OREANDA-NEWS. Fitch Ratings-Moscow/Milan/London-2 August 2016: Fitch Ratings has revised Diageo plc's Outlook to Stable from Negative. Its Long-Term Issuer Default Rating (IDR) and senior unsecured rating have been affirmed at 'A-'/'F2' and its Short-Term IDR at 'F2'. Diageo's subsidiaries' (Diageo Finance BV, Diageo Finance plc, Diageo Capital plc and Diageo Investment Corporation) senior unsecured ratings have also been affirmed at 'A-'/'F2'.

The change of Outlook reflects Fitch's confidence in Diageo's operational turnaround as demonstrated in its stronger organic sales and profit growth in FY16 (ending June 2016) relative to prior years in the important and most profitable North American spirits market (52% of FY16 group operating profits before exceptional items). In this region, the group's wide product portfolio and strong marketing are enabling it to regain market share. In addition, cost rationalisation efforts should continue to provide operational flexibility that can be effectively utilised to maintain a pipeline of product and marketing innovations. This supports our conservative forecast of annual organic sales growth of between 2% to 3% by June 2019. Diageo has also reduced its net debt position thanks to asset divestments which, along with positive free cash-flow (FCF) generation (forecast between 4% and 5% of sales per annum) should enable FFO adjusted net leverage to turn below the 3.0x level consistent with the 'A-' IDR (FY16 estimated: 3.6x).

The 'A-' IDR continues to reflect Diageo's strong business profile, one of the strongest in the industry, thanks to its large overall scale, wide portfolio of brands in several product categories across pricing points and strong marketing along with widely diversified sales in terms of geography. This is reflected in industry-leading profitability which further supports its credit profile.

KEY RATING DRIVERS

US Performance Recovery

North America is Diageo's largest contributing region to revenue and EBIT (FY16: 34% and 52%, respectively before exceptional items). Following on from two years of below-peer performance with stagnating revenues despite the growth of this market, Diageo's FY16 results demonstrate a good ability to turn around performance through new product launches in many of its product categories and effective marketing initiatives. FY16 organic revenue and profit growth in North America were respectively +3% and +4% and we believe this momentum will continue into FY17.

Over FY14 and FY15 some of Diageo's large strategic brands had continued to decline in volumes terms with no or limited offset from price/mix changes and insufficient volume support from the strong growth delivered by the other solid, but still small, brands. In contrast in FY16, the majority of the company's key brands (including Crown Royal North American whiskey, Smirnoff vodka, Johnnie Walker Scotch whisky, Captain Morgan rum,) reported organic growth of sales despite a highly competitive market

Emerging Markets Weigh on Profits

We continue to expect that emerging markets will remain major contributors to Diageo's top-line growth in the long term, driven by favourable demographics whereby the legal drinking age population and disposable income are both growing and should lead to increasing demand for western-style spirits. However, since FY14, individual market challenges in several of Diageo's key countries of operation (Brazil, China, South Korea), including weaker consumer spending power in several countries, excise increases and negative FX translation effects have led to much weaker reported sales and profit growth than historically. As a mitigating factor, we expect the fall in sterling following the Brexit vote to benefit Diageo with less pressure on increasing prices in FY17.

Healthy Cash-Flow Generation

In FY16 Diageo generated GBP0.5bn free cash flow (FCF), 4.7% of sales, despite the continuation of currency headwinds for most of the year and the absorption of GBP170m from working-capital movements. Diageo is slowing the pace of growth of dividends (for FY16, dividends growth fell to +5% from 9% in FY15), has moderated spending on investments in maturing stocks and continuing to make efforts to run working capital efficiently. These actions should continue to protect FCF in the medium term.

Prudent Financial Policies

Diageo has strengthened its balance sheet by divesting assets for GBP1bn, following on from a number of other divestments during FY15. Furthermore, we believe that the company is unlikely to engage in major M&A activity in the near future but will be focusing management's efforts mostly on organic initiatives.

Improving Credit Metrics

Based on preliminary FY16 reported figures, we calculate that Diageo's FY16 FFO-based adjusted net leverage remained broadly unchanged at 3.6x (FY15: 3.7x). This credit metric remains stretched for the 'A-' IDR despite asset divestments and the recovery of operating profit and FCF. This was due to the heavily adverse effect of currency movements on net debt (GBP725m) and also, to a lesser extent, on operating profit (by GBP83m). We estimate that the combination of continuing good FCF generation and the beneficial impact of currency movements linked to the weakening of GBP since June 2016 should enable FFO adjusted net leverage to reach 3.0x in FY17 and return to below this threshold from FY18.

Strong Business Profile

Diageo's strengths are reflected in a high EBITDA margin of around 30%, its wide portfolio of brands and its consistent record of product and marketing innovation. The company is targeting the release of additional resources from a cost rationalisation plan which over FY16-FY18 should deliver GBP500m savings. The majority of these will be reinvested in marketing spending, adding further support to the company's growth potential.

Diageo's wide geographical footprint with a healthy revenue split between developed (around 60% in FY16) and emerging markets enhances long-term sales and profit growth prospects although it exposes the company to some volatility in operating performance.

KEY ASSUMPTIONS

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

- Flat to slightly positive organic sales growth in developed markets, and around mid-single digit organic sales growth in most emerging countries;

- EBITDA margin of around 33% over FY17-20;

- Moderate increase in maturing inventories over FY17-20 and stable capex at around 4.5%-5% of sales;

- Annual dividend growth of 5% over FY17-18 and 10% from FY19;

- GBP200m bolt-on spending per annum over FY17-18 and GBP300-GBP500m per year thereafter.

RATING SENSITIVITIES

Future Developments That May, Individually or Collectively, Lead to Positive Rating Action

? Operational strengthening in North America and other key markets driving organic revenue and profit growth of at least the low single digits.

? Evidence of FFO adjusted net leverage moving below 3x over a 12 month horizon.

? FFO fixed charge coverage ratio above 6x on a sustained basis.

? FCF above GBP300m moving towards mid-single digits percentage of sales.

Future Developments That May, Individually or Collectively, Lead to Negative Rating Action

? FFO adjusted net leverage (including put options) on a permanent basis above 3.0x (FY16 preliminary: 3.6x) - as a result of shareholder distributions, acquisitions, or business weakness.

? FFO fixed charge cover ratio below 6.0x (FY16 Prelim.: 6.9x).

? Decline in revenue and profit or expected decline for three successive six-month periods.

? FCF below GBP300m (FY16 Prelim: GBP498m).

LIQUIDITY

Adequate liquidity: As of 30 June 2016 Diageo had GBP0.7bn of unrestricted cash and cash equivalents on balance sheet, and USD3.4bn undrawn committed bank facilities, providing comfortable back-up in relation to peak utilisation under its USD8bn US commercial-paper programme, its EUR2bn European commercial-paper programme and to its short-term debt maturities. Fitch has adjusted Diageo's cash balance by GBP400m, representing the average of its annual peak-to-trough working-capital fluctuation, with a peak in December and a low point around June.