Markets & Finance

RJ Reynolds Outlook Revised to Negative


On Aug. 12, 2003, Standard & Poor's Ratings Services revised its rating outlook for RJ Reynolds Tobacco Holdings (RJR) to negative from stable. At the same time, Standard & Poor's affirmed its 'BB+' corporate credit and senior unsecured debt ratings on RJR. Standard & Poor's also affirmed its 'BB' senior unsecured ratings on those selected debt issues that are not guaranteed by RJR's material operating subsidiaries (including RJ Reynolds Tobacco Company).

About $2.0 billion of total debt was outstanding at RJR at June 30, 2003.

The outlook revision reflects Standard & Poor's assessment of the U.S. tobacco industry environment and RJR's competitive position. Last week, RJR reported its second-quarter earnings, which included a 47% decline in operating earnings before $55 million of restructuring charges. Although Standard & Poor's had anticipated a weak second quarter for RJR, industry conditions do not appear to be improving. Recent earnings releases from other industry participants indicate that promotional and discounting activity is still at high levels, and it is unclear when this trend will begin to reverse.

In addition, RJR expects to announce a significant restructuring charge in the September/October time period as part of an ongoing review of its business strategy and cost structure. It is uncertain as to how quickly any recommendations or changes to RJR's business can be implemented in order to stem further erosion of volume and operating profit.

The ratings on RJ Reynolds Tobacco Holdings and related entities are based on the company's No. 2 position in the declining domestic tobacco market, its declining brand volume and market share, weakened competitive position, and significant uncertainties about future domestic operating performance and pricing strategies. Furthermore, the U.S. tobacco industry continues to face significant litigation challenges. These factors are somewhat mitigated by the firm's strong financial condition and conservative financial policies.

RJR continues to face intense competition in the U.S. cigarette market and future pricing uncertainty arising from increased state excise taxes and the corresponding growth of deep discount manufacturers. Standard & Poor's believes that these factors will result in continued declines in RJR's domestic cigarette volume and cash flow.

In the first six months of 2003, RJR's shipment volume declined by 12.5%, while the company estimates retail consumption of its brands dropped by about 8%-10%. Operating income declined by about 50% and RJR management expects that operating income could decline by about 50% for the full-year 2003 from previous year levels. This decline will result in estimated EBITDA coverage of interest of just over 6 times in 2003. To maintain its rating, Standard & Poor's expects RJR to sustain its cash flow coverage measures at these reduced levels.

The company's sizable cash balances (which were $1.2 billion as of June 30, 2003) provide its conservative balance sheet with some financial flexibility for investments and dividends, as well as payments for the Master Settlement Agreement (MSA) with the states' attorneys general and bonding requirements for adverse legal judgments, if needed. Standard & Poor's expects RJR to maintain ongoing cash balances of at least $500 million to $600 million. Standard & Poor's does not expect any share repurchases in the near term nor any special dividends.

Standard & Poor's believes that the heightened litigation risk following the $10 billion judgment against Philip Morris USA in the Price "Lights" class action lawsuit in March 2003 demonstrated a level of increased volatility for U.S. tobacco companies with respect to potential bonding requirements for adverse legal judgments. This is especially pronounced in class action lawsuits in states where no bonding caps exist, such as in Illinois. RJR is scheduled for trial for the Turner lights class action lawsuit in October 2003 in Madison County, Illinois. (The trial judge recently denied the company's motion to stay this trial, pending resolution of Philip Morris' similar case. RJR has appealed this to the Fifth District Court of Appeals.) However, it is too early to gauge the impact, if any, of the upcoming Turner case on RJR's ratings.

Standard & Poor's remains concerned about the magnitude of potential future tobacco-related litigation awards at RJR, as well as any related bonding requirements and the outcome of current appeals processes. The litigation landscape has benefited from the recent reversal and decertification of the Engle class action suit and the recent "State Farm" ruling by the U.S. Federal Court. (The latter recommends guidelines for the amount of punitive damages relative to compensatory damages that may be awarded in adverse litigation judgments, yet it is too early to gauge how beneficial it will be to U.S. cigarette companies.) Standard & Poor's believes that U.S. cigarette companies are still exposed to financial uncertainty during class action lawsuits and has not factored any material litigation losses or bonding requirements into RJR's ratings.

Liquidity: RJR's liquidity is good. The balance sheet remains strong, with about $2.0 billion of total debt at June 30, 2003, supported by about $1.2 billion of cash and short-term investments. Cash balances have declined following the April 15, 2003, payment for the Master Settlement Agreement with the states' attorneys general and repayment of about $550 million of scheduled debt maturities. There are no material amortization requirements until 2006.

RJR's $531 million revolving credit facility remains largely available, excluding $23 million of letters of credit outstanding at June 30, 2003. The facility, reduced from $622 million in May, 2003, is available until November 2004 and the company was in compliance with its covenants at June 30, 2003. A springing lien in the bank facility became effective following recent ratings downgrades that required RJR and its guarantors to pledge all of their assets to secure their obligations under the credit facility. However, the company currently does not borrow on the revolving credit facility, and Standard & Poor's is not expecting any near-term borrowings as RJR has substantial cash balances. The ratings downgrades also caused RJR's senior unsecured notes to become secured by certain, but not all, of the guarantors' assets.

Outlook: The outlook is negative. Standard & Poor's expects RJR to maintain its strong balance sheet and adjust its operating model to maintain expected credit measures, including EBITDA to interest of about 6 times. However, a further deterioration in industry conditions, including litigation or the weakening of RJR's credit measures, could lead to a lower rating.


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