OREANDA-NEWS. Fitch Ratings has affirmed US-based tobacco group Philip Morris International, Inc's (PMI) Long-Term Issuer Default Rating (IDR) and senior unsecured long-term rating at 'A'. PMI's Short-Term IDR and short-term debt rating are affirmed at 'F1'. The Outlook on the Long-Term IDR is Negative.

The ratings reflect the strong operating profile of PMI, supported by its leading market shares and pricing power, which translates into a healthy operating EBITDA margin for the sector in excess of 40%. However, this is balanced by a lack of leverage headroom. Fitch expects PMI's funds from operations (FFO)-adjusted gross leverage over 2016-2018 to be slightly above the 3.0x maximum threshold compatible with the current 'A' rating. Fitch expects PMI to retain strong overall financial flexibility and to maintain a prudent financial policy as we do not assume the resumption of share buybacks and acquisitions during 2016-2019.

The Negative Outlook reflects our expectation of profit margin erosion and limited free cash flow (FCF) after dividends over 2016-2017, due in part to investment in reduced risk products (RRPs), and high financial leverage for the ratings. We also expect credit metrics to continue to be impacted, albeit decreasingly, by currency depreciation.

A one-notch downgrade could result from PMI's cash flows being permanently impaired due to continued investments, operating challenges in key markets or elevated shareholder distributions. The Outlook may be revised back to Stable if PMI's superior price/product mix growth and evidence of RRPs breaking even, without profit margin dilution, translate into strengthening FCF generation, while maintaining a conservative financial policy.

KEY RATING DRIVERS

No Leverage Headroom

PMI's FFO-adjusted gross leverage continued to increase to 3.3x in 2015 (2014: 3.2x), above the 3.0x ceiling for PMI's 'A' rating. Fitch forecasts FFO gross leverage over 2016-2018 to continue to be above 3.0x, driven by RRPs-related capital expenditure and continued currency depreciation, albeit to a lesser extent during 2016-2017.

Fitch revised the Outlook to Negative in July 2015, reflecting PMI's stretched credit metrics, after profit margin and compressed cash flow in 2014 due to market challenges, investments in RRPs, and the negative impact from currency depreciation. Shareholder returns also contributed to exacerbating the deterioration of credit metrics.

RRPs' Potential

Fitch believes that, combined with PMI's market clout, the products that the company has available (i. e. iQOS) and under development, should allow it to win market share against peers. We believe PMI's guidance for incremental operating companies' income (OCI) from RRPs of between USD720m and USD1.2bn pa. by 2020 is achievable given the current success enjoyed, especially in Japan where PMI has now reached capacity limits for its Heatsticks (refills for its heat-not-burn iQOS product). PMI has begun commercialisation of iQOS since October 2014. Japan was the first market with nationwide roll-out in April 2016.

However, investments in RRPs since 2014 have further impacted operating profit. Fitch expects FCF (post-dividend) to be neutral over 2016-2017, due in part to increased capital expenditure in RRPs, yet we envisage FCF margin would trend towards 4% by 2018 (2015: 2.4%) which could contribute to a revision of the Outlook to Stable.

Shareholder Distribution Revisited

Fitch also views positively the suspension of PMI's share buyback in 2015, indicating a willingness to protect the company's credit metrics. PMI has historically distributed to shareholders through dividends and share buybacks, more than the FCF it generated. A large part of those share buybacks has historically been debt-funded, which has resulted in an increase in debt quantum over time.

Undistributed Foreign Earnings (UFE)

PMI faces a mismatch between the location of its earnings and debt, given that the company does not have any sales in the US while debt is raised at the holding company domiciled in the US. While PMI regularly repatriates the majority of its foreign earnings, a portion of it is held abroad.

The company had USD3.4bn of cash and cash equivalent on balance sheet at end-2015, all held outside of the US. While Fitch recognised that this cash balance can be accessed, it also attracts a potential tax cost when repatriated. Our adjusted net leverage ratios now include a generic 35% tax haircut on cash, which is based on our conservative assumption that, if repatriated back to the US, these cash balances would be subject to the maximum US tax rate. Nevertheless, gross leverage remains a primary ratio for Fitch when evaluating PMI.

Strong Organic Revenue Performance

In 2015, the company reported pricing gain of 6.8% (2014: 4.8%) and volume decline of only 1% (2014: -2.8%), its best performance since 2012. As a result organic revenue grew 5.8% while adjusted OCI grew 6.6% (2014: flat). This trend continued in 1H16, where the company reported still reasonable pricing gain of 5.1% but declining volumes, resulting in organic revenue growth of 1.9%. We expect PMI's organic growth for 2016 to be stable, driven by better price/product mix, against a predictable global excise tax environment and stable global illicit trade activities.

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, the UK and France implemented plain packaging in May 2016 with full compliance at the retail level by January 2017 in France and by May 2017 in the UK. In Ireland, implementation is subject to a Ministerial Commencement Order, which has yet to be issued. 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 to the still limited popularity of this regulation.

Leading Industry Player

The ratings continue to reflect the leading position of PMI in the global 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 a strong 'A' IDR in relation to other sector peers and compensate for the elevated leverage which would, in isolation, lead to a lower rating.

KEY ASSUMPTIONS

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

- Revenue and profits impacted by currency headwinds as well as investments in RRPs in 2016-2017

- Low single-digit sales growth and slight increase in profitability from 2018 onwards with price gains offsetting volume declines

- Neutral FCF generation with FCF margin resuming to around 4% from 2018 onwards

- Dividends increasing 2%-3% annually, resulting in a dividend pay-out ratio of around 80%-90% between 2016 and 2019

- No share buybacks between 2016 and 2019

RATING SENSITIVITIES

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

- Persistently weaker-than-historical performance with low or negative organic growth, the continuation of negative currency impact and slower-than-expected progress of RRPs leading to operating EBITDA margin remaining under 45% (2015: 42.7%)

- FCF margin failing to return to at least 3.5%- 4% of revenues (2015: 2.4%)

- High debt levels or failure to increase FFO causing FFO-adjusted gross leverage to remain permanently within the 3.0x-3.5x range (2015: 3.3x) and FFO-adjusted net leverage above 2.8x (2015: 3.0x)

- FFO fixed charge coverage below 6x (2015: 7.5x)

- Unfavourable tobacco litigation outcome requiring PMI to pay a large compensation

Positive: 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:

-Improving FCF due to debt reduction, resulting in FFO-adjusted gross leverage trending below 3.0x or FFO-adjusted net leverage below 2.5x by 2018

- FCF margin on track to recover to a level sustainably above 4% beyond 2017

- FFO fixed charge coverage sustainably above 6x

- No material cash outflow from ongoing litigation

LIQUIDITY

At end-2015, PMI's gross debt of USD28.5bn was well spread out with no more than USD3bn of bonds maturing in a given year. Fitch views liquidity backstop resources of up to USD8bn are more than adequate.