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Rating Action:

MOODY'S DOWNGRADES BRITISH AMERICAN TOBACCO PLC AND GUARANTEED SUBSIDIARIES TO Baa1/P-2 FROM A2/P-1; OUTLOOK NEGATIVE

13 May 2003
MOODY'S DOWNGRADES BRITISH AMERICAN TOBACCO PLC AND GUARANTEED SUBSIDIARIES TO Baa1/P-2 FROM A2/P-1; OUTLOOK NEGATIVE

Approximately US$4 Billion of Debt Securities Affected.

Madrid, May 13, 2003 -- Moody's Investors Service today downgraded the long-term senior unsecured ratings of British American Tobacco plc (BAT) and all its guaranteed subsidiaries to Baa1 from A2. The entities' short-term debt ratings were also downgraded, to Prime-2 from Prime-1. Today's rating actions conclude the review process of BAT's ratings initiated on 9 April 2003. The outlook on all ratings is negative.

The rating downgrades reflect an increase in bonding risk in the US tobacco industry at a time when BAT is contemplating making use of its current financial flexibility to carry out acquisitions and a share buyback. The downgrades specifically consider the following key factors:

1) The possible impact on debt protection ratios of management's intention to potentially deplete part of BAT's financial flexibility through share buy-backs and possible debt-financed acquisitions, as well as on its liquidity risk assessment going forward.

2) An increase in bonding risk in general and in light of the potential ramifications for BAT's 100% owned subsidiary Brown & Williamson (B&W). This is as a result of the current Price/Miles Illinois consumer fraud class-action case against Philip Morris USA and the eventual outcome of the trial brought against B&W itself (the Howard case) in the same court as in the Miles case. The risk of periodic future adverse rulings and/or bonding requirements, similar to Price/Miles in the mass of litigation faced by B&W, has increased and could negatively affect B&W and ultimately BAT. Moody's perception that BAT's ring-fencing from any negative financial verdict affecting B&W is open to legal interpretation although this threat is viewed only as remote.

3) Moody´s notes that BAT has maturities of some GB 2.2 billion of outstanding debt over the next 14 months and will need to either increase its bank facilities or access the debt capital markets, because internally generated cash and available bank facilities will not be sufficient to fully cover refinancing needs. BAT should generate an operating cash flow of about GBP1.9 billion in 2003, which together with its available cash on balance sheet, should be sufficient to cover its dividend payouts of about GBP1 billion per year, as well as its capex of about GBP400 million and the recently announced approximately GBP750 million share buyback. In addition, to the company's strong operating cash flow and available balance sheet cash, BAT has recently signed a US$1.75 billion global 364-day revolving credit facility with a one-year term-out option, which comfortably positions it to refinance total debt maturities in 2003 of some GBP350 million. However, BAT faces significant debt maturities and refinancing during the first half of 2004 -- specifically, the maturity in April 2004 of a EUR1.5 billion bond as well as the probable need to refinance GBP800 million of outstanding convertible redeemable preference shares (deferred consideration of the Rothmans acquisition), which implies the need to access the debt capital markets or bank market to partially cover these needs.

Moody´s has also factored into the rating decision that BAT has external debt at operating subsidiary level, which creates structural subordination.

The negative rating outlook reflects the increased litigation risk in the US and the fact that it is very difficult to predict the financial impact of possible negative verdicts and bonding requirements in the US, following the Price/Miles cases. This might lead to reduced liquidity resources at B&W. In addition, Moody's has factored the ongoing profitability pressure occurring in the US tobacco market as well as BAT's significant reliance on access to debt capital markets in order to refinance debt maturities over the next 12 months.

In Moody's opinion, the increase in litigation risk in the US for B&W could potentially constrain the cash flow available to BAT's bondholders in the event of future bonding requirements likely to be imposed by the presiding judge following the outcome of the Price/Miles case. The trial against B&W brought by the same plaintiffs' attorney as in the Miles case is currently scheduled to take place in the same legal jurisdiction of Illinois in March 2004. Although B&W still has the option of seeking a postponement of the trial, Moody's believes that, given the severity of the Illinois jurisdiction, there is a significant chance that B&W could face a similar outcome if the trial does take place with possible bonding proportional to its market share.

Moody's believes that the Miles case illustrates the difficulties faced by tobacco companies such as B&W that are involved in numerous legal claims. The significant share and the longstanding presence of B&W's brands in the US cigarette market make the company an attractive target for litigation. According to Moody's, this factor could increase the risk of B&W facing significant bonding requirements in the future, especially in difficult legal jurisdictions, despite the sometimes strong grounds for appeal.

Moody's notes the uncertainty surrounding not only the outcome but also the timing of the Howard case in Illinois, which could last for years and is, to some extent, outside the control of B&W. The possible bonding requirement could exacerbate pressure on BAT's cash flow, which is otherwise driven by a relatively stable tobacco market outside the US.

Moody's has also taken into consideration the potentially favorable recent State Farm US Supreme Court verdict, which significantly reduces the ratio of punitive damages to compensatory damages to a single-digit figure as a benchmark. Although this ruling should in principle lead to lower tobacco total awards, the positive effect should be considered over time thus bonding risk remains due to possible excessive bonding requirements in lower courts in some jurisdictions in the short term.

The downgrades also reflect the pressure on BAT's operating income as a result of the difficult US tobacco market conditions. In the first quarter of 2003, the operating income of B&W decreased; although the cash flow generated by B&W represented about 15% of the group in 2002, Moody's remains concerned about BAT's approach in considering the US as a strategic market. The decrease in the operating income of the US tobacco subsidiary reflects lower volumes, higher promotional expenses and an expansion of the sales force. Over recent months, original participants (such as B&W) to the 1998 Master Settlement Agreement (MSA) with the States have consistently lost market share to companies that are not parties to the MSA or have signed on to it at a later date (subsequent participating manufacturers). Moody's believes this market share erosion is caused by the cost gap between original participating manufacturers on the one hand and non-participating and subsequent participating manufacturers on the other hand. This cost gap has led to a consumer retail price gap, which B&W has tried to narrow through heavier promotional expenses. Based on the terms of the MSA and the model statute legislation passed by the States, a difference in settlement-related costs is likely to remain for at least several years, and Moody's believes that B&W is unlikely to regain its pricing flexibility during this period.

Bonding risk is distinct from the ultimate outcome of each case after all appeals. B&W's track record in court demonstrates success in winning cases and in moderating awards granted, and recent legal developments may support that record in the future. Nonetheless, juries and judges in state and federal lower courts will retain substantial discretion in their decisions affecting B&W. Especially in difficult jurisdictions, their verdicts could still lead from time to time to substantial bonding requirements that may prove difficult for the company to meet, and plaintiffs may be expected to seek out such jurisdictions.

The following ratings were downgraded:

- To Baa1 from A2: the long-term senior unsecured ratings of all debt issues under BAT plc and its guaranteed subsidiaries

- To Prime-2 from Prime-1: the short-term ratings on BAT International Finance plc and BAT Capital Corporation.

Headquartered in London, England, BAT is the world's second largest listed tobacco company after Philip Morris, and significantly ahead of the third-ranked company, Japan Tobacco. BAT's products are distributed in the USA through its 100% owned US subsidiary, Brown & Williamson. BAT currently has a 15.1% global market share, selling some 777 billion sticks in 2002 in around 180 markets throughout the world. BAT enjoys a leadership position in more than 65 countries through its diverse portfolio of brands, which includes well-established international brands such as Lucky Strike, Kent, Dunhill and Pall Mall.

Madrid
Carlos Winzer
Senior Vice President
Corporate Finance
Moody's Investors Service Espana, S.A.
(34-91-310-1454)

Paris
Eric de Bodard
Managing Director
Corporate Finance
Moody's France S.A.
33 1 53 30 10 20

No Related Data.
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