OREANDA-NEWS. Fitch Ratings has affirmed L'Oreal SA's (L'Oreal) Short-term Issuer Default Rating (IDR) at 'F1+'. The agency has also affirmed L'Oreal USA Inc's commercial paper (CP) programme, guaranteed by L'Oreal, at 'F1+'.

The ratings reflect the company's strong market position and product portfolio as well as its robust geographical diversification. Complementing this, L'Oreal continues to demonstrate healthy financial performance and maintain solid financial flexibility. Based on our projections we expect L'Oreal to continue to generate abundant annual free cash flow (FCF) that should enable some debt pay-down and leverage to return to its historically low levels. Its FCF should also provide the company with sufficient resources to continue its strategy of complementing the brand portfolio with bolt-on acquisitions.

KEY RATING DRIVERS

Leverage to Reduce Rapidly
In 2014 L'Oreal's Nestle transaction and EUR1.2bn acquisition spending led to a temporary increase in leverage, with pro-forma funds from operations (FFO) gross leverage increasing to 1.5x in 2014 from 0.9x in 2013. However, we expect leverage to reduce below 1.0x by 2016, aided by favourable foreign exchange movements in 2015 boosting the group's strong annual FFO generation capacity. We also expect L'Oreal to maintain its conservative balance sheet with solid cash conversion and interest cover metrics.

Strong FCF Generation Ability
The ratings also reflect L'Oreal's strong FCF generation capacity. In 2014 FCF after dividends was EUR1.3bn, in line with the levels achieved in 2013 and in 2012 and up from EUR0.9bn in 2011. Over 2015-2017 Fitch expects the group's annual FCF after dividends to remain above EUR1.3bn, leaving L'Oreal with flexibility for bolt-on acquisitions.

Further EBITDA uplift should thus compensate for working capital needs growing in line with sales, as well as a continued steady increase in dividends and bolt-on M&A activity. Additional financial flexibility comes from its 8.96% stake in Sanofi SA (AA-/Stable) held as a financial investment which the company could monetise in case of need.

Consolidating Leading Market Position
L'Oreal's strong business profile is underpinned by the company's leading position in the cosmetics industry. In 2014 sales continued to grow faster than the cosmetics market in all its geographical areas of operations, with total organic growth, excluding currency fluctuations, of 3.7% against market growth of 3.5%. This momentum extended into 1H15 as revenue grew 3.8% in organic terms.

Comprehensive market coverage, product range and pricing points enable the group to take advantage of structural factors benefiting the cosmetics industry, such as an ageing global population and the faster economic growth in emerging markets.

Shake-up in Competitive Landscape
Following the acquisition of several beauty brands from Procter & Gamble, Coty will emerge as a stronger and more focused player in the global beauty market than P&G. The US player will challenge L'Oreal in the mass market cosmetics segment, in professional haircare and in fragrances. Fitch estimates that L'Oreal will, however, preserve its global advantage and maintain its leading position, due to its larger scale, wider portfolio of products with robust brands as well as stronger operations in emerging markets.

Strong Geographical Diversification
In 2014, cosmetics revenues were well balanced across L'Oreal's different geographies of operations with emerging markets being the largest sales contributor at 40% of total revenues. This reflects the company's successful strategy at adapting to local consumer tastes in the context of fast-growing beauty products consumption in these geographies. Despite some slowdown in consumer spending in emerging markets, increasing sales exposure to this faster growing part of the world provides L'Oreal with greater resilience in operating performance and strengthens its long-term growth prospects.

Weakening Emerging Market Currencies
At the same time emerging markets presence exposes the company to fluctuations in currencies, primarily via translation effect. After two years of negative foreign-exchange impact on its reported sales (-2.3% impact in 2014), the trend should reverse and positively affect L'Oreal's performance in 2015 as already seen in 1H15 with a positive effect of 9.7%. We expect, however, some headwinds from weakening emerging market currencies in 2H15.

Slowing Emerging Markets
Due to economic growth deceleration experienced in major emerging countries such as China and Brazil since 2013, L'Oreal has reported slower organic sales growth from those markets to 6.3% in 1H15 from 9.4% in 2013. Nevertheless, we expect the recent deceleration in Brazil to be offset in 2015 by strong performance in Eastern Europe (and especially Russia), Africa and Middle East.

KEY ASSUMPTIONS

- Low-to-mid-single digit organic sales growth and slight margin improvement over time driven by innovation and pricing power
- Favourable high single-digit impact from foreign currency movements in 2015
- FCF to remain above EUR1.3bn annually due to limited working capital outflow and stable capex as a percentage of sales
- Budget for acquisitions of EUR500m annually

RATING SENSITIVITIES

Negative: Future developments that could lead to negative rating action include:
-Sharp deterioration of the group's FCF
-FFO-adjusted gross leverage of more than 2.0x (1.5x net) or temporarily higher (including use of L'Oreal's Sanofi shares as a source of funding)
-Total CPs back-up lines falling below 100% of total amount drawn under the CP programmes.

LIQUIDITY AND DEBT STRUCTURE

L'Oreal uses mostly CPs for its financing needs. As of end-December 2014, issuance under the CP programme increased to EUR2.3bn (none at end-2013) to fund the share buyback from Nestle. Committed back-up facilities available to L'Oreal exceed 100% of expected CP issuance at any given time.