TEXT-Fitch affirms Japan Tobacco at 'A+'

Sept 27- Fitch Ratings has affirmed Japan Tobacco Inc.'s (JT) Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'A+', Short-Term Foreign and Local Currency IDRs at 'F1' and senior unsecured rating at 'A+'. The Outlook is Stable.

JT's ratings reflect its solid operating performance, dominant market position in Japan, its improved geographical diversification since its 2007 acquisition of UK's Gallaher Group PLC, and prudent financial policy (focusing on positive free cash flow generation and de-leveraging post Gallaher acquisition). The Stable Outlook reflects Fitch's expectation that JT will continue to generate positive free cash flows despite the challenging operating environment, and maintain a prudent financial profile.

JT posted solid operating performance in the financial year ended March 2011. Despite a large excise tax hike in October 2010, volume sales decline was lower than expected and the company was able to offset the volume shortfall with retail price increase. As a result, JT posted total revenue (adjusted net sales excluding excise tax) of JPY1,956bn (-1.2% Y/Y) and EBITDA of JPY541bn (+2.7% Y/Y). In Q1FY12, JT still posted robust overall performance with revenue of JPY410bn (-13.1% Y/Y) and EBITDA of JPY122bn (-8.4% Y/Y) despite the impact of the earthquake on its domestic operations.

JT's domestic market share dropped sharply in the initial days following the March earthquake, falling to as low as 21% in April due to disruption in production and distribution. However, normalization has been faster than expected with shipments of all brands resuming in July 2011. As a result market share has edged closer to pre-quake levels in recent months, reaching 62% and 58% in July and August, respectively and is expected to do so further in coming months.

With steady positive free cash flow, the company continued to post improvements in its credit metrics. In FY11, adjusted debt to EBITDAR improved to 1.4x from 1.7x and EBITDAR interest coverage ratio improved to 17x from 12x.

As one of various options for funding post-quake reconstruction, it has been reported that the government is discussing an additional increase in excise tax, which could result in further volume decline. However, given JT's strong brand loyalty and below-average international prices, Fitch believes there is still room for further price increase in the event of another tax increase.

There have also been reports that the government is mulling the sale of its stake in JT as another post-quake reconstruction funding option. The government currently holds 50.01% (five million shares). Responding to the reports, JT management has emphasized its position in favour of the government divestment, while noting partial share buyback as a possibility.

While a share buyback is potentially credit negative, whether it would have an impact on the rating would depend on the timing and size of the buyback, which in turn would depend on the timing and size of the government stake sale, details of which remain undecided at the moment.

Other rating risks include the adverse impact of foreign exchange volatility on JT's international operations, as well as the small and unprofitable non-tobacco business segments. Fitch may take negative rating action if there are material debt-funded acquisitions or changes in financial policy, resulting in deterioration in JT's credit profile including adjusted total debt to EBITDAR over 1.75x on a sustained basis. Positive rating actions are not expected in the next 12-18 months given risks of unfavourable financial policy changes, with the rating also constrained by exposure to a single market with potential increasing regulatory pressure and declining demand.