CORRECTION TO TEXT: MOODY'S DOWNGRADES R.J. REYNOLDS (SENIOR GUARANTEED UNSECURED TO Ba1); RATINGS REMAIN UNDER REVIEW FOR POSSIBLE DOWNGRADE
--- Moody’s Investor Service downgraded the long term ratings of R.J. Reynolds Tobacco Holdings, Inc. (RJR) and kept the ratings under review for possible further downgrade. Ratings downgraded and kept under review are as follows:
R.J. Reynolds Tobacco Holdings, Inc.
Senior guaranteed unsecured indebtedness to Ba1 from Baa2
Senior unguaranteed unsecured indebtedness to Ba2 from Baa3.
Nabisco Group Holdings Corp.
$98 million defeased junior debentures due 2047, to Baa1 from A2
The downgrade reflects RJR’s uncompetitive operating cost structure; Moody's expectation of significant volume drops in the US tobacco market; increased competition from small manufacturers; and the difficult litigation environment that RJR Tobacco faces over the medium term.
The downgrade of RJR’s guaranteed senior debt rating to Ba1 reflects the currently uncompetitive operating cost structure of RJR, and its having to change its strategy in a market more and more driven by value. Moody's estimates that in 2002, RJR’s operating profit per pack of cigarettes was 17 cents, while it was 52 cents for Philip Morris USA and 69 cents for Lorillard. Moody’s believes that this lower profitability could reflect RJR’s less efficient manufacturing than its competitors, as well as reduced pricing power. In an environment of reduced opportunities for advertising, the power of RJR’s brands (mainly Winston, Camel, Salem and Doral) --and therefore the ability of the company to set higher prices-- could be weakening. RJR's brand portfolio must also compete with that of Philip Morris USA, significantly stronger with a market share of approximately 50%. Moody’s notes that RJR has engaged in an effort to reduce its cost structure. However, the likelihood of success of this effort remains uncertain, given the magnitude of the task. Also, Moody's believes that benefits on profitability from this effort are not likely to be immediate.
The downgrade also reflects the severely reduced profitability from decreasing volumes in the US tobacco market, where RJR derives almost all of its cash flow. In many states facing budgetary difficulties in 2002, legislatures have passed and governors have signed tobacco excise tax increases in order to generate additional revenues. Proposals for further increases are being contemplated in a significant number of other states for 2003. These higher taxes result in higher prices for the US consumer, and contribute to decreased volumes purchased at a time of weakness in the US economy. The effect of these tax increases on volumes has been and could continue to be exacerbated by new regulations restricting venues available for smoking in various states and municipalities.
Within this adverse environment, the 1998 settlements under the Master Settlement Agreement (MSA) with 46 states, and under separate agreements with Florida, Minnesota, Mississippi and Texas (the four initial states), have substantially increased costs for RJR Tobacco and the other three large participants to the US tobacco industry. These cost increases have been passed through in price increases. However, because of these price increases, brands sold by RJR (accounting in the aggregate for an approximate 23% market share) are now significantly more expensive than the ones sold by smaller companies that do not participate in the MSA (non-participating manufacturers, or NPMs) or who signed on to it at a later date (subsequent participating manufacturers, or SPMs). These higher prices have contributed to market share erosion for RJR. While laws passed by the states require non-participating manufacturers to fund escrow accounts with regular payments, Moody’s expects that over the medium term the settlement cost structure of NPMs will continue to be lower than the one of OPMs such as RJR, which must also make payments to the four initial states and to tobacco growers. Competition is likely to remain especially difficult for RJR in Florida, Mississippi and Texas – which represent approximately 10% of the US population --, where companies outside of RJR, Philip Morris USA, Lorillard and Brown & Williamson do not have to make payments.
Finally, the downgrade reflects increased litigation and bonding risk in the industry. While they have been parties to litigation for decades, tobacco companies had always succeeded in avoiding verdicts that could imperil their ability to post bond. They had done so by obtaining case dismissals or victories in lower courts, by having cases transferred outside of unfavorable jurisdictions, or by encouraging the passing of bond caps by state legislatures. The recent Price/Miles trial against Philip Morris USA has resulted in a $12 billion verdict against that company. While the presiding judge ultimately imposed a non-crippling bonding requirement, Philip Morris USA was not able to use any of the defenses mentioned above. Moody’s is concerned that this case might signal an erosion of the ability of the industry – including RJR -- to protect itself from excessive bonding requirements in view of the massive litigation against it. Also, almost all of RJR’s cash flow comes from RJRT, and a bankruptcy of RJR Tobacco would trigger an event of default under RJR’s indentures. Since RJR faces a claim similar to Price/Miles in the same jurisdiction, Moody’s will watch closely how RJR’s own case evolves, and specifically if the lower court trial is postponed pending the outcome of appeals in Price/Miles. Moody's notes that Brown & Williamson -- facing a similar claim -- has recently obtained a stay.
However, Moody’s notes some recent positives in the tobacco litigation area. The State Farm of Utah ruling by the US Supreme Court has the potential to bring levels of punitive damages down. The recent ruling by the Third District Court of Appeals in the Florida Engle case – which could still be appealed to the Florida Supreme Court – is in line with Moody’s expectation that the class will ultimately be decertified in this case. An appellate court in Massachusetts recently decertified a consumer fraud claim similar to Price/Miles. Legislation voted by the US House of Representatives and to be considered in the Senate could lead – if passed – to a reduction in the number of class actions certified. However, Moody’s believes that tobacco litigation risk (especially bonding risk) remains high for RJR and all industry participants, and that this litigation has the potential to evolve quickly in an unanticipated manner. Moody's notes that one adverse decision could be sufficient to create severe liquidity pressure for RJR.
Moody’s notes that RJR’s liquidity is currently solid. Excluding cash built up for the purpose of settlement payments, RJR’s cash and short-term investment position amounted to $1.9 billion at the end of the first quarter of 2003. The $531 million bank facility maturing in 2004 is undrawn. There are no significant bond maturities before 2006.
The ratings remain under review for potential downgrade because of the possible action of rating triggers in the bank credit facility. Moody’s expects its rating action today to trigger the establishment of a guarantee from the Santa Fe subsidiary and other smaller subsidiaries for the benefit of bank lenders, and – because of a negative pledge clause in their indentures – for the benefit of holders of notes guaranteed by RJRT as well. Should another rating agency also downgrade the guaranteed senior unsecured rating below investment grade, all assets would be pledged to bank lenders. In this case, because of the negative pledge clause in their indentures, notes guaranteed by RJRT would become collateralized with principal property (land, buildings and equipment) and shares of stock in subsidiaries. Unguaranteed notes would remain uncollateralized because of the 1999 elimination of the negative pledge clause in their indentures. Should the rating trigger embedded in the bank credit facility be tripped, resulting variations in collateral coverage could lead Moody's to notch down the guaranteed notes, and to increase the notching gap between guaranteed and unguaranteed notes.
Headquartered in North Carolina, R.J. Reynolds Tobacco Holdings is the parent company of R.J. Reynolds Tobacco Company. R. J. Reynolds Tobacco Company is the second largest tobacco company in the United States.
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