OREANDA-NEWS. July 13, 2015 Fitch Ratings has revised the US-based tobacco group Philip Morris International, Inc's (PMI) Outlook to Negative from Stable and affirmed the Long-term Issuer Default Rating (IDR) at 'A'. The Short-term IDR has been affirmed at 'F1'.

The revision in Outlook reflects PMI's stretched credit metrics, after profit margins and cash flow were compressed in 2014 by specific market challenges in Asia, foreign currency effects as well as investments in reduced-risk products (RRPs). Past shareholder returns have also contributed to exacerbating the deterioration of credit metrics.

However, if PMI prioritises debt reduction from improving free cash flow (FCF), leading to (FFO) adjusted gross leverage to fall below 3.0x or net leverage below 2.5x by 2016, then the Outlook may be revised back to Stable. Fitch assumes that there will be no share buybacks during 2015-2018.

KEY RATING DRIVERS

Profit Margin Compression
PMI remains one of the most profitable tobacco companies with its EBITDA margin of 44.1%, higher than British American Tobacco's 41.3% (A-/Negative) and Imperial Tobacco Group PLC's 43.1% (BBB/Negative). Yet, in 2014 EBITDA margin suffered from specific market challenges in Asia (Indonesia, the Philippines and Australia), transactional FX headwinds and investments in RRPs. While Indonesia, the Philippines, Australia and the European Union should perform better in 2015, there is a risk of EBITDA margins contracting further in 2015 as a result of continuing currency headwinds, an important excise tax increase in South Korea and ongoing challenges in Japan.

Lower FCF
After a period of stability at around USD10bn, PMI's FFO dropped to USD8.4bn in 2014 due to margin reduction and the strengthening of USD against the currencies of the markets in which the company sells its products. As a result also of increasing dividend distributions, FCF contracted materially to USD551m (1.9% of sales) from an average USD3bn over 2012-2013. This adverse effect on leverage, however, is partly mitigated by almost half of the company's debt (40%) being denominated in EUR at end-2014.

Leverage Beyond Rating Guidance
FFO net leverage rose to 3.2x in 2014 from 2.6x in 2013 and Fitch projects leverage to peak around 3.3x-3.5x in 2015 before falling to approximately 3.0x in 2016, a level still above the 2.5x threshold compatible for the 'A' rating.

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 level (domiciled in the US). While PMI intends to repatriate its foreign earnings, it is unlikely to be immediate, and could be costly under the current US tax regime.

Our net debt figure now includes 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.

Significant Shareholder Distributions
The deterioration in credit metrics has been exacerbated by large shareholder distribution up until 2014. Through dividends (high pay-out ratio of 70%) and its share buyback programmes, PMI has historically distributed to shareholders more than the FCF it generated. A large part of those share buybacks has historically been debt-funded, which resulted in an increase in debt quantum over time.

Fitch views positively the company's announced suspension of share buybacks in 2015, indicating PMI's willingness to protect its credit metrics. However, the extent to which PMI allocates cash flow to shareholders is one of the main drivers of leverage, which is currently outside the range compatible with its 'A' rating. Fitch estimates that the dividend pay-out ratio in 2015 will be in excess of 90%. This is above historical rates and PMI's long-term dividend pay-out target of 65%.

RRPs Weigh on Profits
Fitch is confident that PMI would be able to manage successfully a transition of tobacco consumption towards e-cigarettes or other RRPs, should the consumption shift from traditional cigarettes accelerate. The agency believes that, combined with PMI's market clout, the products that the company has available and under development, should allow it to win against small independent e-cigarette players. However, investments in RRPs in 2014 have further impacted operating profit, adding to the adverse impact from currency movements, a trend that Fitch expects to continue in 2015.

Scope for Performance Recovery
We expect PMI's organic growth to recover over time, driven by better overall pricing/product mix as well as volume recovery in Asia. In 1Q15, the company reported good pricing gain of 7.7% and positive volume growth of 1.4%, resulting in high net revenues organic growth of 9.1%. This followed organic growth of 2% in 2014, as prices rose 4.8% largely offsetting a volume drop of 2.8%.

Leading Industry Player
PMI's ratings continue to reflect the company's leading position 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.

KEY ASSUMPTIONS

- Revenue and profits impacted by currency headwinds as well as investments in RRPs in 2015
- Low single-digit sales growth and slight increase in profitability from 2016 onwards with price gains offsetting volume declines
- FCF margin below 1% in 2015 and resuming around 4% from 2016 onwards
- Dividends increasing 2%-3% annually, resulting in a dividend pay-out ratio of around 80%-90% between 2015 and 2018
- No share buybacks between 2015 and 2018

RATING SENSITIVITIES

Negative: Future developments that could lead to a negative rating action include:
- Persistently weaker than historical performance with low or negative organic growth and operating EBITDA margin failing to return above 45% in 2015 and 2016 (2014: 44.1%)
- Neutral to negative FCF in 2015 and failing to return to at least 3.5% - 4% of revenues by 2016 (2014: 1.9%)
- Inability to reduce debt or increase FFO causing FFO-adjusted gross leverage to remain above 3.0x (2014: 3.3x) and FFO-adjusted net leverage above 2.5x (2014: 3.2x)
- FFO fixed charge coverage below 6x (2014: 7.0x)
- 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. Future developments that could lead to a revision of the Outlook to Stable include:
- Evidence that the allocation of improving FCF prioritises debt reduction and enables FFO adjusted gross leverage to drop below 3.0x or FFO adjusted net leverage below 2.5x by 2016
- FCF margin on track to recover to a level sustainably above 5%
- FFO fixed charge coverage sustainably above 6x
- No material cash outflow from ongoing litigation

LIQUIDITY

At year-end 2014, 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 as comfortable considering the projected amount of commercial paper issuance.