UK brewer and pub retailer Scottish & Newcastle (S&N) has received downgrades from international rating agency Fitch Ratings to both its Senior Unsecured debt and Short-term ratings, reports Reuters. Senior Unsecured debt has moved from A to A- and the Short-term rating is now at F2, down from an F1 rating.
The move follows S&N's bid for Hartwall, Finland's leading brewer. This acquisition will add another strong position in an EU country to S&N's existing portfolio while also giving it exposure to Russia, currently one of the most dynamic beer markets in the world.
Yet although Fitch views the transaction as strong strategically, the increase in financial risk and the group's exposure to more volatile markets means that S&N's risk profile has increased to a level causing both of its ratings to be downgraded by one notch.
S&N has reached agreement with Hartwall to make a recommended offer for all its shares. The Hartwall family, which owns 48.5 per cent of the share capital and 83.5 per cent of the voting rights, has given irrevocable undertakings to accept the share offer.
The offer is subject to S&N shareholder approval, clearance by the EU and Ukraine competition authorities and due diligence on Baltic Beverage Holding (BBH), which is 50 per cent owned by Hartwall and 50 per cent by Danish brewer Carlsberg.
However it is not these conditions which have led Fitch to downgrade S&N's ratings. Hartwall's operations are an excellent fit with those of S&N, and Hartwall, handling 45 per cent of the total beverage sector, is the leader in Finland's drinks market.
Hartwall's operations are cash generative, but it is currently half way through a €225 million upgrade of its infrastructure, so the operations are not expected to generate net free cash flow until 2003.
BBH is the leading brewer in both Russia, where it has 30 per cent of the market share and the Baltics (46 per cent of the market share) and is the third-largest in the Ukraine. It has been very successful, having grown rapidly during the last decade by investing its cash flow to expand throughout Russia.
To date, it has not paid any dividends. Fitch anticipates that BBH will continue to increase its production capacity by reinvesting its cash flow to maintain/capture market share in what remains a fast growing market.S&N management has produced pro forma financials on the basis that Hartwall shareholders will take up their consideration as 60 per cent equity and 40 per cent as cash.
S&N's pro forma debt (including assumed debt) will thus increase by some €984million to €3.1 billion.
Not only is this income stream of different quality to S&N's other operations, but this income may not be available in the short-term to service S&N's additional £600m (€984m) of acquisition debt and the dividends on the new shares issued.
Management has outlined an optimal capital structure relative to its capitalisation value (debt to be up to 40 per cent of S&N's market cap).Although not directly comparable with conventional financial ratios, this guidance indicates potential for further leverage -particularly that attained on conversion of the Danone option.
Following the merger of S&N and Danone's Kronenbourg brewing interests, Danone was granted the right to sell its interest in the partnership to S&N for €1.98bn at any time between 31 December 2000 and 30 April 2003. It is likely that S&N's Senior Unsecured debt rating will come under pressure if Danone exercises its option.
However, in the interim the group could choose to focus entirely on brewing, thus freeing up capital. This contingent financial risk is reflected in Fitch's Negative Outlook.