OREANDA-NEWS. Fitch Ratings has placed British American Tobacco plc's (BAT) Long-Term Issuer Default Rating (IDR) and senior unsecured ratings of 'A-' on Rating Watch Negative (RWN) following last Friday's announcement by BAT of its proposed merger with US-based Reynolds American Inc. (Reynolds or RAI, BBB/Rating Watch Positive). A full list of rating actions is shown at the end of this commentary.

The rating action reflects the likely material balance sheet re-leveraging of BAT, should its plans to launch a formal offer for RAI and proceed to a merger be successful at the terms published on Friday 21 October 2016. At the same time, the transaction would enhance BAT's geographic diversification by giving it full exposure to the very large and profitable US tobacco market. It would also create scope for cost and product development synergies from the integration of two companies that share the same brands but are run separately.

Reynold's board has yet to respond to the proposal. The ratings are likely to be downgraded by up to two notches upon a successful completion of the merger, or affirmed if the transaction fails to complete.

KEY RATING DRIVERS

Leverage Increase: Based on the current terms of the proposal, BAT plans to finance the acquisition price of the 57.8% it does not own by offering cash of USD20bn (GBP16.6bn) and a large equity component for approximately 60% of the total price. We calculate that BAT's consolidated funds from operations (FFO)-based gross leverage could rise in 2017 on a pro-forma basis, when the transaction should close, to over 6.0x (equating to total debt/consolidated EBITDA of 4.5x in 2017, up from 2015's respectively 4.4x and 2.8x. This leverage would not be compatible with a rating in the 'A' category.

The transaction will take time to complete, but we expect limited free cash flow (FCF) generation in 2016 by BAT and project net debt to increase at the end of the financial year to December 2016 (FY16) - from FYE15's GBP15.2bn as a result of currency movements.

Scope for Subsequent Deleveraging: BAT has historically targeted a net debt/EBITDA ratio of between 1.5x to 2.5x and we expect management to aim for swift deleveraging and protect BAT's investment-grade rating. However, based on our estimation of annual pre-dividends consolidated FCF of approximately GBP6bn and the assumption that BAT would reduce its dividend payout back to 65%, we project that the merged entity would only reduce consolidated FFO adjusted leverage towards 5.0x by FY19, a level which we can tolerate as 'BBB', considering its pro forma solid business profile and profitability would be compatible with a strong investment-grade rating.

Strong, Stable Business Profile: The ratings would continue to reflect BAT's position as a leading international tobacco company, supported by the diversity of its portfolio of brands and of the countries it operates in. BAT's geographical diversity, including high-growth emerging markets which Fitch estimates contribute more than over 50% of total profits, enables the company to protect profits through price increases and cost rationalisation in an industry that is facing declining consumption. In addition, BAT continues to make progress on its cost rationalisation programmes which allow supporting improvements in its operating profit margin.

Attractive US Tobacco Industry: We calculate that as a result of this transaction, BAT would derive almost 50% of its profits from the US market. The US cigarette industry remains in secular decline, typically in a range of 3% to 4% per year in terms of cigarette volumes, but the industry benefits from an oligopoly structure with essentially three players commanding over 90% of volumes. RAI is the second largest, and has a track record of consistent price increases that compensate for volume declines.

Fitch believes the risk of tobacco litigation court cases leading to major payouts by tobacco companies has significantly abated in the US market. Furthermore, in our view the plan to ban menthol cigarettes - which generate more than 50% of RAI's revenues - seems less likely now.

DERIVATION SUMMARY

In a post-RAI merger scenario, BAT would have an initially very high leverage of 6.0x for a BBB-rated tobacco company ('BBB' FFO net leverage median is 3.5x; 'BB' is 4.5x) and this would fall in 2019 (second full year) below 5.0x. The company's operational profile supports a higher rating than those medians. BAT would remain the second-largest player in the US (after Altria) and internationally (after PMI) but, on a consolidated basis, would become slightly larger than current industry leader PMI. It will continue to enjoy similarly strong EBITDA margins compared to major tobacco peers and have a very strong FCF margin (post dividends) of around 10%.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

- BAT acquires full control of RAI for USD20bn (GBP16.6bn) cash in mid-2017

- BAT assumes USD13bn (GBP11bn) of RAI's debt

- Organic annual revenue and profit growth of low single digits for both the BAT and RAI businesses

- USD/GBP exchange rate of 0.83

- Annualised cost synergies of around USD400m (GBP330m) by 2019 with a related implementation cost of around USD400m spread between 2018 and 2019

- 65% dividend payout

RATING SENSITIVITIES

Future Developments That May, Individually or Collectively, Lead to Positive Rating Action

Subject to BAT not proceeding with a merger with RAI, Fitch would affirm the IDR at the current level with a Stable Outlook based on the following parameters:

FFO adjusted net leverage below 3.0x

FCF margin recovering above 3%, reflecting a stable operating environment and more conservative shareholder remuneration

FFO fixed charge cover staying above 6.0x

Future Developments That May, Individually or Collectively, Lead to Negative Rating Action

Upon conclusion of the merger Fitch would downgrade BAT's rating by up to two notches in the following circumstances:

The expectation that BAT's FFO adjusted net leverage will remain above 3.5x for over two years post merger completion

FFO fixed charge cover under 6.0x (2015: 6.1x)

LIQUIDITY

Adequate Liquidity: On a standalone basis BAT has strong liquidity with no more than 20% of total debt maturing over a 12-month period, cash balances averaging GBP1.5bn-GBP2.0bn and a GBP3.0bn revolving bank facility due May 2020. We assume that, should BAT proceed to a merger with RAI the USD20bn would be funded mainly with bonds and we take comfort from BAT's ability to regularly access the debt markets.

FULL LIST OF RATING ACTIONS

British American Tobacco plc:

--Long-Term IDR: 'A-' placed on RWN

--Short-Term IDR: 'F2' placed on RWN

--Senior unsecured long-term rating: 'A-' placed on RWN

B. A.T. International Finance (BATIF)

--Senior unsecured long-term rating: 'A-' placed on RWN

--Senior unsecured short-term rating: 'F2' placed on RWN

B. A.T. Netherlands Finance B. V.

--Senior unsecured long-term rating: 'A-' placed on RWN