Moody's Investors Service confirmed the ratings of five tobacco companies operating in the U.S. market, but sustained their negative rating outlooks, following the announcement of a proposed settlement of Medicaid reimbursement lawsuits brought by various state attorneys general. The confirmation reflects Moody's view that: 1) the proposed settlement would eliminate the most challenging form of litigation facing the tobacco industry; 2) the payments required under the settlement will likely be passed on to consumers; and, 3) the likely pace of volume declines precipitated by price increases and marketing restrictions should be manageable. Moody's noted, however, that the capacity of each company to sustain its current rating level under the terms of this agreement and in the face of ongoing uncertainty with respect to future excise tax increases and federal tobacco legislation, varies considerably. This capacity is determined largely by each company's respective competitive position within U.S. and international markets, and by its individual level of financial flexibility.
Ratings confirmed are:
Philip Morris Companies, Inc.: Senior debt rated A2 and Prime-1 short-term rating.
RJR Nabisco, Inc.: Senior debt rated Baa3 and Prime-3 short-term rating.
British American Tobacco p.l.c.(BAT): Senior debt rated A2 and Prime-1 short-term rating.
Loews Corporation: Senior debt rated A1.
UST Inc.: Prime-1 short-term rating.
Following are the essential elements of the proposed settlements. The four cigarette companies that would be party to the agreement (Philip Morris, RJR, BAT and Loews) would pay a total of $206 billion over 25 years. UST, a smokeless tobacco producer, would be party to a separate but similar agreement, and would pay approximately $100 to $200 million over ten years. All five companies would also agree to various marketing and promotional restrictions. In return, the states which are party to the agreement would settle Medicaid reimbursement suits which are pending or which might have been brought in the future. We expect that the costs associated with this settlement would precipitate an increase of about 40 cents in the price of a pack of cigarettes during the first year of the agreement, with an additional increase of about 10 cents per pack by 2002.
There are some important differences between the currently proposed settlement with the four cigarette companies and the June 20, 1997 proposal. The most important is that the tobacco industry would be afforded no protection from class action suits and there would be no caps on amounts that can be paid in individual suits. Mitigating the lack of these protections is the fact that the total 25-year cost of the current proposal would be about $160 billion less than the $368 billion required in the earlier proposal. In addition, only $2.4 billion in payments are due immediately following acceptance of the proposal, rather than the original $10 billion. Finally, marketing restrictions are not as broad, there are no penalties for failing to reduce under age smoking, and the FDA is not awarded regulatory jurisdiction over the industry.
State attorneys general have until Friday, November 20 to evaluate the terms and conditions of the proposals and decide whether or not their state will opt to be party to the agreements. On Monday, November 23, the five tobacco companies will decide if the number of states opting into their respective agreements is sufficient. If it is, they will recommend to their boards of directors that they formally approve the settlement.
During June 1997, Moody's noted its expectation that all five tobacco companies had the ability to sustain their ratings under the terms of the June 1997 proposal. We do not believe that the overall credit quality of the industry would be materially compromised under the current proposal relative to its position under the June 1997 proposal. This is due to the current proposal's lower cost, and the very favorable litigation track record of the industry since June 1997. Moreover, we would view a finding in favor of the industry during the first phase of the Engle class action suit, which will likely be concluded by the end 1998, as another very important indicator of an improved litigation outlook for tobacco companies. Nevertheless, certain companies - most particularly RJR and BAT - are now more vulnerable to a potential downgrade. This is a result of their relative competitive positions and overall financial flexibility rather than the differences between the June 1997 proposal and the current proposal.
Although the rating outlooks for all tobacco companies remain negative, acceptance of the current proposal could result in select rating outlook changes. Following is Moody's assessment of the near-term credit quality of each of these companies:
Philip Morris: Philip Morris has considerable capacity to sustain its current ratings. The company has the most formidable brand franchise and competitive business position in both the U.S. and international cigarette markets. It also enjoys a strong and globally diverse food business. Moreover, about 70% of the company's $14 billion in annual operating income is generated by operations other than it U.S. tobacco business. Philip Morris is currently generating fixed charge coverage in excess of 10 times, its annual rate of free cash flow (after working capital, capital expenditures and dividends) is running about $2.5 billion, and its cash balances stand at $5.5 billion compared with about $15 billion in debt. Acceptance of the current proposal could contribute to Philip Morris' rating outlook being changed to stable.
RJR Nabisco: RJR has minimal capacity to sustain its current rating. This is due to eroding share in the U.S. cigarette market, declining profitability of its Russian and Asian operations, and modest financial flexibility. Factors which will be important in determining RJR's ability to retain its current rating level include: 1) the possibility that RJR might strengthen the competitive position of its international tobacco operations through an alliance with a stronger global tobacco company; 2) the impact of such an alliance on RJR's capital structure and on its ability to access the cash flow generated by the international tobacco operations; 3) the degree to which a potential spin-off of Nabisco might be structured in order to offset the resulting loss of approximately $150 million in dividends that RJR currently receives from Nabisco; and 4) RJR's financial strategy with respect to dividends and share repurchases. Even if the current proposal is accepted, RJR's rating outlook is likely to remain negative.
BAT: BAT is weakly positioned at the A2 long-term and Prime-1 short-term rating level and has modest capacity to sustain these ratings. Although the company has broad geographic diversity and strongly performing international tobacco operations, its share position and earnings in the U.S. have suffered from highly competitive market conditions. In addition, BAT is one of the international cigarette companies with whom RJR could seek to establish an international tobacco alliance. The operating and financial structure of any such alliance would be an important factor in assessing BAT's longer-term credit quality. Even if the current settlement proposal is accepted, BAT's rating outlook is likely to remain negative.
Loews Corporation: Loews has adequate capacity to sustain its current rating. Its Newport cigarette brand is highly competitive and profitable, and has been gaining market share. The company also benefits from the considerable market values of its investments in CNA Financial Corporation and Diamond Offshore Drilling subsidiaries. These investments have a value in excess of $9 billion. In addition, Loews has a portfolio of cash and liquid investments (exclusive of CNA's own portfolio of investments) that exceeds $4 billion. These substantial resources compare with approximately $2.3 billion of debt. Acceptance of the current proposal could contribute to Loews' rating outlook being changed to stable.
UST Inc.: UST has solid capacity to maintain its current rating. The company is the leading manufacturer of smokeless tobacco with a 50% market share. During the nine months to September 1998 it generated $563 million of operating income, had $121 million in cash and only $100 million in debt. The principal risk is that subsequent to some form of litigation settlement, UST might accelerate the pace of share repurchases in order to enhance shareholder returns. Nevertheless, the company's resulting financial strategy, debt protection measures and business position could remain supportive of the current rating, and acceptance of the proposal could result in its rating outlook being changed to stable.
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