OREANDA-NEWS. January 19, 2016. Fitch Ratings has downgraded the long-term ratings of Brown-Forman Corporation (Brown-Forman) to 'A' from 'A+'. The Rating Outlook is Stable. A full list of ratings follows at the end of this release.

Brown-Forman announced yesterday that it has reached an agreement to sell its Southern Comfort and Tuaca trademarks to Sazerac for \\$544 million. The sale of these brands is expected to close by March 1, 2016 and is subject to regulatory clearance in the U.S. and customary closing conditions. Fitch expects proceeds to be deployed towards share buybacks or special dividends absent any acquisition opportunity. Fitch views acquisition opportunities as limited given the scarcity of available brands that fits Brown Forman's portfolio strategy. If the company did make an acquisition, the high multiple required for an above-premium brand would not contribute a material level of EBITDA.

KEY RATING DRIVERS

Credit Profile Eroded

The ratings downgrade reflects the erosion to Brown-Forman's credit profile, with leverage (debt to EBITDA) expected to be sustained over 1.6x or on a FFO basis, FFO adjusted leverage above 2.5x. This compares to debt/EBITDA in the 1.0-1.1x range during the last few years. The increased leverage reflects i) the \\$1 billion debt-financed share repurchase program that Brown-Forman announced in early 2015 ii) the divestiture of Southern Comfort, and Tuaca which generated a material level of EBITDA and iii) Fitch's expectations that the proceeds from the divestiture will be deployed towards share buybacks or special dividends.

Fitch does view the portfolio pruning positively as it allows Brown-Forman management to focus resources on its highest strategic priorities of its premium and above-premium liquor brands. Southern Comfort has been in a moderate structural decline the past several years due primarily to pressure from flavored whiskeys and continued weakness in the on-premise channel.

Strong Anchor Brand, Favorable Demand Trends

Brown-Forman's ratings are supported by the sizeable operating earnings and consistent cash flow generation that is derived from the strong and competitive brand portfolio of one of the largest worldwide spirits companies. Major contributors to Brown-Forman's operating earnings are its Jack Daniel's franchise, which is the fourth-largest premium spirits brand and the largest selling American whiskey brand in the world including its highly successful line extensions, Tennessee Honey and Tennessee Fire.

The Jack Daniel's family represents on an annual basis approximately half of the depletions of the company's major brands. Brown-Forman's other major brands, Finlandia Vodka, Canadian Mist and El Jimador Tequila have experienced further volume pressure during FY2016. The El Jimador brand family declined in Mexico as the company continues brand repositioning at a more premium price point through multi-year price increases.

Brown-Forman's spirits portfolio primarily competes in the premium and super premium categories and skews toward American whiskeys. Fitch views this as a competitive strength, because the aging process and inventory investments required are a barrier to entry providing an impediment particularly for value competition. Brown-Forman spirits have taken share from beer and clear spirits with the favorable demand trends driven by flavored and higher-end American whiskey.

As such, Brown-Forman has experienced strong category momentum for Jack Daniel's Tennessee Honey and the higher-priced Woodford Reserve family with depletion volume growth at 12% and 26% respectively during the first half of fiscal 2016. The Jack Daniel's Tennessee Fire line extension experienced underlying net sales growth of 30% through the same time period. Industry demand trends should remain strong for the foreseeable future that when coupled with Brown-Forman's portfolio would allow the company to grow at above average rates for the next several years.

Operating Performance In-line with Expectations

Sales, net of excise taxes, decreased 3% to \\$2.06 billion for the first half of FY2016 ended Oct. 31, 2015. Sales growth on an underlying basis was 6% with growth in volume of 3%, price/mix of 3%, and foreign exchange impact of 8%. Growth in the U.S. and Europe, which represents approximately 74% of net sales, was 7% and 6% respectively on an underlying basis. Fitch expects underlying revenue growth of approximately 6% in FY2016 and FY2017 and foreign currency pressure of 8% and 4% in FY2016 and FY2017 respectively.

Operating income increased by only 1% to \\$529 million for the first half of 2016, pressured by foreign currency of 4% and change in distributor inventories by 3%. Underlying operating income continues to benefit from positive volume and price/mix growing by 9% during the first half of 2016. EBITDA margins for the LTM period ended Oct. 31, 2015 were 35.8% negatively affected by higher wood prices during the second-half of fiscal 2015. Currency headwinds in the high-single-digits are expected to impact the full year results for fiscal year 2016. Fitch expects currency headwinds will continue to weigh on the results in FY2017, although to a lesser extent than in FY2016. Fitch expects EBITDA growth to be flat in both FY2016, due to currency, and FY2017 due primarily to the brand divestitures offset by improvements in gross profit margin, a decline in SGA expense and organic growth in the rest of the portfolio.

M&A Bolt-on Focused

Brown-Forman purchased all of the shares of Slane Castle Irish Whiskey in June 2015 and announced plans to invest \\$50 million to build a new distillery, construct warehouses, and develop a consumer experience at Slane Castle Estate in Ireland. Given the current momentum behind Irish whiskey, Fitch believes this transaction aligns closely with the company's acquisition strategy to acquire brands opportunistically with growth potential that are complementary to Brown-Forman's current portfolio.

DEBT STRUCTURE AND LIQUIDITY

Solid Liquidity Underpins Profile

Brown-Forman's cash balances, stable FCF generation and substantial credit facility capacity provides good liquidity. As of Oct. 31, 2015, Brown-Forman had \\$195 million of cash with \\$140 million offshore. FCF for the past 12 months was \\$310 million. FCF is expected to be at least \\$250 million annually for the next three years due to organic growth in the mid-single digit range, expected decreases in capital spending offset by the loss in cash flow from the Southern Comfort brand.

The company has not drawn on its \\$800 million five-year credit facility that matures in November 2018, which can be expanded by \\$400 million. The credit facility is primarily used to support the company's \\$1 billion commercial paper program. Commercial paper borrowings were \\$295 million for the quarter ended Oct. 31, 2015, which leaves available capacity on the credit facility of \\$505 million. The credit facility includes an interest coverage financial maintenance covenant of 3.0x.

Brown-Forman maintains a very manageable maturity profile with approximately \\$250 million coming due in 2016 and \\$250 million in 2018. Fitch expects the 2016 maturity will be refinanced.

In March 2015, Brown-Forman authorized a new stock repurchase program of up to \\$1 billion that is available through March 24, 2016. Share repurchases totalled \\$744 million for the six months ended Oct. 31, 2015. Fitch expects Brown-Forman to fully complete the share repurchase program.

KEY ASSUMPTIONS

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

--Underlying revenue growth of approximately 6% in FY2016 and FY2017 and foreign currency pressure of 8% and 4% in FY2016 and FY2017 respectively.
--EBITDA growth to be flat in both FY2016, due to currency, and FY2017 due primarily to the brand divestitures offset by improvements in gross profit margin, a decline in SGA expense and organic growth in the rest of the portfolio.
--EBITDA margin in the 36-37% range over the forecast period.
--FCF margin (absent any special dividends) in the 8-9% range over the forecast horizon.
--Share repurchases pacing with FCF over the course of the forecast.
--Proceeds of further asset divestitures deployed towards share buybacks.

RATING SENSITIVITIES

Future developments that may, individually or collectively, lead to a positive rating action include:

Positive rating actions are not anticipated in the intermediate term but could occur on continued strong operating performance driven by the Jack Daniel's Brand Family combined with:

--Decreased leverage such that total debt-to-operating EBITDA below 1.5x;
--FFO adjusted leverage in the low 2.0x on a sustained basis.

Any potential ratings upgrade however would be limited given Brown-Forman's dependence on the Jack Daniel's franchise.

Future developments that may, individually or collectively, lead to a negative rating action include:
--Total Debt to EBITDA above 2.0x
--FFO adjusted leverage sustained at or above 3.0x;
--FCF margin sustained below 5%;
--A material leveraging transaction;
--A significant and sustained loss of market share for the Jack Daniel's brand.

FULL LIST OF RATING ACTIONS

Fitch has downgraded the following Brown-Forman ratings:

--Long-term Issuer Default Rating (IDR) to 'A' from 'A+';
--Senior unsecured notes to 'A' from 'A+';
--Bank credit facility to 'A' from 'A+'.

Fitch has affirmed the following short-term Brown-Forman ratings:

--Short-term IDR at 'F1';
--Commercial paper at 'F1'.

The Rating Outlook is Stable.