April 18 (The following statement was released by the rating agency)
Fitch Ratings has downgraded Tesco PLC's (Tesco) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB+' from 'A-'. The Short-term rating has been affirmed at 'F2'. The Outlook on the Long-term IDR is Stable.
The downgrade reflects Tesco's heightened business risk profile as highlighted in its weaker than expected FY13 (financial year ending 23 February 2013) results with a 13% drop in group trading profit. Credit metrics are now more commensurate with a 'BBB+' rating including its FFO lease-adjusted net leverage which Fitch expects to be around 3.0x or the equivalent lease-adjusted net debt/EBITDAR at around 2.7x. The group has been negatively impacted not only in the UK but also in its International business. This is reflective of a difficult consumer environment, increased competition in the UK and also the increased structural challenges facing large food retailers across Europe.
These structural challenges include competition from specialist retailers and the internet on the food retailers' non-food offer, the preference for convenience store format compared with large hypermarket stores, the price transparency available to consumers as a result of the internet and that consumers are less loyal to brands/retailers, switching between retailers for better promotions or deals.
KEY RATING DRIVERS
UK Execution Risks:
The key challenge for Tesco remains the successful execution and improvement of its core UK operation, in similar ways that Carrefour SA ('BBB'/Stable) had and is still facing in its core French market - combined with the challenges facing the non-food business. Like Carrefour, these structural issues and the changing consumer trends have meant that Tesco has had to continue reinvesting in its business. Tesco has admitted that the UK business was under-invested for a number of years and a plan needs to be put in place to turn the business around.
In January 2012, Tesco committed over GBP1bn in revenue and capital investments as it embarked on its plan to improve competitiveness with an aim of halting a loss of market share (albeit marginal) to competitors like Sainsbury's and Asda.
The plan focused on more staff, refurbished stores, revamped food range and price initiatives. This has led to a deliberate and permanent downward reset of its UK margins to 5.2% in FY13 from 5.8% in FY12. Fitch expects profitability in the UK will therefore remain below historical levels albeit above industry peers.
Poor International Performance:
Fitch notes ongoing price pressures in the food retail industry in Europe due to government austerity measures, high unemployment rate as well as intense competition in the non-food segment from specialist retail chains and the development of internet shopping. Although the group's European business represents about 14% of group sales and 10% of group trading profit, this business division has nonetheless contributed to the weak FY13 financial results. In Asia, Tesco has been negatively impacted in Korea and China with the trading margin down by 105bp to 5.76% in FY13. While growth will likely resume in some of these markets, especially in Asia, Tesco needs to demonstrate that it can improve profit margins in its international operations.
Prudent Financial Policy:
Fitch expects a stabilisation in Tesco's metrics over the next 18 months, as reflected in the Stable Outlook. Moreover, Fitch views positively Tesco's more cautious financial strategy, as evidenced by the group's stable dividend payout ratio and the focus on cash flow with strict capex discipline. Tesco has indicated that there is limited scope for share buybacks until the business is stabilised and credit metrics restored.
Tesco US Exit:
Tesco has confirmed the exit of its Fresh & Easy US business where it made a cumulative loss of GP782m since its first store was opened in November 2007, with cumulative capex of GBP1.2bn as of H112. The exit will benefit Tesco's financial profile by halting several years of operating losses and would allow the retailer to focus on addressing more pressing issues in its home market and other key markets.
Positive: Future developments that could lead to a positive rating action include:
- Group EBIT margin above 5%, mainly reflecting the success of the turnaround of Tesco's operations in UK; together with positive FCF generation on a sustainable basis
- FFO fixed charge cover sustainable at or above 4.0x
- Retail-only (excluding Tesco bank) FFO lease-adjusted net leverage trending towards 2.5x or lease -adjusted net debt/EBITDAR of 2.0x
Negative: Future developments that could lead to a negative rating action include:
- Group EBIT margin decreasing to below 4.0%
- Continued loss of market share
- FFO fixed charge cover below 3.0x
- Retail-only (excluding Tesco bank) FFO lease-adjusted net leverage above 3.5x or lease-adjusted net debt/EBITDAR increasing to above 3.0x
- The emergence of shareholder pressure for shareholder-friendly measures
FULL LIST OF RATING ACTIONS
Long-term IDR: downgraded to 'BBB+' from 'A-'; Outlook Stable
Senior unsecured debt: downgraded to 'BBB+' from 'A-'
Short-term IDR: affirmed at 'F2'
Tesco Treasury Services PLC
Senior unsecured debt guaranteed by Tesco PLC: assigned 'BBB+'
Short-term debt guaranteed by Tesco PLC: affirmed at 'F2'