintain gross leverage below 2.0x.

Future developments that may individually or collectively, lead to a negative rating action include:

–EBITDA pressures arising from greater-than-expected market contraction or a heightened competitive environment, such that gross debt leverage rises and stays above 2.5x;

–Regulatory decisions immediately banning sale of mentholated cigarettes or meaningfully increasing state or federal excise taxes on smoking products that significantly accelerates volume declines;

–Substantial changes in the litigation process, whereby legal cases may reach verdict quicker and/or material adverse judgments significantly increase in number and amount.

LARGER SCALE & STRONGER MARKET POSITION

Fitch believes that Reynolds’ June 2015 acquisition of Lorillard, Inc. (Lorillard) made sound strategic sense, as it significantly enhanced Reynolds’ competitive position and strengthened distribution and visibility for Lorillard’s key Newport menthol cigarette brand. The addition of Newport strengthened Reynolds position as the second largest seller of cigarettes in the U.S. behind Altria Group, Inc. (Altria). The acquisition of Newport (and concurrent divestiture to Imperial Tobacco Group, PLC (Imperial) of its Kool, Winston, Salem and Lorillard’s Maverick cigarette brand and blu e-vapor brand along with Lorillard’s owned and leased real property, certain transferred employees, and associated liabilities) resulted in a net increase in overall U.S. market share to more than 34% as of first-quarter 2016 from 26% pre-transaction.

The primary catalyst for the Lorillard acquisition was the addition of Lorillard’s Newport brand, the leading menthol cigarette and second-largest overall cigarette brand in the U.S. Newport has steadily grown its market share for several years. Newport is also well positioned with the ASU30 market which augurs well for the durability of the brand. Faster growing menthol brands now comprise roughly 55% of Reynolds total cigarette volumes, and the company’s share of the ASU30 market is 42%, higher than Reynolds 34% share of the overall market.

When Reynolds acquired Lorillard, it identified $800 million of cost synergies, $500 million of which were realized on day one, largely related to the transfer of certain Lorillard employees and property to Imperial. Reynolds expects Newport’s manufacturing integration to be completed by the middle of 2016, which would be ahead of the originally expected 18-month transition period that would have seen Newport’s manufacturing integration completed by the end of 2016. The Newport integration should put Reynolds on a clear path to realizing the incremental $300 million of cost synergies. The resulting cost savings should help support margins if recent favourable volume mix toward premium brands reverses.

U.S. CIGARETTE CONSUMPTION IN DECLINE

The secular cigarette decline in the U.S., typically in the range of 3% to 4% per year, is expected to continue. U.S. tobacco companies currently experiencing moderating volume declines should continue to see a favorable consumption pattern in 2016, but not to the same degree. The historical decreasing trend in cigarette volume eased in 2015 to a decline of less than 1% and will likely modestly reverse in 2016 given a difficult year-over-year comparison. Increased disposable income causing the improvement should remain in the hands of the U.S. smoking population given Fitch’s expectations of U.S. economic recovery and subdued oil pricing (and thus lower gasoline prices) through 2016. Up-trading to premium brands coupled with operational leverage under this environment will help maintain strong margins for U.S. tobacco manufacturers. Fitch estimates a return to the historical annual rate of cigarette decline by 2017.

Reynolds maintains a leading market position in several products that serve as alternatives to traditional combustible tobacco products. Fitch views these products, which include VUSE, Reynolds’ market leading vapor “cig-a-like”, and Zonnic, Reynolds’ nicotine gum, as part of a longer term strategy that could gain traction as tobacco consumers continue to transition away from combustible tobacco products due to health concerns. Presently, these products comprise a fairly small portion of Reynolds sales and profitability

PERSISTENT LEGAL & REGULATORY OVERHANG

Litigation risk is high for the large tobacco manufacturers, including product liability, consumer fraud, and health recovery cases totalling in the thousands. Reynolds is the second-leading cigarette producer in the U.S., behind Altria and is therefore exposed with high risk stemming from the Engle progeny legal actions in Florida consisting of 2,963 cases, nearly all of which are currently pending in Florida state courts. The company, like its competitors, has an experienced legal team that has stretched the period to resolution of litigation by effectively using the appellate process.

Of particular relevance to Reynolds, which generates more than 50% of net sales from menthol cigarettes, is the possibility that the FDA will move to ban or severely restrict the sale of menthol cigarettes. Fitch notes that the issue of menthol cigarettes in not currently on the FDA’s unified agenda. As such, a near-term ruling appears unlikely. Fitch believes that an immediate or “day one” ban on the sale of menthol cigarettes in the U.S. is not likely. However, if it were to occur, the growth outlook for tobacco producers would change dramatically. Fitch expects the industry to mount legal challenges to any proposal offered by the FDA, further delaying implementation. During this time period, Fitch believes that many smokers would likely switch toward a similar non-mentholated product line within the brand, or other smoking alternatives, which would help mitigate some potential lost revenues.

SHAREHOLDER STANCE DAMPENS UPWARD RATINGS MOMENTUM

Fitch expects Reynolds to maintain its shareholder-friendly posture through the ratings horizon, which includes dividend pay-outs of around 75% – 80% of net income over the forecast period. The company gains flexibility for heavy shareholder returns from limited acquisition opportunities and light capital spending (around 2% of revenues). The Company has increased its dividend by 250% since 2004, paying $12 billion in dividends over that time period, and recently increased its quarterly dividend by 16.7% starting in the second-quarter of 2016.

Share repurchases have recently been limited to offset dilution and maintain BAT’s ownership stake at 42%, although Fitch expects the company to complete additional share repurchases on an opportunistic basis during its forecast period. Fitch sees this strategy as manageable at current cash flows and with gross leverage expected to be maintained between 1.5x – 2.5x.

SOLID LIQUIDITY

Liquidity is solid with cash of $4.4 billion and full availability under a recently extended $2 billion five-year revolver due Dec. 2020 as of March. 31,2016. Internal liquidity is provided by strong operating cash flows that increase annually and should comfortably exceed $2.5 billion in 2016. Excess liquidity is important given Reynolds’ annual payment to the MSA that is expected to average around $3.0 billion over the next three years.

Reynolds debt structure is well laddered and the company faces no significant near-term debt maturities until 2018, when $1.25 billion of senior unsecured notes mature. Reynolds plans to pay down its $500 million August 2016 debt maturity with cash in hand. Fitch expects that Reynolds will be able to refinance its debt maturities in normally functioning capital markets.

FULL LIST OF RATING ACTIONS

Fitch has assigned the following ratings:

Reynolds American Inc.

–IDR ‘BBB’;

–Short-term IDR ‘F2’;

–Commercial paper ‘F2’:

–Senior Unsecured Credit Facility ‘BBB’;

–Senior Unsecured Notes ‘BBB’.

R.J. Reynolds Tobacco Company

–IDR ‘BBB’;

–Senior Unsecured Notes ‘BBB’.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Corporate Rating Methodology – Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1004204

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1004204

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Fitch Ratings
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Gregory Dickerson
Director
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Fitch Ratings, Inc.
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New York, NY 10004
or
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Senior Director
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or
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