Fitch Places Reynolds American Inc. on Rating Watch Positive

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has placed Reynolds American Inc.'s (Reynolds) Long-Term Issuer Default Rating (IDR) of 'BBB' and Short-Term IDR of 'F2' on Rating Watch Positive. The actions follows today's announcement by British American Tobacco plc (BAT, 'A-'/Outlook Negative) of its proposed merger with Reynolds.

The current terms of the proposal include a cash offer of $20 billion and an equity component of $27 billion, for total consideration of $47 billion ($60 billion including the assumption of $13 billion of Reynolds debt).

A full list of rating actions, which apply to approximately $13 billion of Reynolds debt at Sept. 30, 2016, appears at the end of this release.

KEY RATING DRIVERS

Affirmation or Upgrade Likely: The Rating Watch Positive reflects Fitch's view that (based on information currently available) the most likely outcome if the merger is completed as currently contemplated would be either an affirmation or a one-notch upgrade of Reynolds' 'BBB' ratings. However, significant uncertainty remains as to the structure of the transaction, and, Fitch could potentially equalize Reynolds and BAT's ratings as more information becomes available. These structural considerations include whether BAT guarantees Reynolds' debt and the outcome of Fitch's analysis of parent/subsidiary linkage.

If the merger is not completed, Fitch will most likely affirm Reynolds' existing ratings with a Stable Outlook.

Higher Leverage: Fitch calculates that BAT's consolidated funds from operations (FFO)-based gross leverage could rise to over 6.0x on a pro forma basis in 2017, when the transaction should close. This equates to total debt/consolidated EBITDA of 4.5x in 2017, up from BAT's 2015's 4.4x and 2.8x, respectively.

Scope for Subsequent Deleveraging: BAT has historically targeted a net debt/EBITDA ratio of between 1.5x to 2.5x, and Fitch expects management to aim for a swift deleveraging path and protect BAT's investment grade rating. However, based on its estimation of annual pre-dividends consolidated FCF of approximately GBP6 billion and the assumption that BAT would reduce dividend pay-out back to 65%, Fitch projects that the merged entity would only reduce consolidated FFO adjusted leverage toward 5.0x by FY19.

Enhanced Competitive Position: The combined entity would benefit from enhanced geographic diversification. BAT would benefit from gaining full exposure to the very large and profitable U.S. tobacco market, while retaining its exposure to relatively faster growing emerging markets. The combination would also create scope for cost and product development synergies. BAT currently estimates approximately $400 million of cost synergies that are not included in Fitch's current financial forecasts.

BAT's ratings would reflect the combined entities' position as the largest publicly traded global tobacco company, supported by the diversity of its portfolio of brands and of the countries it operates in. BAT's geographical diversity, including high-growth emerging markets that Fitch estimates contribute more than 50% of total profits, enables the company to protect profits through price increases and cost rationalization in an industry that is facing declining consumption.

KEY ASSUMPTIONS

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

--BAT acquires full control of Reynolds for USD20 billion cash in mid-2017;

--BAT assumes $13 billion of Reynolds' debt;

--Organic annual revenue and profit growth of low single digits for both the BAT and Reynolds' businesses;

--GBP/USD exchange rate of 0.83;

--Annualized cost synergies of around $400 million by 2019 with a related implementation cost of $400 million spread between 2018 and 2019;

--65% dividend payout ratio.

RATING SENSITIVITIES

If the merger is completed as currently contemplated, Fitch would likely either affirm Reynolds' ratings or upgrade them by one notch.

If Reynolds' merger with BAT is not completed, future developments that may individually or collectively lead to a positive rating action for Reynolds include:

--Mitigation of negative industry factors with an emphasis on the slowing or reversal of secular volume declines;

--Reynolds fully offsetting cigarette volume pressures with meaningful portfolio diversification;

--Significantly reducing litigation risk, most notably the Engle progeny exposure;

--A commitment to a conservative financial strategy demonstrated by lower dividend pay-outs and a commitment to maintain gross leverage below 2.0x.

If Reynolds' merger with BAT is not completed, future developments that may individually or collectively lead to a negative rating action for Reynolds include:

--EBITDA pressures arising from greater than expected market contraction or a heightened competitive environment, such that gross debt leverage rises and stays above 2.5x;

--Regulatory decisions immediately banning sale of mentholated cigarettes or meaningfully increasing state or federal excise taxes on smoking products that significantly accelerates volume declines;

--Substantial changes in the litigation process, whereby legal cases may reach verdict quicker and/or material adverse judgments significantly increase in number and amount.

LIQUIDITY

On a stand-alone basis, Reynolds has solid liquidity with cash of $1.9 billion and full availability under a $2 billion revolver due Dec. 2020, as of Sept. 30,2016. Internal liquidity provided by strong operating cash flows that increase annually and which Fitch models to exceed $2.5 billion in 2016. Excess liquidity is important given Reynolds' annual payment to the MSA that is expected to average around $3 billion over the next three years. On April 15, R.J. Reynolds made its MSA payment of $2.3 billion, which included $597 million paid into the non-participating manufacturer disputed payments account.

Reynolds targets a shareholder pay-out ratio of 80% of net income. The company has increased its dividend by 250% since 2004, paying over $12 billion in dividends over that time period Fitch models shareholder dividends to exceed $2 billion in 2016, consuming the majority of operating cash flow and pressuring FCF.

Reynolds' debt structure is well laddered, and the company faces no significant near-term debt maturities until 2018 when $1.25 billion of senior unsecured notes mature. Fitch expects that Reynolds will be able to refinance its debt maturities in normally functioning capital markets.

FULL LIST OF RATING ACTIONS

Fitch has placed the following ratings on Rating Watch Positive:

Reynolds American Inc.

--IDR 'BBB';

--Short-term IDR 'F2';

--Commercial paper 'F2':

--Senior unsecured credit facility 'BBB';

--Senior unsecured notes 'BBB'.

R.J. Reynolds Tobacco Company

--IDR 'BBB';

--Senior unsecured notes 'BBB'.

Summary of Financial Statement Adjustments

Stock-Based Compensation: Fitch adds back $ 79 million of stock based compensation to our EBITDA calculation in 2015.

Merger and Integration Expense Adjustment: Fitch adds back $54 million of merger and integration related expenses to our EBITDA calculation in 2015.

Mark to-Market Adjustment: Fitch adds back $126 million of a mark-to-market adjustment relating to the company's pension plan to our EBITDA calculation in 2015.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Additional Disclosures

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1013554

Endorsement Policy

https://www.fitchratings.com/regulatory

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Source: Fitch Ratings

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