S&P Raises Outlook on Reynolds American (RAI) to Positive

Standard & Poor's Ratings Services affirmed all of its ratings on Reynolds American Inc. (RAI) (NYSE: RAI), including the 'BBB-' corporate credit rating, and revised the rating outlook to positive from stable. Debt outstanding as of June 30, 2015, was about $18 billion.

"The outlook revision to positive reflects our assumption that RAI will follow through with its previously announced intension to lower leverage following the Lorillard acquisition, and therefore apply the majority of after-tax net cash proceeds from the NAS international sale toward debt reduction," said Standard & Poor's credit analyst Gerald Phelan. "Assuming no meaningful negative regulatory developments--particularly with respect to menthol cigarettes--and no adverse litigation outcomes, we could raise our ratings if the company reduces and sustains leverage at approximately 2.5x."

Standard & Poor's ratings on RAI reflect its substantially improved portfolio of cigarette brands following the Lorillard acquisition and select divestitures to Imperial Tobacco Group in June of 2015. Its portfolio is now focused on products with high brand equity that--from a volume standpoint--have performed much better than the industry as a whole. Assuming no significant setbacks with respect to menthol regulation, we believe RAI's position relative to industry leader Altria has strengthened, and that RAI will realize significant revenue and cost synergies. The proposed NAS international transaction provides a near-term boost to credit ratios, furthering RAI's goal to reduce leverage closer to its unadjusted 1.5x-2.5x target.

Our ratings also factor in the substantial increase in RAI's exposure to menthol cigarettes, which we believe will account for close to 60% of profits and could be subject to unfavorable regulatory developments over the next few years. It is possible the U.S. Food and Drug Administration could propose regulations that are unfavorable to menthol cigarette manufacturers, including reductions in menthol content or an outright menthol ban, the latter of which we view as unlikely. This is because we believe such a proposal would need to be supported by scientific evidence, which we believe menthol cigarette manufacturers would aggressively contest, and potentially litigate for years. Moreover, last year a U.S. District Court found that certain members of the FDA's advisory committee (the Tobacco Products Scientific Advisory Committee, or TPSAC) had conflicts of interests and ordered the FDA to reconstitute the committee. It also enjoined the FDA from relying on TPSAC's report, which concluded removal of menthol cigarettes would benefit public health. The agency has appealed. We do not believe this finding would necessarily prohibit the FDA from proposing adverse menthol cigarette regulations, though it's a potential obstacle.

In addition, the tobacco industry remains subject to substantial litigation, particularly with respect to Engle progeny and "lights" class actions. We assume RAI will continue to successfully manage these risks.

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