OREANDA-NEWS. Fitch Ratings has revised UK-based retailer Tesco PLC's (Tesco) Outlook to Stable from Negative while affirming its Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BB+'. 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 Outlook revision to Stable reflects Fitch's expectation of a progressive recovery in Tesco's core UK market, after a stabilisation in the retailer's operating performance for financial year ended February 2016 (FY16). It also reflects the strengthening of the group's balance sheet and financial flexibility, mainly achieved by the divesture of Tesco's Korean operations (Homeplus) and other capital preservation measures, including working capital and capex rationalisation, and no dividends being paid.

Assuming that strict financial discipline will be maintained over to FY19, Fitch believes its regained financial flexibility will enable Tesco to keep financial metrics comfortably in line with a 'BB+' credit profile while management continues to implement their turnaround strategy in the UK and to repair the group's business model.

The ratings also reflect the execution risk associated with turning around the UK operations in a competitive and highly challenging market environment. This is balanced by the group's large scale and leading position across core markets and retail formats.

KEY RATING DRIVERS
Focus on UK Turnaround
Fitch views the return to positive like-for-like sales in 4Q16 a result of Tesco's wide-reaching repositioning with a focus on price, offer, range, and brand. Fitch views the size of Tesco's UK operations (which Fitch estimates at more than 27% market share currently) as a key competitive advantage in implementing its volume-driven recovery strategy, as the retailer can extract scale benefits from suppliers, which in turn should support pricing power.

Fitch assumes a gradual rebuilding of retail group EBIT margin towards 2.5% by FY19, driven by the group's core UK operations. Fitch expects a slow uplift in UK profitability (UK & Republic of Ireland EBIT margin: growth towards 2.2% by FY19 from an estimated 1.2% margin in FY16), driven by operating leverage effect from growing sales on a lower fixed cost base. Fitch's conservative assumption regarding profitability improvement continues to mirror the execution risk in turning around sales and profitability in a highly competitive and fast-changing retail environment.

Lower Balance Sheet Risks
Fitch recognises management's progress in reducing balance sheet risks by strongly improving liquidity through the sale of the Homeplus Korean business and by closing the UK defined benefit pension scheme. The liquidity improvement in FY16 was also supported by management's more disciplined cash flow policy, including no dividend payment, working capital optimisation measures and rationalised capex. Fitch expects management to maintain its strong focus on free cash flow generation supporting financial flexibility and their turnaround strategy over the rating horizon.

Active Property Management
Fitch views the efforts to increase freehold assets as positive as they improve the group's medium-term strategic options around store development and footprint optimisation, and reduce Tesco's retail operations' exposure to index-linked and fixed-upwards rents. Fitch identifies the latter as a potential drag on recovery in profitability and leverage in the longer term.
During FY16 management's property acquisitions have improved the mix of freehold properties for the UK and Republic of Ireland to 53% (FY15: 47%) and reduced the annual rent bill by around 10% to GBP1.2bn. However, these transactions also added GBP1.5bn of debt to Tesco's balance sheet.

In its rating case Fitch assumes further property transactions that will result in annual average GBP200m annual spending, GBP90m rental savings and GBP900m additional debt on balance sheet.

Evolving Landscape in UK Retailing
Fitch expects that 2015 would have been the UK food retail sector's low point in profitability but projects the trajectory of recovery to be uneven. Driven by increasing volumes observed in 2015, Fitch views pricing as a key driver for the sector performance, together with an increasing need for retailers to sufficiently differentiate their offerings to attract shoppers, particularly to the larger shopping formats.

We believe price deflation will ease over the next 12 months, but will not disappear, as discounters continue to build market share. The UK food retail market is undergoing a period of structural change, characterised by consumer habits shifting their focus to value and convenience (including smaller store formats and online shopping), and by disruptive competition from fast-growing hard discounters creating an environment of price deflation.

Improved Financial Risk Profile
Fitch sees the improvement in Tesco's financial flexibility and financial structure as critical to the ratings. Due to the sale of Homeplus and the various liquidity protection measures taken by management funds from operations (FFO) adjusted net leverage declined to an estimated 4.6x in FY16 (FY15: 5.4x) and FFO fixed charge cover improved to an estimated 2.1x (FY15: 1.8x), within our guidelines for a 'BB+' financial profile.

Fitch believes the regained financial flexibility provides management with sufficient rating headroom to pursue their turnaround strategy in the UK and continue to repair the group's business model, notably through their newly implemented property strategy. Assuming the group maintains strict financial discipline we forecast key financial metrics to remain broadly stable at FY16's levels over the next four years.

KEY ASSUMPTIONS
Fitch's expectations are based on the agency's internally produced, conservative rating case forecasts. They do not represent the forecasts of rated issuers individually or in aggregate. Key Fitch forecasts are based on (continuing) retail-only figures (excluding Tesco Bank) and our assumptions include:
-Stabilising UK like-for-like sales in FY17 before rising modestly from FY18; low single-digit like for-like sales growth in other countries
-UK & Republic of Ireland EBIT margin up at 2% in FY19, driven by operating leverage effect from growing sales and lower fixed cost base
-Further working capital optimisation resulting in cash inflows
-Retail-only capex growing towards GBP1.3bn in FY19 from GBP1bn in FY16
-No dividend payments over FY17-FY19
-Retail-only annual FCF fluctuating between 0.5% and 1% of sales
-Annual asset sales proceeds of GBP200m
-Annual spending of GBP200m to regain property ownership, resulting in annual rental cost savings of GBP90m and annual additional debt (brought back on balance sheet) of GBP900m

RATING SENSITIVITIES
Positive: Future developments that could, individually or collectively, leading to a positive rating action:
-Sustained group retail-only EBIT margin of more than 2.5% (FY16: estimated at 1.4%), reflecting the success of the turnaround of Tesco's operations in UK, further profitability improvement in the international businesses, and successful strategic repositioning
-Retail-only (excluding Tesco bank) FFO fixed charge cover stabilising above 2.0x (FY16: estimated at 2.1x)
-Improving retail-only (excluding Tesco bank) FFO adjusted net leverage to below 4.5x (FY16: estimated at 4.6x) on a sustained basis
- Sustained positive FCF generation after capex & dividends

Negative: Future developments that could, individually or collectively, lead to a negative rating action include:
-Inability to restore group retail-only EBIT margin to levels sustainably above 2%, reflecting an inability to withstand persistent competitive pressure in the UK
-Retail-only (excluding Tesco bank) FFO fixed charge cover below 1.8x on a sustained basis
-Retail-only (excluding Tesco bank) FFO adjusted net leverage above 5.0x on a sustained basis
-Sustained negative FCF margin (post capex & dividends), resulting in an upward trend in leverage

LIQUIDITY AND DEBT STRUCTURE
Liquidity improved strongly following the sale of Homeplus and as of FYE16 was sufficient to meet Tesco's short-term debt obligations. It is supported by Fitch's estimated unrestricted cash of GBP5.7bn (which Fitch adjusts at year-end by GBP250m for what the agency considers as either legally restricted or being absorbed in the working capital cycle) and undrawn and committed bank facilities of GBP5bn at FYE16.
Tesco has a well-diversified debt maturity profile, and its senior unsecured debt is not subject to financial covenants.

FULL LIST OF RATING ACTIONS

Tesco PLC
Long-term IDR: affirmed at 'BB+'; Outlook changed to Stable from Negative
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'

Summary of Financial Statement Adjustments for FY15 (FY16 figures used in Fitch's analysis are based on audited preliminary results; however, we treat them as estimates only until the full annual report is available):
- EBITDA: Fitch's FY15 EBITDA (GBP2,335m) calculation takes into account statutory operating profit of - GBP5,792m, depreciation and amortisation of GBP1,551m and restructuring and one-off costs of GBP6,814m. It also excludes property losses of GBP60m.
- Readily Available Cash: As at 28 February 2015, Fitch has considered that GBP300m 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.
- Leases: Fitch has adjusted the debt by adding 8x of yearly operating lease expense related to long term assets of GBP1,312m for FY15.