SECTOR IN-DEPTH Support Credit Strengthening Recovery in ...coca-colahellenic.com/media/2563/2016may04-emea... · 2 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation

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SECTOR IN-DEPTH4 May 2016

TABLE OF CONTENTSProfit contribution from maturemarkets to grow ahead of last year 2Russia, China, Nigeria and Turkeyto remain a drag on profit growthbut compensated by growth in otheremerging markets 2Profit to grow ahead of revenues andvolume despite some challenges 4Free cash flow generation to supportdeleveraging and credit strengthening 5Moody's Related Research 7

Contacts

Paolo Leschiutta 39-02-9148-1140VP-Sr Credit [email protected]

Marina Albo 44-20-7772-5365MD-Corporate [email protected]

Julien Haddad [email protected]

Sara Santagostino 39-02-9148-1108Associate [email protected]

Beverages - EMEA

Recovery in Mature Markets, Innovation toSupport Credit StrengtheningRecovery in mature markets, innovation to support credit strengthening. Despiteexposure to economies pressured by lower commodity prices such as Russia and Nigeriaand to the slowdown in China, we expect a degree of recovery in Europe and the US forEMEA beverage companies. Combined with ongoing premiumisation, innovation and costcutting this will aid organic operating profit growth of between 4.0%-5.0% in the next 12-18months.

Operating profit from US, Europe to grow ahead of 2015 despite modest GDPgrowth expectations. Across Europe we expect modest volume growth for beers andthe contraction of spirits volumes to slow. We expect stronger momentum in the US spiritmarket to result in a degree of recovery for Diageo PLC (A3 stable) and Pernod Ricard S.A.(Baa3 positive). Improving mature markets will strengthen the average credit quality ofEuropean beverage companies and possibly remove some negative pressure on weaklypositioned credits.

Russia, China, Nigeria and Turkey to remain a drag on profit but will be compensatedby growth in other emerging markets. Anadolu Efes Biracilik ve Malt Sanayii A.S.(Efes,Baa3 negative) and Carlsberg Breweries A/S (Baa2 negative), which are more exposed tothese markets, will find profit growth more challenging. However we expect most players tosuccessfully weather volatility in these markets with growth in other countries such as India.

Profit to grow ahead of revenues and volumes despite some challenges. Bettermargins on premium products, low commodity prices and ongoing cost cutting will helpprofit growth and we expect low single digit revenue growth. Brexit, heightened regulatoryrisk, currency volatility and ongoing pressure from retailers are the main uncertainties andchallenges to top line and operating profit growth.

Operating profit growth will support further deleveraging through ongoing freecash flow generation. M&A risk remains limited among European players, although currentconsolidation in the beer industry with the merger of Anheuser-Bush InBev (ABI, A2 reviewfor downgrade) and SABMiller plc (A3 review direction uncertain) increases event risk.

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This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

Profit contribution from mature markets to grow ahead of last yearIn line with global peers we expect EMEA beverage companies to grow organic operating profit by 4.0% to 5.0% during the next 12 to18 months1. This is because we expect a degree of recovery in the mature markets of Europe and the US to compensate for pockets ofsluggish growth in specific emerging markets.

In Western European markets, such as France, Spain and the Netherlands, a gradual, albeit modest, economic recovery will supportoperating profit growth and offset ongoing pressure on consumption in much of Eastern Europe and in Russia in particular. Thisexpectation is based on improving trends reported by the largest companies we rate in recent quarters, and our forecast of euro areaGDP growth of between 1.0%-2.0% in 20162. The Union of European Football Associations (UEFA) Euro 2016 cup is also likely boostsoft drink and beer consumptions. As official sponsors of the event, Carlsberg Breweries A/S (Baa2 negative) and Coca-Cola Enterprises,Inc (A3 review for downgrade) will probably benefit as sole suppliers at venues. Coca-Cola HBC AG, parent company of Coca-Cola HBCFinance B.V. (Baa1 stable), is also expected to benefit.

Beer volumes would grow ahead of spirits in Europe. The Western European beer market has shown improving trends with smallercontraction rates over the last couple of years. We expect this to continue over the next 12 to 18 months owing to the economicrecovery and the growth in craft and flavoured beers. As a result we expect beer volumes to grow in the low single digit rate this year.We also expect premiumisation to continue with premium lager, specialty and flavoured beers to grow at the expenses of mainstreambeer across Western Europe and to compensate for ongoing volume decline in Eastern Europe.

Beer volumes in the US would remain under pressure but European brewers have limited exposure to the US market. We expectHeineken N.V (Baa1 stable) to perform better than SABMiller plc (A3 review direction uncertain) given its stronger position in thegrowing premium segment in the US.

Despite the pressure in Eastern Europe, European spirits volume contraction slowed in 2015 and we forecast further recovery in thenext 12 to 18 months, in light of gradual economic recovery and stronger consumer sentiment. Volumes will be flat at best, althoughall rated European spirits manufacturers have reported positive growth momentum in recent quarters, with growth in Western Europecompensating for ongoing volume pressure in Russia.

As well as volume recovery in Europe, we expect stronger momentum in the US spirit market to result in profit growth for allEuropean spirits players. We forecast US spirits volumes to grow at low single digit rate as the spirits category is taking share ofconsumption from beers thanks to innovation and strong demand for brown spirits3. Despite strong growth in reserve spirits, theperformance of both Diageo PLC (A3 stable) and Pernod Ricard S.A. (Baa3 positive) in the US has been soft due to their large exposureto the traditional vodka segment which has become less popular. However both companies are addressing this issue: after years ofcontraction, net sales of Diageo's Smirnoff, the world's largest premium brand, grew 4% during the six months to December 2015 inNorth America. Over the same period Pernod also reported positive net sales growth in the US, where its revenues increased by 3%.Remy Cointreau S.A. (Baa3 negative) also reported positive organic revenue growth in the US of 1% in the 12 months to March 2016. Inthe same period it also reported a 7.9% organic revenue growth in Europe.

Russia, China, Nigeria and Turkey to remain a drag on profit growth but compensated by growth inother emerging marketsWe expect several emerging markets to remain a drag on profit growth in the next 12-18 months: most notably Russia, Turkey, Nigeriaand China. As Exhibit 1 shows, Efes and Carlsberg are more exposed to these markets and will find profit growth more challenging.

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3 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

Exhibit 1

Efes and Carlsberg More Exposed To Riskier Emerging MarketsEstimated revenues exposure

Note: Red represents estimated percentage of revenues from Brazil, China, Nigeria, Russia and Turkey.Source: Moody's Investors Service estimates based on companies' last available financial reports.

We expect beer volumes in Russia (Ba1 negative) to decline at a mid to high single digit percentage rate in the next 12-18 months asa result of the difficult macroeconomic environment there: we forecast a GDP contraction of between 2.0% and 3.0% in 2016. Exciseduties were increased again in January 2016 by 11% after a freeze in 2015, in a government effort to reduce consumption. Althoughthis is broadly in line with inflation, higher taxes will result in higher prices, which will in turn further reduce consumption. We expectCarlsberg to be most affected because of its high exposure to Russia. Russia's contribution to group profit fell to 16.0% of consolidatedgroup profit in 2015, from more than a third of group profit just a few years earlier.4 However Carlsberg has been able to compensatefor declining profit from Russia with double digit profit growth in Asia, where the company reported strong momentum in India,Vietnam, Cambodia and Nepal. While we do not expect the same strong growth in Asia in 2016 that Carlsberg experienced in 2015,when profit rose 13.0% on an organic basis and 27.0% on a reported basis, it will still help offset ongoing beer volume contraction inRussia.

Soft drink volumes will also remain under pressure in Russia. This will have the most impact on Coca-Cola HBC AG, as this is its largestmarket, representing 16.4% of its 2015 revenues, down from 21.8% in 2013. Soft drink volumes declined in the low teen percentin 2015, but Coca-Cola HBC AG's Russian volumes only declined 6.0% thanks to new product launches and increased promotionalactivity. The company also benefited from low input costs, of sugar in particular, and high inflation in Russia. This allowed for priceincreases which helped offset declining volumes, as did a recovery in mature markets, where volumes returned to growth for the firsttime in five years. A stronger performance in mature markets and ongoing low commodity prices will continue to help Coca-Cola HBCAG report profit growth.

In Nigeria (B1 stable) we expect alcoholic beverage volumes, and to lesser extent soft drink volumes, to remain under pressure and forconsumers to trade down to cheaper brands. Nigeria is one of the largest markets for Heineken. It is the Nigerian market leader with66.5% market share ahead of Diageo subsidiary Guinness which had a 24.7% market share at the end of 20145. In contrast with thebrewers, Coca-Cola HBC AG’s 2015 performance in Nigeria, the company’s third largest market by revenues, has been strong, withdouble-digit volume growth thanks to increasing trade activation, additional PET production capacity and greater focus on productavailability. However this positive trend is unlikely to continue and we expect currency volatility to affect its profit generation in theregion.

Beer volumes in Turkey (Baa3 negative) are likely to continue to decline at low to mid single digit rates due to low consumerconfidence and weak tourism traffic. Volumes declined 1.5% in 2015 and a significant excise duty increase of 15% in January this year,at twice the rate of inflation, will add to pressure on volumes. We expect this to affect domestic brewer Efes most, because this is itslargest market, but also because its largest international market in terms of EBITDA contribution, Russia, also remains under pressure.

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4 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

China (Aa3 negative) will remain a challenging market for European beverage manufacturers although we expect some recovery inlight of our forecast of GDP growth of 6.3% in 2016. According to Carlsberg beer volumes have contracted at a mid single digit ratein 2015 due to weaker consumer confidence as a result of the economic slowdown and unfavorable weather conditions. Sales of high-premium spirits remain subdued since government restrictions on corporate gifts were introduced in 2013, which continue to affectDiageo, Pernod and Remy. While China represents around 2.0%-3.0% of Diageo's revenues, it represents around 9.0% of Pernod's andeven more of Remy's revenues, given its focus on high premium spirits. 6

We expect alcoholic beverage players to compensate for soft trading conditions in China with growth in other Asian markets, andin India in particular. Growth rates in other emerging markets such as India are in double digits as disposable income increases andconsumers shift to international premium brands. This will help companies to increase revenues ahead of volumes during the next 12 to18 months.

Carlsberg, Efes and Remy all have negative outlooks on their current ratings as a result of their exposure to these weaker markets andtheir more modest geographic diversification. Their ability to weather volume contractions in Russia and Turkey, the slowdown in Chinaand, in Remy's case, to maintain growth momentum in the US, could result in the stabilisation of their outlooks.

Profit to grow ahead of revenues and volume despite some challengesOngoing low commodity prices, cost efficiencies and the stronger margins of increasingly popular premium products and certainflavored drinks will support profit growth ahead of revenues during the next 12-18 months. Flavored beers in particular are normallysold at premium prices but have lower excise duty due to their lower alcoholic content, resulting in higher gross margins. For example,9.2% of Heineken's 2015 revenues were generated from new products, a rate which has steady increased during the past five years7.Cider is also experiencing strong growth across Europe. Sales of Carlsberg's Somersby cider brand grew by 21% in 2015 and this willpartially compensate for the difficulties the company is experiencing in Russia.

Although we expect innovation and low commodity prices to support profit growth we have identified several potential near-termuncertainties and challenges to the industry.

Firstly, if the UK votes to leave the EU in its 23 June referendum we believe that the near-term impact on the industry would belimited, although there would be a level of uncertainty about the future trading environment, which could affect investment decisions8.This might add volatility over the short term and possibly increase costs for those companies with large operations in the UK in themedium to long term. Scottish whisky, which needs to be produced locally, represented 24% of Diageo’s net sales and 22% of Pernod’srevenues at June 2015, and this segment would probably be most affected by any disruption or negative change to current commercialagreements. During the 2014/15 fiscal year ending June 2015, 43% of Diageo sales were generated in emerging markets with which theEU often has trading agreements.

There is also heightened potential for increased regulation which could curb volume growth. On 16 March the UK governmentannounced a new sugar levy on soft drinks, to be introduced in April 2018 in an effort to reduce sugar consumption and tacklechildhood obesity. We expect this to reduce soft drink consumption as higher costs will probably be passed on to consumers. It couldalso set a precedent which may be followed elsewhere or extended to other products9.

A number of countries have also restricted beer sales in certain outlets with the aim of reducing consumption, including Indonesiain 201510. Heineken reported double-digit volume declines in the country as a result that year. Russia and Turkey have also bannedsales of beer from kiosks in recent years in a bid to regulate consumption and to support responsibly drinking, adding to the pressureon the beer segment, with product availability and sales hour restrictions reducing volumes. The Russian government is also mullingimposing a ban on beer sold in PET plastic bottles in large sizes and although we expect brewers to channel these volumes throughother containers or smaller PET bottles, this is likely to create further disruption in the sector which will affect all major players in theregion, including Carlsberg, Efes, Heineken and ABI.

We also see ongoing pressure from retailers, particularly in the competitive UK grocery market. In early October, Tesco plc (Ba1 stable)decided not to stock most of Carlsberg's products after what we understand was a failure by the two companies to reach a commercialagreement. Although the contract with Tesco was probably not particularly lucrative for Carlsberg, Tesco has around 28% of the

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5 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

grocery market in the UK and as a result of this Carlsberg reported a 7% decline in its UK volumes in 2015. Although we do not see thisas the start of a trend, it shows how the pressure at retail level can affect rated issuers.

We also expect ongoing currency exchange fluctuations to result in reported earnings volatility. The impact on companies will dependon their cost base, reporting currency and debt mix. In most cases, currency fluctuation represents less than 0.5x in terms of debt toEBITDA. During 2015, companies which reported revenues in euros, and those with a large cost base across Europe benefitted from theeuro's weakness in contrasts with those that reported in pounds, like Diageo, or US dollars, like SABMiller which were translating lowerprofits in weaker currencies. For the 12 months to March 2016, Remy's organic revenues rose 0.3% on year, but reported revenuesrose 8.9%. By contrast SABMiller, which reports in US dollars and derives only around 14% of its profit from Europe, generated organicgrowth at constant exchange rate of 5% in the same period, but reported revenues contracted 8%. It is impossible to predict howcurrencies will move, but volatility is likely to remain an issue and will affected reported results. As a result we tend to focus on organicgrowth when assessing profit growth expectations for the industry.

Free cash flow generation to support deleveraging and credit strengtheningOur expectation of operating profit growth, combined with the absence of large restructuring programmes and stable financial policiessuggest ongoing free cash flow generation for most of the European beverage companies we rate. In most cases we expect companiesto apply excess cash to reducing financial leverage. This would be credit positive for Carlsberg in particular because its leverage,measured as Moody's adjusted debt to EBITDA is currently high for its rating, as Exhibit 2 shows.

Exhibit 2

Key Financial Ratio Improvements Expected For Most Companies

Note: All ratios are based on adjusted financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations. [1] This represents Moody's forward view; notthe view of the issuer; and does not incorporate significant acquisitions and divestitures. [2] This represents a summary of a more extensive guidance. For full text and exact guidance pleaserefer to text disclosure on www.moodys.comSource: Moody's Financial Metrics

We view the ratings of Coca-Cola HBC, SABMiller, and Heineken to a lesser extent, as strongly positioned in their rating categories.Operating profit growth in line with industry expectation, together with containment of currency volatility and further reduction indebt, might result in positive pressure building on Coca-Cola HBC's rating in particular, leading to a possible positive outlook over time.

Diageo and Pernod's credit strengthening will in large part depend on further recovery in the US market. Despite its stable outlook,Diageo's retained cash flow to net debt ratio, as adjusted by Moody's, has been below the guidance to maintain the rating since June

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6 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

2015. Pernod's positive outlook reflects its strong positioning in its rating class, though the company has so far failed to show thefinancial leverage reduction required for an upgrade. As at December its Moody's adjusted debt/EBITDA ratio stood at 4.4x, but itsoutlook reflects our expectation that financial leverage will move towards below 4.0x in the next 12 months.

We do not expect any major M&A amongst European players in the next 12-18 months as most companies do not have the ability tomake large debt-funded acquisitions without putting negative pressure on their current ratings. However small, bolt-on acquisitions ofsmall fast growing brands will probably continue to help companies to fill gaps in their product portfolios.

As we have said previously, the merger of ABI and SABMiller is unlikely to significantly disrupt the European beer market. However,it might push smaller players to close the gap by seeking external growth through acquisitions. Debt-funded acquisitions would becredit negative for Carslberg and Efes because both companies' ratings remain weakly positioned with negative outlooks. By contrastHeineken's rating could accommodate a multibillion debt financed acquisition, although we do not factor this into the current ratingand outlook.

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7 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

Moody's Related ResearchIndustry outlook:

Outlook Update: Global Beverage Industry: Cost-Cutting, Higher Pricing Offset Slowdown in Emerging Markets, April 2016 (1021697)

Sector comment:

Beverage companies - Europe: Full-year Results Support Credit Quality, Potential For Improvement For Many Seen In Next 12-18Months, February 2016 (1017227)

Sector in depth:

Alcoholic Beverages - Europe: ABI-SABMiller Merger Unlikely to Change Competitive Landscape in Europe, February 2016 (1011635)

European Alcoholic Beverage Manufacturers: Regulation To Curb Profitability Growth In India Despite Strong Potential As EconomyGrows, Consumption Increases, July 2015 (1005431)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.

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8 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

Endnotes1 See “Outlook Update: Global Beverage Industry: Cost-Cutting, Higher Pricing Offset Slowdown in Emerging Markets,” 6 April, 2016

2 See “Global Macro Outlook 2016-17 - Global growth faces rising risks at time of policy constraint,” published 18 February 2016

3 See “Global Beverage Industry - Emerging Markets Slowdown Will Dampen Growth, but Pockets of Strength Remain,” 30 October 2015

4 Russia represents around 70% of Carlsberg's Eastern Europe division, which contributed 22.2% of total group profit in 2015, versus 41.8% in 2013

5 Based on Euromonitor data

6 Remy's Asia Pacific region represented 27% of its revenues for the six months to September 2015, and a large part of this is China.

7 Heineken measures its innovation rate as revenues generated from innovation introduced in the past 40 quarters for a new category, 20 quarters for a newbrand and 12 quarters for all other innovations

8 See “Non-Financial Corporates and Infrastructure Companies - UK: Brexit Would Create Prolonged Uncertainty Until Alternative Agreements Emerge,”published 22 March 2016

9 See “Soft Beverage Manufacturers - UK, Impact of Sugar Levy Will be Limited but May Set Precedent,” and “Coca-Cola Enterprises, Inc.: UK sugar tax iscredit negative for CCE but does not affect rating; rating remains under review,” published March 2016

10 See “New Indonesian Beer Sales Restrictions Are Credit Negative For Heineken and Diageo,” published April 2015

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9 4 May 2016 Beverages - EMEA: Recovery in Mature Markets, Innovation to Support Credit Strengthening

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