OREANDA-NEWS. Tesco's planned sale of its Korean operations will reduce leverage and improve financial flexibility, bringing key credit metrics closer to the level we generally view as appropriate for its 'BB+' rating, Fitch Ratings says. But reduced diversification following the sale increases the importance of turning around the UK business to drive further deleveraging. Following completion of the announced disposal, we will therefore need to review the progress in the UK before considering lifting the Negative Outlook.

Assuming receipt of shareholder and regulatory approvals, the sale will generate net proceeds of nearly GBP3.6bn (including GBP200m lower lease liabilities associated with the South Korean operations) and Fitch expects Tesco to receive a further GBP700m in FY16 from the expected sale of its Dunnhumby customer data unit. Applying the proceeds to debt reduction, we estimate FFO adjusted net financial leverage for FY16 and FY17 will be up to 0.4x lower than we previously expected.

But while the proceeds will increase financial flexibility and improve liquidity ahead of GBP2bn of debt maturities in FY16, the FFO adjusted net financial leverage of the less diversified group will remain above the 5.0x we see as consistent with a 'BB+' rating.

The modest immediate deleveraging achieved by the Korean disposal comes at the price of removing a profitable and cash generative business. Korea contributed 9% of FY15 group sales, but had a strong trading profit margin of 5.4% compared with 1.1% in the UK. We estimate the sale will dilute the overall near-term, retail-only profitability of the group to just above 1.0%.

For the remainder of the group, the UK turnaround is increasingly important to drive deleveraging and restore credit metrics. We believe progress will require time as the market in the UK is very competitive, with traditional food retailers challenged by disruptive competition from hard discounters and changing consumer shopping habits.

Tesco has made encouraging efforts to adjust its business model, notably improving its product offer, brand awareness, and supplier relationships. But we expect its volume-driven strategy to suppress UK margins to just above break-even in FY16. We expect to see further information on the progress and breadth of the recovery in the group's 1H16 interims on 7 October 2015. Evidence of an improvement in the retailer's larger formats across the group is particularly important, given their market position and high operational leverage.

We believe Tesco will use its improved financial flexibility to accelerate its focus on property management. The retailer is increasing direct store ownership to help floor space optimisation. Rental obligations are a major part of Tesco's cost base in the UK, and therefore a key factor in a sustainable profitability recovery in this market. We see this strategy as positive for Tesco's evolving business risk profile as it offers improved flexibility on store optimisation and the cost base but it could lead to an increase in near-term debt, weakening the financial profile.