OREANDA-NEWS. Fitch Ratings has revised Imperial Brands PLC's (Imperial) Outlook to Stable from Negative. Its Long-term Issuer Default Rating (IDR) and senior unsecured rating have been affirmed at 'BBB' and its Short-term IDR at 'F3'. Imperial's subsidiary Imperial Brands Finance PLC's senior unsecured rating has also been affirmed at 'BBB'.

The Outlook revision reflects Fitch's confidence regarding Imperial's de-leveraging path, supported by the company's improved performance in its core European market, a return to a strong cash flow generation and the maintenance of a financial policy focused on debt pay-down.

Our forecast of a persistently elevated leverage until the financial year to September 2018 constrains rating headroom for M&A or for a step-up in shareholder distributions, including share buybacks.

We have also assumed moderate success by Imperial in its US strategy and manageable adverse effects from the imminent introduction of plain packaging in the UK, Ireland and France.

KEY RATING DRIVERS
Solid Profitability
The company's trading performance in FY15 improved compared with the previous two years, when profits had contracted in many of its core markets. On a constant currency basis, total organic adjusted operating profits were up 7% in FY15 compared with no growth in FY14. Excluding the effect from the sizeable low-margin distribution business (Logista), overall we expect EBITDA margin to remain above its FY15's 46% (calculated against the company's economic net revenue of GBP7bn), a level that we consider strong for the rating.

Q116 Results Confirm Positive Trend
FY15 profits were supported by market share gains in the profitable Australian market, a stabilisation of illicit trade in western Europe and progress in the company's cost rationalisation and brand migration efforts, despite some currency headwinds. Imperial's cost optimisation programme delivered another GBP85m savings in FY15, achieving GBP179m out of a target of GBP300m p.a. cost savings from 2018. Q116 results confirm the positive trend with organic tobacco net revenue up 2% and the company confirming cost savings of GBP55m for FY16.

Leverage Beyond Rating Guidance
Lease-adjusted net debt/funds from operations (FFO) peaked at 5.1x as a result of the completion in July 2015 of the acquisition of assets from Reynolds American Inc. and Lorillard, Inc. Fitch forecasts leverage should decline to below 4.0x in FY17 and only reduce in FY18 to approximately 3.5x, a level compatible with the 'BBB' rating. This is supported by our projected strong and steady annual free cash flow of GBP600m to GBP700m (FY15: GBP743m).

Positive US Acquisition
We believe the acquisition of Lorillard and Reynolds' assets has significantly strengthened Imperial's US business and enhanced its geographic diversification, reducing its historical reliance on Europe. The latter's share should fall to approximately 55% of operating profits (62% in FY14) in FY16. US operations enjoy high profitability and exposure to a market with better scope for price increases compared with western Europe, where price elasticity has tested its limits during the tougher times of the recent consumer crisis. Litigation risk exposure is minimal for Imperial in the US.

Challenging US Turnaround
Imperial's strategy in the US hinges on a relaunch of the Winston brand, which has suffered a secular decline in volume. Fitch is confident that at least a mild turnaround is achievable; however, we see a risk of the profit margin being compromised if Imperial has more ambitious market share targets.

Manageable Regulatory Changes
Fitch considers the impact of smoking bans, cabinet display bans and graphic health warnings on consumption, and plain packaging including the revised European Union Trade Product Directive (EUTPD), as broadly manageable for the industry. However, the likely negative impact from plain packaging may be greater only in the medium- to long-term as we expect an erosion of pricing power. A revised EUTPD will be implemented in May 2016 alongside the adoption of plain packaging, which has been approved in the UK, France and Ireland.

Management's Commitment
Excluding the effect of the US acquisition, net debt was down GBP1.1bn in FY15 due to free cash flow (FCF) and foreign exchange translational gains (of GBP0.3bn) associated with Imperial's euro-denominated debt. Management's allocation of the proceeds from the partial IPO of Imperial's non-core distribution arm, Logista, to debt reduction, combined with an intention to continue to prioritise paying down debt, underlines the company's willingness to protect its credit metrics.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Mid-single digit annual price and product mix increases more than compensating for volume declines.
- Margin improvement incorporating efficiency gains, benefits from the acquired US business and assuming limited impact from plain packaging legislation.
- FCF margin at 8%-9.5% (calculated as a percentage of economic net revenue) in FY15-FY19 enabling continued debt pay-down of GBP600m on average per annum.
- Dividends increasing 10% annually
- No share buybacks or M&A spending.

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
-Another M&A transaction or a change in shareholder distribution policies preventing FFO net leverage from returning to a sustainable level of around 3.5x (FY15: 5.1x).
-FFO fixed charge cover ratio below 4.0x (FY15: 5.1x).
-Annual FCF margin below 5% (FY15: 10.6%) on a sustained basis.

Positive: In light of the company's current stretched financial profile, we do not foresee any rating upside in the short-term. However, future developments that could lead to positive rating action include:
- The trading environment in Imperial's territories is not permanently challenged by widespread introduction of plain packaging legislation or by an accelerated substitution of traditional cigarettes by other products
- FFO net leverage below 3.0x and FFO fixed charge cover ratio above 5.0x.
- EBITDA margin above 48% (FY15: 46%)
- Maintenance of current financial policy

LIQUIDITY
Liquidity is adequate. At FYE15, Imperial had GBP1.7bn of unrestricted cash (as defined by Fitch) and undrawn committed facilities of GBP3.3bn. This is sufficient to meet short-term debt of GBP1.6bn due in FY16. The majority of debt is composed of bonds issued by the wholly owned issuing vehicle Imperial Brands Finance PLC and guaranteed by Imperial Brands PLC and by the sub-holding and UK operating subsidiary Imperial Tobacco Ltd.