OREANDA-NEWS. Fitch Ratings has affirmed Royal Ahold N.V.'s (Ahold) Long-term Issuer Default Rating (IDR) and senior unsecured ratings at 'BBB' following the company's announcement that it will merge with the Belgian food retailer Delhaize Group SA (Delhaize) by mid-2016. The Outlook is Stable.

The rating affirmation reflects the expected benefits of an enlarged group (Ahold Delhaize), in terms of scale and diversification, with a strong presence in the important US food retail market. We expect management's announced cost savings of around EUR500m to be achievable in the long run. However, Fitch views the merger as a defensive move as the group will operate in fiercely competitive food retail markets in both the US and Europe. While we expect savings derived from an enlarged scale and attendant improved purchasing possibilities to support the group's profitability in the medium term, the latter is likely to remain constrained by some further margin sacrifices to support sales growth.

With the transaction structure based on a share exchange between Ahold and Delhaize, no additional debt will be raised; therefore we expect lease-adjusted funds from operations (FFO) leverage (net of EUR488m non-readily available cash) to increase only marginally on completion to 3.5x before improving mildly thereafter. This is consistent with a 'BBB' financial profile and will give the group reasonable financial headroom to execute on its integration plan.

KEY RATING DRIVERS
Greater Scale
Further to the merger Ahold Delhaize will have enhanced scale with a turnover of over EUR54bn and 6,500 stores in Europe and the US. The combined group will enjoy slightly better geographical diversification with operations in eight countries, and will have critical size in the US, which should lead to improved purchasing power.

Stronger US Presence
Ahold and Delhaize have little cross-over in European markets, so the success of the transaction will depend on their ability to successfully integrate their US operations, which are concentrated on the east coast and which account for more than 60% of combined sales and operating profit in 2014. Although operating margins are reasonable, there is now fierce competition from discounters such as Costco and Trader Jo's. Managing the combination of IT and logistics operations will also be a challenge, but the US overlap creates the opportunity for savings in the supply chain.

Defensive Move; Margin Pressure
Ahold and Delhaize are facing margin pressure in both their home and North American operations, due to weak sales growth prospects. These are exacerbated by the structural changes to retailers' business model resulting from e-commerce development, which remains less profitable than physical stores and require high operating investments.

Cost Cutting Realistic
Management plans to cut costs by around EU500m in the next three years after merger completion, with one-off restructuring costs estimated at EUR350m. We view these cost savings as achievable as they were already part of the individual companies' objectives and are modest in comparison with their existing cost base. Fitch nevertheless expects the savings to take time to feed through as Ahold Delhaize negotiates with its trade union partners in the US and in Europe. Fitch considers the achievement of operational integration and cost savings, accompanied by a turnaround of the group's operations in core European markets and the US as key rating considerations.

Stable Post-merger Leverage
With the merger being structured as a share exchange with no additional debt, we project only a mild increase in leverage with lease-adjusted FFO net leverage at 3.5x (Ahold 2014 stand-alone: 3.3x) on completion, expected in mid-2016, and moderate de-leveraging towards 3.0x by 2017 (excluding potential asset divestments). Despite margin pressure remaining high due to fierce competition, cost savings should further improve already positive free cash flow (FCF) generation, supporting moderate deleveraging prospects.

US Anti-Trust; Disposals
As the merged group will have around 1,900 US stores, US anti-trust regulators could require disposals to approve the deal, which could accelerate deleveraging. The Federal Trade Commission will look at how much overlap there is between the businesses in local markets when deciding whether to mandate closures, given that both chains are predominantly east coast-based. Our preliminary assessment suggests these would be limited.

Solid Financial Flexibility
Fitch expects the combined group to enjoy strong FFO fixed charge cover between 2.7x- 3.0x for the 'BBB' rating and healthy liquidity. The rating affirmation also reflects our expectation that the combined group will pursue a conservatively funded balance sheet post-completion.

KEY ASSUMPTIONS
-Low single-digit organic sales growth in both the European and US operations
-EUR500m of sustainable cost savings to be progressively realised in the next three years post-merger completion
-EBIT margin contraction in 2015, before recovering to 4% in 2017 as synergies are progressively achieved
-FCF at 1%-1.5% of sales after the merger completes
-EUR350m one-off restructuring costs and around EUR100m of transaction fees in merger year
-EUR161.3m share buyback in 2015 and EUR1bn capital return to Ahold's shareholders before merger completion

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to a positive rating action include:
-Positive like-for-like sales growth in core markets and EBIT margin sustained above 4.5%. This would reflect successful integration in the US and Holland/Belgium, which represent the core of group's sales and profits
-FFO fixed charge coverage above 3.0x (2014 Ahold stand-alone: 2.7x)
- Maintaining a conservatively funded balance sheet, as reflected in lease-adjusted FFO net leverage consistently below 2.5x (2014 Ahold stand-alone: 3.3x)

Future developments that may, individually or collectively, lead to a negative rating action include:
- EBIT margin below 4% on a sustained basis, due to intense competition in core markets
- FFO fixed charge coverage below 2.5x
- Lease-adjusted FFO net leverage consistently above 3.5x, driven by either sustained operating underperformance or a more aggressive financial policy

LIQUIDITY
Fitch expects the new group to enjoy strong liquidity, with a combined total of over EUR2.7bn of readily available cash and EUR1.4bn of undrawn committed credit facilities at end-2014. This compares favourably with Fitch's assumption of around EUR700m of debt repayments in 2015, together with Ahold's completion of its 2015 share buyback programme (EUR161.3m, terminated on 25 June 2015) and EUR1bn return to shareholders before the completion of the merger.