European tobacco, operating profit could improve over the next 12-18 months

European tobacco, operating profit could improve over the next 12-18 months

Moody’s has today published its outlook for European tobacco companies this morning, which forecasts that operating profit could improve over the next 12-18 months to 4.0%-5.0% from 2.5%-3.5% in late 2014 (excluding foreign exchange effects). However, it still remains within the range for a stable outlook. We would consider changing the outlook to positive if we expected operating profit growth of more than 6%.

“Tobacco companies’ underlying business model remains strong and the suspension of share buybacks will help alleviate the pressure on leverage resulting from ongoing foreign exchange volatility”, said Ernesto Bisagno, Moody’s Vice President and Senior Analyst. “However we expect that recent M&A activity will keep leverage high for British American Tobacco and Imperial Tobacco”, added Mr Bisagno.

Key messages:
Strong cash flow generation and strengthening margins (excluding foreign exchange effects), support profit forecasts. Tobacco companies’ underlying business model remains strong and the suspension of share buybacks will help alleviate the pressure on leverage resulting from ongoing foreign exchange volatility. However we expect recent M&A activity to keep leverage high for British American Tobacco plc (“BAT” A3 stable) and Imperial Tobacco Group PLC (Baa3 negative). Swedish Match AB (Baa2 stable) will remain better positioned in its rating category because it is less affected by foreign exchange pressures.
Foreign exchange translation effects will curb operating profit growth. We expect a negative impact on 2015 aggregated reported operating profit for the sector between 10%-15% mainly as a result of translation effects. This will affect Philip Morris International Inc (“PMI” A2 stable) and BAT the most, because they have the biggest exposure to weakening currencies in developing markets, Imperial to a lesser extent due to the weaker euro. However Imperial and BAT may also benefit from the dollar’s strength in the next 12-18 months thanks to their involvement in the recent Reynolds-Lorillard transaction. A significant contribution from its US business, bolstered by the strong dollar, could have a marginal positive impact for Swedish Match.
Forex pressures and high leverage will limit share buybacks. BAT and Imperial need to preserve cash after their participation in the Reynolds-Lorillard transaction, while PMI needs to offset the negative impact of foreign exchange. We do not expect share buybacks to resume until forex rates move in favour of the tobacco companies and BAT and Imperial start reducing leverage. However we expect dividend payouts to remain aggressive and anticipate an increase of around 5%-10%

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