Fitch Affirms Philip Morris International at 'A'; Outlook Negative.
The Negative Outlook reflects the risk of a downgrade in the absence of reforms to the current US tax system. This system leads PMI to build up offshore cash balances and carry increasing leverage. Also, PMI's profile is shifting from a business characterised by predictable cash flow generation to one with an increasing investment and development component. While PMI's new Reduced Risk Products (RRP) are showing promising performance and the related investments should proceed at a measured pace, we project more limited post-dividend Free Cash Flow (FCF) than historically. We believe this should be counterbalanced by a return of leverage within the parameters consistent with the current 'A' IDR.
However, we project that the current investment phase for RRPs, combined with the build-up of cash, will cause leverage to remain elevated until at least 2019. Given the increasing chances of a tax reform in the US, this may lead PMI to change its capital structure; in which case, Fitch could affirm PMI's IDR at 'A' and revise the Outlook to Stable.
KEY RATING DRIVERS
"IQOS" Potential Game Changer: During 2017, PMI's "IQOS" - a Reduced Risk Product that offers smokers a smoke-free alternative that heats tobacco but does not burn it - reached relevant levels of contribution to PMI's revenues (9.8% in 9M17). PMI is enjoying a first mover advantage, particularly in Western Europe and Japan. Fitch believes this product, which by utilising tobacco is the closest possible electronic variant to a traditional cigarette, will grow to represent an increasingly material portion of PMI's revenues and profits. Also, we believe that consumers and regulators view it as healthier option compared to combustible cigarettes. Currently, per-unit profitability for PMI benefits from pricing at comparable levels to Marlboro, but excise duty is lower.
Constrained Cash Flow Generation: Since 2014, as a result of currency headwinds and more intense R&D and capex efforts in connection to its RRPs, PMI's operating profit and FCF have reduced from their peak levels of 2012-2013. The EBITDA margin shrunk by almost 400bp between 2013 and 2016 to 43.3% and the FCF margin dropped to around 2% of revenues. Fitch expects FCF (post-dividend) to be broadly neutral in 2017 and remain between 2% to 3.5% in 2018-2019. The recovery of FCF in the outer years of our projections is dependent on a larger scale success of PMI's RRP operations. FCF could however be constrained by further investments, in the event PMI decides to maintain the steady roll-out pace of the product.
Shareholder Distribution Revisited: PMI has historically distributed to shareholders through dividends and share buybacks more than the FCF it generated. Fitch views positively the suspension of PMI's share buyback since 2015, which was followed by a slowdown in the pace of increased dividends since 2014. This indicates a willingness to protect the company's credit metrics and prioritise the allocation of cash flow towards investing to grow the RRP business.
Unremitted Foreign Earnings (UFE): PMI continues to face a mismatch between the location of its earnings and debt, given that it does not have any sales in the US, while debt is raised at the holding company domiciled in the US. PMI regularly repatriates the majority of its foreign earnings. Its cash balances - which are fully abroad - represent the portion of profit that it does not repatriate. We calculate net debt by treating 35% of PMI's cash as restricted (USD1.5 billion for 2016), assuming it would be subject to an up to 35% tax deduction in case of repatriation. We currently expect FFO adjusted net leverage trending below 3.0x by 2018.
Potential Tax Reform Benefits: In the absence of a reform of the US tax system towards a territorial principle, we envisage that PMI would increasingly accumulate more cash balances (up to USD12 billion in 2019 in our forecasts) and correspondingly continue to raise debt to fund the payment of dividends. Conversely, should PMI be able to repatriate those cash balances without an extra tax deduction, we estimate a faster pace of de-leveraging, with a benefit of between 0.3x and 0.5x lower leverage respectively in 2018 and 2020, compared to our rating case projections. Given that PMI already repatriates a majority of its profits, we believe a reduction of the US corporate tax rate would also likely provide some benefits to PMI's tax bill.
Regulatory Changes Manageable: Fitch views the impact of smoking bans, cabinet display bans and graphic health warnings on consumption, including the revised European Union Trade Product Directive, as broadly manageable. Following its introduction in Australia since 2012, France and the UK fully implemented plain packaging in their markets respectively in January and May 2017. We believe that while plain packaging erodes the pricing power for more premium brands and in the longer-term could contribute to reducing the number of new smokers, the medium-term effect on tobacco companies is manageable, due to their geographic diversification and the limited spreading of this regulation.
Leading Industry Player: The ratings continue to reflect the leading position of PMI in the international tobacco industry (excluding the US and China), supported by the diversity of its portfolio of brands and the countries in which it operates. It enjoys large market shares and pricing leadership in many of the most profitable and growing tobacco markets, with superior diversification across continents. All these factors remain consistent with PMI's 'A' IDR in relation to other sector peers and partly compensate for the elevated leverage which would, in isolation, lead to a lower rating.
PMI is the highest rated issuer in the tobacco industry, reflecting its position as the largest international player, followed by British American Tobacco (BAT, BBB/Stable), its price leadership, strong profitability and geographic diversification. PMI benefits from comparable scale as BAT (post Reynolds acquisition) and is ahead of Imperial Brands PLC (BBB/Stable). PMI is rated one notch higher than Altria (A-/Stable) which only operates in the US, but has lower leverage. However, should PMI's leverage not reduce by 2018, its rating would be downgraded to the same level as Altria.
Fitch's key assumptions within our rating case for the issuer include:
- mid to high single-digit sales growth and slight increase in profitability from 2018 onwards, thanks to constantly growing RRP contribution to sales and profit.
- slightly negative FCF generation in 2017, with FCF margin at 2-3% from 2018 onwards.
- no share buybacks between 2017 and 2019.
- sizeable capex of USD1.5 billion - USD1.7 billion per annum to support RRPs.
Fitch does not currently expect management to pursue financial policies that would be commensurate with an upgrade. However future developments that could lead to a revision of the Outlook to Stable include:
- PMI's RRPs maintaining good momentum and supporting positive, at least low, single digit annual organic growth for PMI as a group;
- Change in financial policy or in US tax system allowing FFO adjusted gross leverage trending below 3.0x (2016: 3.4x) and FFO adjusted net leverage trending below 2.5x (2016: 3.1x);
- FCF margin on track to recover towards a level sustainably above 3% (2016: 2.0%); and
- FFO fixed charge coverage sustainably above 6.0x (2016: 7.5x).
Future developments that may, individually or collectively, lead to negative rating action include:
- Persistently weak performance with low or negative organic growth and worse than expected progress of RRPs revenue and profitability, preventing operating EBITDA from growing at least at low single digits;
- FCF failing to return to at least 2% of revenues by 2018;
- inability to deliver a stable to decreasing adjusted net debt (net of Fitch-defined restricted cash) leading to FFO-adjusted gross leverage remaining above 3.0x and FFO-adjusted net leverage above 2.5x by 2019; and
- FFO fixed charge coverage below 6.0x.
Adequate Liquidity: at year-end 2016, PMI's gross debt of USD29.1 billion was well spread out, with no more than USD3 billion of bonds maturing in a given year. PMI needs to regularly issue debt to finance its dividends distribution. Fitch views liquidity backstop resources of up to USD8 billion as comfortable, considering the projected amount of commercial paper issuance.
FULL LIST OF RATING ACTIONS
Philip Morris International, Inc.
-- Long-Term IDR affirmed at 'A', Negative Outlook
-- Senior Unsecured Long-Term Rating affirmed at 'A'
-- Short-Term IDR affirmed at 'F1'
-- Senior Unsecured Short-Term Rating affirmed at 'F1'
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|Publication:||Daily the Pak Banker (Lahore, Pakistan)|
|Date:||Jan 10, 2018|
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