OREANDA-NEWS. Fitch Ratings has affirmed British American Tobacco plc.'s (BAT) Long-term Issuer Default Rating (IDR) at 'A-' with a Stable Outlook. The Short-term IDR has been affirmed at 'F2'. In addition, the senior unsecured long-term rating of debt issued by BAT's subsidiaries, B.A.T. International Finance plc and B.A.T. Netherlands Finance B.V., has been affirmed at 'A-'. The short-term debt rating has been affirmed at 'F2'.

The affirmation follows BAT's announcement of a tender offer to acquire the remaining 24.7% share it does not own in Souza Cruz for a total cash disbursement of up to GBP2.3bn and to delist the company. This transaction, coupled with the planned USD4.7bn (GBP3.0bn) capital disbursement linked to the Reynolds American Inc (RAI) transaction announced in July 2014, which will also likely complete in 2015, will keep leverage at a level beyond the maximum compatible with BAT's 'A-' rating in 2015 and 2016.

However, in Fitch's view, the impact of higher leverage is sufficiently mitigated by i) BAT's decision to suspend its share buyback programme until at least end-2016, which should enable a swift deleveraging, ii) the future benefits from the fuller integration of Souza Cruz; and iii) the prospect of a stronger RAI in which BAT will maintain a 42% stake.

KEY RATING DRIVERS
Potential New M&A Transaction
As US antitrust authorities have not yet approved Lorillard's acquisition by RAI, there is still the possibility that RAI's cash offer for rival Lorillard will not go ahead and consequently BAT will not be required to contribute USD4.7bn of capital. However, Fitch calculates that the Souza Cruz minority buy-out announced today, combined with the USD4.7bn outflow related to RAI, would lead to a deterioration of BAT's credit metrics, with funds from operations (FFO) adjusted net leverage reaching a high of approximately 3.3x to 3.5x this year if both transactions complete as planned.

Tight Rating Headroom
The projected 2015 leverage in the event of both transactions completing is above the level compatible with BAT's 'A-' rating and leaves no headroom for further M&A or share buybacks over 2015 and 2016. This is mitigated by our projection of healthy EBITDA margin of over 41%-42% and a strong free cash flow margin of 3%-5% from 2016, enabling swift de-leveraging. BAT's strong global market position in a consolidated and highly cash-generative industry provides comfort that this cash flow generation is predictable and achievable.

Share Buyback Suspension
The suspension of share buyback from mid-2014 is helping BAT build sufficient headroom ahead of the two announced transactions (when completed) and minimise the adverse effect from these cash disbursements. Post completion in 2016, the suspension in share buybacks should help contain FFO-based net leverage to a level slightly above 2014's 2.5x, which is already high as it was impacted by foreign currency headwinds not sufficiently offset by organic growth. The affirmation is premised on net leverage returning below 3.0x in 2016 and towards or below the ceiling for the rating of 2.8x from 2016.

Stable Business Profile
The ratings 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 superior geographical diversity, which Fitch estimates to include over 50% of profits coming from high-growth emerging markets, continues to enable it to protect profits through price increases and cost rationalisation in an industry that is facing declining consumption and the penetration of illicit trade. These dynamics have accelerated since 2013, particularly in the European Union and Australia but have only slightly impacted BAT's consolidated performance and track record of profit growth.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Low to mid-single digit revenue growth (pricing offsetting volumes) with mid-single digit foreign currency adverse effect in 2015
- Slight margin improvement over time
- 65% dividend pay-out
- M&A spending of GBP5.3bn for the RAI investment and Souza Cruz minority buy-out in 2015, and no M&A thereafter
- Share buybacks resuming in 2017

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- FFO-adjusted net leverage above 3.0x in 2016 and not trending towards a ceiling of 2.8x in the medium term (2014: 2.5x)
- FCF margin falling below 3% as a result of litigation or dividend distributions (2014: 0%)
- FFO fixed charge cover under 6.0x (2014: 6.8x)
- A deteriorating operating profile, as evidenced by impaired organic profit growth capability resulting from weak pricing power and lack of cost rationalisation to offset volume contraction

Positive: Fitch does not currently expect BAT to pursue financial policies consistent with an upgrade.