October 10, 2017 / 5:12 PM / 2 months ago

Fitch Affirms Tesco at 'BB+'; Outlook Stable

(The following statement was released by the rating agency) LONDON, October 10 (Fitch) Fitch Ratings has affirmed UK-based retailer Tesco PLC's (Tesco) Long-Term IDR at 'BB+' and senior unsecured rating at 'BB+'. The Outlook remains Stable. Fitch has also affirmed the Short-Term IDR and short-term debt ratings at 'B'. A full list of rating actions is available at the end of this commentary. The affirmation of Tesco's IDR and its Stable Outlook reflects Fitch's expectation of a consolidation of the rating headroom regained over the past two years, in terms of both Tesco's business and its financial profile. Fitch forecasts further recovery in Tesco's operating performance but this is likely to be hampered by accumulating challenges in the group's core UK market, including the still uncertain impact of Brexit on consumer behaviour in the medium term. Significant debt repayments and Tesco's property management strengthened the group's financial profile in the financial year ended 25 February 2017 (FY17). Fitch forecasts this to be sustainable, assuming the maintenance of a strict financial policy, notably regarding dividend distributions. Please note that all the metrics mentioned below refer to Tesco's retail operations only. KEY RATING DRIVERS Sales Recovery in the UK: Fitch expects like-for-like sales to continue to increase after coming back to growth on a full-year basis in FY17, supported by regained competitiveness through lower prices and an improved offering. In the current inflation environment the size of Tesco's UK operations is a key competitive advantage as the retailer can extract scale benefits from suppliers, which in turn should support pricing power. However, risks remain that sales growth pace may be compromised by declining consumer confidence. Improving International Operations: After a deterioration in FY17, Fitch expects Tesco's international operations to strengthen from FY18, supported by management's ability to implement abroad the measures initiated in the UK. We do not expect a significant amelioration in the trading environment, especially in Tesco's largest foreign markets of Poland (highly competitive environment) and Thailand (political issues). However, management's initiatives should structurally improve Tesco's foreign business models. These include organisational changes towards a better regional focus, optimisation of the offerings, and a reorganisation of logistics leading to substantial cost savings. Scope for Margin Expansion: After a strong uplift to 2.1% in FY17 (FY16: 1.5%), Fitch expects further increases in Tesco's retail EBIT margin. However, we conservatively forecast EBIT margin to only reach 2.6% in FY20 (UK: 2.3%) due to important market risks, especially in the UK. These include structural changes in consumer behaviour with an increased focus on value and convenience, and disruptive competition from both discount retailers and online players, all in the context of the Brexit process. Such challenges could lead Tesco to reinvest a large part of its gains from higher sales volumes and cost savings into measures to maintain competitiveness. Neutral Free Cash Flow: Fitch expects FCF after dividends will be at best neutral over the next three years, after inflows in FY16 and FY17 due to capex restrictions and the absence of dividend payments. FCF should be supported by further improvements in profitability, but a normalisation of capex, modest further improvement in working-capital management and the restart of dividends distribution are likely to limit it to neutral. Satisfactory Financial Flexibility, Deleveraging: Fitch factors in management's cash allocation over FY16-FY17, into profitability but also debt repayments. FFO fixed charge cover should cross over the 2.0x level in FY18. FFO adjusted net leverage dropped from 5.4x in FY15 down to 4.5x in FY17, bringing Tesco's financial profile more in line with its 'BB+' IDR. Fitch expects FFO adjusted net leverage to remain around the current level over the next three years. A further reduction appears now mainly contingent on EBIT margin growing above 2.5%, combined with broadly self-funded property buybacks and a strict financial policy regarding dividend distributions. Booker Acquisition Neutral: Fitch assesses the acquisition of Booker, planned for end-2017 or early-2018, as broadly credit-neutral. It should have marginal impact on Tesco's financial profile as it will be 80% equity-funded and does not require any new debt. The merger is a defensive move in the highly competitive and mature UK market. Fitch expects a consolidation of the group's market share and scale in the UK, some sales and cost synergies, and more promising growth prospects through an access to the faster-growing catering and convenience store segments. However, the group will continue to heavily rely on the UK (75% of FY17 retail EBIT including Booker). DERIVATION SUMMARY Compared to European food retailers, Tesco benefits from its large scale, a leading market share in its core market as well as adequate format diversification by geography, store formats and distribution channels. However, its profit margins are lower than most peers', such as Carrefour SA ('BBB+'/Stable) or Casino Guichard-Perrachon SA ('BB+'/Stable). Due to its unmatched scale and market share it should withstand the pressure related to ongoing UK market challenges better than the other "big four" traditional food retailers Asda, Morrisons and Sainsbury's. Therefore Fitch still expects some improvement in Tesco's operating margins, although these are unlikely to reach the level of its continental peers in the next three years. The sale of Tesco's Korean subsidiary Homeplus in 2015 strongly enhanced its financial flexibility, helping the group to finance its turnaround in the UK and significantly strengthen its financial structure. However, the latter remains significantly weaker than investment-grade peers such as Ahold Delhaize NV (BBB/Stable) and Carrefour SA. KEY ASSUMPTIONS The assumptions below are for Tesco retail-only operations. Fitch's key assumptions within our rating case for the issuer include: - completion of Booker acquisition by FYE18; - low single-digit growth in UK like-for-like sales supported by inflation and minor volume growth; - stabilisation in international sales in FY19 followed by low single-digit growth; - Tesco retail EBIT margin of 2.6% in FY20 driven by UK and Irish EBIT margin up at 2.3% in FY20, recovery in international margins supported by structural operating initiatives, and broadly stable EBIT margin at Booker; - Fitch also assumes annual cost synergies from Booker absorption to rise from GBP50 million in FY19 up to GBP130 million in year 3 of integration (FY21); - modest further improvement in working-capital management; - capex at GBP1.2 bullion in FY18, average GBP1.4 billion thereafter; - increasing dividend payments reflecting stable dividend policy for Booker and rising dividend outflows for Tesco starting in FY18; - neutral to slightly negative FCF due to resumption of Tesco's dividend payments; - annual asset sales proceeds of GBP250 million; - average annual spending of GBP250 million to regain property ownership, resulting in annual rental cost savings of GBP30 million and annual additional debt (brought back on balance sheet) of GBP300 million. RATING SENSITIVITIES The rating sensitivities below apply to Tesco retail-only operations. Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - Sustained EBIT margin of more than 2.5% (FY17: 2.1%) with clear trend towards 3%, reflecting the success of the turnaround of Tesco's operations in the UK, further profitability improvement in the international businesses, and successful strategic repositioning - FFO fixed charge cover stabilising above 2.0x (FY17: 1.8x) - Improving FFO adjusted net leverage to below 4.5x (FY17: 4.6x) with clear trend towards 4.0x - At least neutral FCF generation after capex and dividends Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - Inability to maintain EBIT margin at above 2%, reflecting Tesco's inability to withstand persistent competitive pressure in the UK - FFO fixed charge cover below 1.8x on a sustained basis - FFO adjusted net leverage above 5.0x on a sustained basis - Sustained negative FCF margin after capex and dividends, resulting in an increase in leverage LIQUIDITY Adequate Liquidity: Liquidity improved strongly following the disposal of Homeplus in FY15. As of FYE17 liquidity was supported by Fitch's estimated unrestricted cash of GBP5.5 billion (which Fitch adjusts at year-end by GBP250 million for what the agency considers as either legally restricted or being absorbed in the working-capital cycle, but not for the GBP777 million to be spent on the acquisition of Booker in FY18, included in Fitch's FY18 forecasts) and undrawn and committed bank facilities of GBP4.4 billion. Fitch does not expect the integration of Booker to lead to a deterioration in liquidity. At end-March 2017 the group had GBP161 million of cash on its balance sheet, an undrawn committed revolving credit facility of GBP120 million and we expect it to keep on generating positive free cash flow after dividends. FULL LIST OF RATING ACTIONS Tesco PLC Long-Term IDR: affirmed at 'BB+'; Outlook Stable Senior unsecured debt: affirmed at 'BB+' Short-Term IDR: affirmed at 'B' Short-term debt rating (including commercial paper): affirmed at 'B' Tesco Corporate Treasury Services PLC Senior unsecured debt: affirmed at 'BB+' Short-term debt rating (including commercial paper): affirmed at 'B' Contact: Principal Analyst Anne Porte Director +33 1 44 29 91 36 Supervisory Analyst Sophie Coutaux Senior Director +33 1 44 29 91 32 Fitch France SAS 60, rue de Monceau 75008 Paris Committee Chairperson Giulio Lombardi Senior Director +39 02 8790 87214 Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Summary of Financial Statement Adjustments - Fitch's FY17 Tesco retail EBITDA calculation (GBP2,307 million) calculation takes into account statutory operating profit of GBP940 million, depreciation and amortisation of GBP1,180 million and restructuring and one-off costs of GBP183million. It also excludes property losses of GBP4 million. - Tesco Bank: Fitch has made adjustments on Tesco's P&L and cash flows stripping out the results of Tesco Personal Finance PLC (Tesco Bank) to reflect true cash flows available to Tesco's retail operations. Fitch has also fully deconsolidated Tesco Bank's debt as Fitch estimates the bank is sufficiently capitalised not to be a cash drain to the retail operations over the rating horizon. - Readily Available Cash: As at 25 February 2017 (YE17), Fitch has considered that GBP250m of cash is needed for day-to-day operational activities including funding of intra-year working capital needs, therefore not readily available for debt repayments. - Fair Value of Debt: Fitch made a GBP752m downward adjustment on the debt of Tesco retail operations in order to reflect the nominal value of the debt to be repaid at maturity. - Operating Leases: Fitch has adjusted the debt by adding 8x of yearly operating lease expense related to long term assets of GBP959 million for FY17. Additional information is available on www.fitchratings.com. 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