OREANDA-NEWS. Fitch Ratings has affirmed Pernod Ricard SA's (Pernod) Long-term foreign currency Issuer Default Rating (IDR) and senior unsecured rating at 'BBB-' and Short-term IDR at 'F3'. The Outlook is Stable.

The affirmation reflects Pernod's strong quality brand portfolio and its demonstrated ability to maintain a healthy group operating performance despite a challenging environment in particular markets and FX headwinds translating into a robust business risk profile and profitability relative to other global spirits producers.

While leverage metrics (as adjusted for leases, factoring and not readily available cash by Fitch) are not consistent with the rating, this was partly affected by adverse FX movements in FY15 (ending June). A solid business profile should ensure Pernod's deleveraging in the mid term towards levels more consistent with its rating. A prudent approach to M&A and shareholder distributions, together with control over investments into aging stocks are key factors to ensure a deleveraging path. Acquisitions would negatively affect the rating but we assume Pernod will continue to mostly focus on its organic growth strategy.

KEY RATING DRIVERS
Strong Business Profile
Pernod's ratings reflect its number-two position in the global spirits industry, its geographically diverse operations, and powerful brands in several major international consumption categories. This results in operating performance resilience, healthy profitability and solid ability to generate free cash flow (FCF) in the long term. Pernod's large exposure to emerging markets (FY15: 39% of sales) remain a major driver for long-term organic sales growth, while a combination of pricing power of Pernod's higher-end exclusive products and its innovation and adaptation capabilities supports revenues in the event of volume weaknesses. Pernod's business profile and profitability levels are commensurate with the low 'A' category.

Resilient Profitability
Pernod has continued to demonstrate relative stability in its operating margins despite a recent weakening and FX headwinds in its growth engine markets. Group profitability resilience stems from wide geographical diversification, pricing power and a strong brands portfolio, together with an active, market-tailored management of costs, in particular advertisement and promotion spending. We expect Pernod to be able to maintain EBITDA margins at around 28%-29% over the next four years, also thanks to resources released by the on-going Allegro efficiency programme.

Historically Low Performance
Fitch expects modest organic sales growth over the next two years, at around 2%-3% annually, below the management guidance of 4%-5% for mid-term. Despite some improvement since the second half of FY15 with recovery of volumes in US market and a deceleration of sales declines in China, we expect the operating environment will remain challenging in a number of major markets. High competition and modest market growth, limited to some remaining scope for premiumisation, mean that organic sales growth in US and Western Europe will be weak in the medium term. At the same time, growth in emerging markets will be constrained by the still challenging situation of China, Russia and Brazil, pressuring demand for mid and highly priced spirits.

Muted FCF in FY16
We project FCF will remain low in FY16 with an FCF margin at around 2% (FY15: 1.6%) due to still elevated investments in ageing whisky and cognac inventories. Their growth is related to the strengthened GBP (the currency of purchase of whisky) against the euro over the past 18 months. In the medium term, the affirmation reflects our forecasts of FCF recovering to 3.5%-4.0% on the back of some improvement in operating margins and completion of the aged stocks investment phase.

Low M&A Risk Assumed
Our ratings assume that management will maintain its cautious approach to M&A over the mid-term, relying on organic growth. We take comfort from the company's good and diversified stable of brands, which makes it possible to generate at least low single digit organic growth rates as well as from management's continued commitment to maintaining an investment grade rating.

We therefore assume no M&A in our rating case, other than very limited bolt-on spending. We deem larger transactions as an event risk given that the rating does not have any headroom for them.

FX Debt Exposure
In FY15, the appreciation in EUR terms of a large component of USD debt (50% at end-FY15) led to an increase in the company's net debt position by almost EUR1bn. Given the lower proportion of USD-denominated revenues (below 20% in the US) and the chances of further USD appreciation in FY16, there is some risk of further adverse effects from currency movements in FY16. This could further affect funds from operations (FFO) adjusted for lease and factoring net leverage, which increased to 6x in FY15.

Slowly Declining Debt Burden
The affirmation is based on our expectation that thanks to continuing cash flow generation, FFO adjusted net leverage should return closer to 5.0x by FY17, the maximum threshold that Fitch considers consistent with Pernod's existing 'BBB-' IDR.

Fitch adjusts Pernod's net debt by adding back factoring lines (EUR591m utilisation in FY15) and by deducting EUR300m from readily available cash, as an estimate of the average extra use of bank facilities during the year in order to fund a peak-to-trough EUR600m-EUR700m swing in trade receivables (including factoring) between end-December and end-June.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Pernod include:
- Organic sales growth of around 2% in FY16 strengthening towards 3.0-3.5% by FY19 thanks to some recovery in emerging markets. Fitch expects less than 1% positive FX impact on sales in FY16 as most benefits from USD appreciation against the euro will be offset by devaluation of a number of currencies in emerging countries, like Russia and Brazil.
- EBITDA margin gradually increasing toward 29% (FY15: 28.3%) over the next four years benefiting from operating efficiency programme implementation and increasing share of more profitable Asian operations in the group revenue.
- Low-digit FCF margin in FY16 gradually increasing to 3.5%-4.0% by FY19 thanks to operating margin gains and investment phase in ageing inventories (cognac and whisky) coming to an end.
- No change in dividend policy.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Evidence of weakening market position, operating efficiency and/or pricing power resulting in sustainably weak sales growth and profit margins.
- FCF margin reduction towards low single digits on sustainable basis due to erosion of operating profitability, increased dividend distributions or material FX headwinds.
- FFO net leverage (adjusted for leases and factoring) sustainably above 5.0x.
- Fixed charge cover ratio under 3.0x.
- Material M&A spending if not offset by divestments or equity injections.

Positive: Although Fitch considers the scope for an upgrade to be limited over the next two years, upward rating pressure could materialise if the following occurred:
- FFO net leverage (adjusted for leases and factoring) sustainably below 4.0x.
- Fixed charge cover ratio above 4.0x on a sustained basis.

A pre-condition for an upgrade would be maintaining FCF in the mid-high single digits as a percentage of sales and preserving a top three position in the industry.

LIQUIDITY
As of end-FY15, Pernod had EUR2.75bn liquidity available, split between a EUR2.5bn revolving credit facility due in October 2018 and EUR245m in unrestricted (based on Fitch's definitions) cash and cash equivalents (EUR545m reported cash). Together with our estimates of positive FCF for FY16, this is enough to cover Pernod's debt repayments due in FY16 of EUR2bn (EUR2.6bn if adjusted for factoring).