CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed Reynolds American Inc.'s (NYSE: RAI) ratings as follows:
Reynolds American Inc.
--Long-term Issuer Default Rating (IDR) at 'BBB-';
--Guaranteed bank credit facility at 'BBB-';
--Guaranteed unsecured notes at 'BBB-'.
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R. J. Reynolds Tobacco Holdings, Inc. (a wholly-owned subsidiary of RAI)
--IDR at 'BBB-';
--Senior unsecured notes at 'BBB-';
--Guaranteed unsecured notes at 'BBB-'.
The Rating Outlook is revised to Positive from Stable.
Rating Rationale
The Positive Outlook is driven primarily by an improving balance sheet. RAI has continued to reduce debt; its pension funding has greatly improved, and the company's withholding of disputed payment funds will likely be resolved in a neutral to favorable manner.
RAI continues to pay current maturities with cash generated by operations. RAI repaid $900 million of maturing debt the past two years including $400 million of floating-rate notes due June 15, 2011. Fitch anticipates this trend to continue as long as RAI is able to maintain a liquidity cushion with respect to its Master Settlement Agreement (MSA) obligation. Fitch expects RAI may have to access the capital markets next year or the year after to maintain its liquidity position, but the required funding would not substantially alter the company's improving credit metrics.
RAI has been shoring up its pension funds, and in 2010 the company contributed $811 million to its pension funds. The year before that, it contributed approximately $300 million. Its pension funding has improved to 89% funded at Dec. 31, 2010 from 66% funded at Dec. 31, 2008. While RAI plans to contribute more than $300 million this year, further extraordinary contributions are unlikely given the plans' funded position.
A tentative resolution has been reached for the disputed payment funds related to the MSA. RAI has been a large contributor to the disputed funds escrow account despite withholding $400 million in 2009. Under the tentative agreement, Fitch believes RAI likely would not have to repay the $400 million and may possibly receive further compensation.
The affirmation reflects RAI's continued ability to generate substantial cash flow from operations as a result of its high operating margins; its significant levels of liquidity; and its prominent industry position as the second largest U.S. tobacco company. The ratings further consider RAI's shareholder-friendly high target dividend payout ratio - recently raised to 80%. RAI's significant losses in cigarette market share for its non-growth brands, which comprise slightly less than half of the company's cigarette volume, are balanced by the continued growth of its Pall Mall brand.
RAI possesses operational diversification beyond cigarettes which is provided by its growing smokeless tobacco subsidiary, American Snuff Co. (formerly Conwood). American Snuff Co. only represents approximately 13% of RAI's operating income, but its contribution is expected to grow as Fitch's forecast for the moist smokeless tobacco category's annual volume growth is in the mid-single-digit range. RAI's ratings are lower than those of companies with similar credit profiles, largely due to industry factors of continued cigarette volume declines; ongoing, albeit reduced, litigation risk; and increasing regulatory risk.
Key Rating Drivers
--The rating would be positively affected by continued repayment of maturing debt with internally generated cash. Continued cigarette share stability would also positively affect RAI's credit profile along with ongoing moderation of litigation risk.
--A large share repurchase program or material acquisition financed with debt, while not anticipated, would likely result in a Stable Outlook or negative rating actions depending upon the size of the debt funding commitment.
--A return to the litigation risks faced in the early 2000s would result in negative rating actions. A heightened litigation risk environment would be highlighted by a marked rise in probability of material adverse judgments and increasing legal actions in multiple jurisdictions.
Credit Metrics and Liquidity
RAI's credit metrics for the latest 12-month (LTM) period ending March 31, 2011 were within Fitch's expectations and remained strong for the rating category. The company's total debt-to-operating EBITDA was 1.5 times (x) compared to 1.6x at Dec. 31, 2010 and 1.7x at Dec. 31, 2009. RAI's funds from operations (FFO) adjusted leverage was 2.9x, down from 3.2x at Dec. 31, 2010 but up from 2.6x at Dec. 31, 2009. FFO was adversely affected by RAI's large pension contributions. The company's operating EBITDA-to-gross interest edged up to 11.7x from 11.4x at Dec. 31, 2010 and 10.1x at Dec. 31, 2009, due to the company's reduced debt levels.
RAI's liquidity remained substantial with a cash balance of $3 billion at March 31, 2011, of which, a large portion was held for its annual MSA payment, which was $2 billion for the April 2011 payment. The company's liquidity position is bolstered by $491 million of availability under its $498 million revolving credit facility, which expires June 2012. Fitch expects the company to renew its credit facility well before expiration. RAI's maturity schedule is manageable with $449 million, $683 million, $0, and $199 million due in 2012, 2013, 2014, and 2015, respectively.
Litigation
The U.S. Supreme Court refused to hear the Scott case, and the tobacco companies are liable for the funding of a smoking cessation program in Louisiana. In decisions from 2010 and 2007, the tobacco companies are liable for $242 million plus judicial interest and possibly legal costs which have yet to be determined. RAI is responsible for 50% of the judgment and 50% of legal costs of the plaintiffs, which have yet to be determined, on a pre-tax basis. Fitch believes RAI has ample liquidity to meet its obligations per the judgment.
Fitch believes the litigation environment overall continues to improve for the tobacco companies. Engle progeny cases in which tobacco company defendants lose generate headlines, but tobacco companies have had a number of wins, including Engle progeny cases, within the past year.
Regulation
Fitch believes the tobacco companies will be able to manage current regulatory pressures despite increased regulatory oversight. The FDA recently decided upon nine graphic warnings that must be included on cigarette packaging and advertising. The warning labels will need to be on each package of cigarettes manufactured starting in September 2012 and be present on all cigarettes sold in October 2012. While the graphic warnings are startling, a number of countries have had them for years, including Canada. Studies have found the graphic warnings prompt users to think about quitting smoking but quit rates have not been significantly altered by the warnings.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 16, 2010).
Applicable Criteria and Related Research:
Corporate Rating Methodology.
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