OREANDA-NEWS. April 27, 2015. Fitch Ratings has downgraded UK-based Tesco PLC's (Tesco) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BB+' from 'BBB-'. The Outlook remains Negative. The Short-term IDR has been downgraded to 'B' from 'F3'. A full list of rating actions is available at the end of this commentary.

The downgrade reflects a weakening outlook for the group's near term profitability in its core UK operations relative to our prior expectations as the company implements its wide-ranging turnaround plan, which has started to support volume and market share gains in the UK. In addition, Fitch expects next year's free cash flow (FCF) generation to be impacted by the timing of restructuring charges and working capital effects associated with changes to supplier relationships. These, despite discipline on shareholder returns and investments, have led to a spike in leverage and a financial risk profile, including asset disposals, that is more aligned with a 'BB+' rating.

Fitch now views the acceleration of strategic initiatives such as non-core asset disposals as a key source of near-term deleveraging. This is because we expect UK profitability in the short term to remain impaired and volatile as the company implements its restructuring in a deflationary environment for food retailing.

The Negative Outlook reflects the continued pressures Tesco's core UK business faces in restoring profitability, despite the initiatives carried out by management. Fitch believes that management have identified, and will use, available strategic options to improve credit metrics; however, these are subject to execution risks and uncertain timing, which in turn are reflected in the Negative Outlook. During this period, the group's ratings will remain underpinned by strong liquidity, relative to the rating category, which supports the execution of the announced strategic changes and helps protect value in the business.

KEY RATING DRIVERS

UK Operating Environment Remains Challenging
Tesco's UK operating model is challenged by structural pressures affecting the UK food retail market, such as changing consumer behaviour and disruptive competition from hard-discounters. This has resulted in an evolving retail channel mix favouring smaller retail and online formats.

As a UK leader in large retail formats, Fitch views Tesco as particularly susceptible to high operational leverage, which adds to pressure on margins in the currently deflationary environment for core grocery products. Strengthening UK consumer confidence so far has not benefited food retailers, with consumer spending favouring big-ticket items, leisure activities and debt repayment, and Fitch expects the strong focus on value to remain a key feature in the UK food retail segment.

Defending Volume/Market Share
Fitch expects Tesco to continue focusing on volume growth and defending its dominant market share. The group has reported positive like-for-like sales momentum so far in 2015. Volume and scale are key to supporting its UK store network across all retail channels, including Tesco's leading market position in online and convenience. Key components of this strategic repositioning are a refocused product range (albeit remaining a multi-choice retailer), simplification of its price positioning and transparency, supply chain and availability, as well as a leaner management structure and better in-store service.

Near-term Profitability under Pressure
Fitch assumes profitability for Tesco's UK operations at just above breakeven for the financial year ending February 2016 (FY16), as it sacrifices margins to boost footfall. Weak group profitability, supported by adequate margins from Asia, is low relative to the 'BB' rating category median for the sector. To achieve a sustainable and above-industry average profitability Fitch believes further cost reduction will be needed over and above the announced measures, with a focus on addressing the high rent expenses in the business.

Focus on Cost, Property Management
Fitch recognises rental obligations as the key component of Tesco's cost base, and therefore of a meaningful recovery in profitability in the UK. We consider Tesco's flexibility in the UK as weak in the near-term, due to a lower number of directly owned stores (around 40% owned properties in the UK by value) and long-term lease arrangement partially subject to unfavourable RPI linkage, particularly for its larger store formats. Renegotiation and rebasing some of these rents will take time and is one of the key assumptions for Fitch in delaying its underlying recovery assumptions in our rating projections. In addition, Tesco has realised GBP4.7bn of non-cash write-downs on their owned store portfolio, recognising the impaired value of such retail properties in the current difficult retail environment.

In this context, Fitch expects an accelerated focus on property management in line with the recent transaction executed with British Land. We also see Tesco seeking to increase direct ownership of its stores, to allow for greater management and cost flexibility, albeit accompanied by a potential increase of debt in the near-term.

Financial Risk Profile Elevated
Given the delayed recovery assumptions in the core UK market, coupled with softness in some of the international operations, Fitch views the deleveraging potential from internal cash preservation and improving trading performance in the near term as limited. We expect FFO adjusted net leverage to peak at 5.6x, with FFO fixed charge cover bottoming out at 1.6x in FY16 before increasing thereafter, leading to a financial profile, excluding asset disposals, that is more aligned with the 'BB' rating category.

We therefore see further cash preservation measures such as asset disposals as the likely key route to deleverage the business and repair the balance sheet.

LIQUIDITY & DEBT STRUCTURE

Liquidity is sufficient to meet Tesco's short-term debt obligations. It is supported by access to undrawn bank facilities of GBP5bn and a large cash and cash equivalent balance of GBP1.8bn at FYE15 (which Fitch adjusts at year-end by GBP300m for what the agency considers as either legally restricted or absorbed in the working capital cycle).

Tesco has a well-diversified debt maturity profile and demonstrated continued access to capital markets. Furthermore, its debt is not subject to financial covenants and Fitch considers the maintenance covenants as undemanding. The downgrade of the Short-term IDR is linked to that of the Long-term IDR.

KEY ASSUMPTIONS

-Continuation of improvement in UK like-for-like volumes in FY16
-Continuing pressure on group profitability, driven by the UK trading profit margin which is expected to be above break-even point for FY16
-GBP1bn annual capex in FY16 and FY17
-No dividend pay-out for FY16 and FY17
-The rating case assumes that management will continue to explore strategic options to further repair the balance sheet over and above the disposal of dunnhumby expected to be completed in FY16

RATING SENSITIVITIES

Positive: Future developments that could, individually or collectively, leading to a positive rating action, including a revision of the Outlook to Stable:
-Sustained group EBIT margin of more than 2.5% (FYE15: estimated at 1.9%), reflecting the success of the turnaround of Tesco's operations in UK, improving profitability in its international businesses, and a successful execution of its strategic repositioning
-FFO fixed charge cover stabilising above 2.0x (FYE15: estimated at 1.9x)
-Improving retail-only (excluding Tesco bank) FFO adjusted net leverage to below 4.5x (FYE15: estimated at 5.6x) on a sustained basis
-Move towards positive FCF generation (FCF after capex & dividends)

Negative: Future developments that could, individually or collectively, lead to a negative rating action include:
-Continuous deterioration in EBIT with accelerating competitive pressures in the UK food retail market and continuing headwinds in the international operations
-Continued loss of market share in domestic operations
-FFO fixed charge cover below 1.8x on a sustained basis
-Retail-only (excluding Tesco bank) FFO adjusted net leverage staying above 5.0x
-Sustained negative FCF margin (post capex & dividends), resulting in an upward trend in leverage

FULL LIST OF RATING ACTIONS

Tesco PLC
Long-term IDR: downgraded to 'BB+' from 'BBB-'; Outlook Negative
Senior unsecured debt: downgraded to 'BB+' from 'BBB-'
Short-term IDR: downgraded to 'B' from 'F3'

Tesco Corporate Treasury Services PLC
Senior unsecured debt: downgraded to 'BB+' from 'BBB-'
Short-term IDR: downgraded to 'B' from 'F3'