Moody's Cuts Tesco plc to Junk

Moody's Investors Service has today downgraded to Ba1 from Baa3 the senior unsecured long-term ratings of Tesco Plc and its guaranteed subsidiaries. Concurrently, Moody's has downgraded to Not Prime from Prime-3 (P-3) the short-term ratings of Tesco and its subsidiaries and has assigned a corporate family rating (CFR) of Ba1 and a probability of default rating (PDR) of Ba1-PD. The rating outlook is stable.

"We have downgraded Tesco's ratings because of our expectation that the structural changes in the UK grocery retail market will continue to challenge the company's operating performance even with the benefits of the significant restructuring actions announced by the company earlier today," says Sven Reinke, a Moody's Vice President -- Senior Analyst and lead analyst for Tesco. "Moreover, we think that the company's efforts to stabilise the UK operations and to protect the balance sheet, while helpful, will take time to implement and the company's financial profile is likely to remain leveraged beyond what we consider to be commensurate with an investment grade profile."

RATINGS RATIONALE

Today's rating action primarily reflects Moody's view that the increasingly competitive environment among UK grocers will foster continued pricing pressures that could result in a permanent reduction in average operating margins in the industry to the 3%-4% range. Tesco's UK operations have suffered persistent sales declines and its trading margin for H1 2015 fell to 2.3% from 5.2% a year earlier. However, the decline in like-for-like sales (excluding fuel) slowed somewhat in the third quarter of fiscal 2015 to 4.2% and 0.3% during the Christmas period. Nevertheless, Tesco's UK supermarket segment continues to suffer from (1) price pressure from the growing discounters; (2) the high level of price cuts among the four large supermarket companies; and (3) the consumer trend towards shopping at convenience stores and online shopping outlets while moving away from large, out-of-town supermarkets and hypermarkets, which are Tesco's dominant UK formats.

Tesco has announced a number of measures to improve the competitiveness of its UK operations including targeted price investments and better product availability. Moreover, Tesco will execute a far-reaching cost cutting and efficiency programme including the closure of its head office in Cheshunt, a flat investment in the payroll for the UK business and the closure of 43 underperforming stores in the UK. These actions will help to stabilise the company's UK grocery operations, but their full effect will not be felt in the immediate future.

As a result, Tesco's earnings will only improve gradually from the GBP1.4 billion full-year trading profit guidance for fiscal 2015 that the company confirmed during today's announcement. Tesco's sustainable debt capacity is impacted by the company's long-term operating profit margin that will likely remain below its historic level.

Tesco's materially reduced EBITDA generation alongside elevated levels of debt led to a significant increase in the company's adjusted (gross) debt/EBITDA ratio to 5.4x in H1 2015 compared with 4.1x at the end of fiscal 2014. Based on the company's latest profit guidance and excluding the effect of the capital measures announced today, Moody's expects Tesco's adjusted (gross) debt/EBITDA ratio to rise to around 6.0x at the end of fiscal 2015.

The company will employ certain measures to protect and strengthen its balance sheet such as the cancellation of the final dividend for fiscal 2015, a material reduction in capex to GBP1.0 billion in fiscal 2016, the disposal of Blinkbox and Tesco Broadband and the appointment of an advisor to explore strategic options for Dunnhumby. Moody's is cautious of execution risk with regard to the intended asset monetisation as well as the risk of shareholder litigation and its potential financial impact that could delay the company's efforts to strengthen its balance sheet. Even after a successful execution of intended assets sales the company's leverage will likely remain at levels more consistent with a Ba1 rating over the intermediate term.

As Tesco works to address the operating challenges facing its business including its large operating lease obligations, Moody's believes that the company has a sound liquidity profile that offers important financial flexibility to manage working capital needs and short-term debt maturities. The company has access to GBP5 billion of committed, currently undrawn bank facilities and a high balance of cash, cash equivalents and short-term financial investments totalling GBP4.9 billion at the end of H1 fiscal 2015. Capital measures announced today, the forecasted reduction in capital expenditure to GBP1.0billion in fiscal 2016 and the cancellation of the final dividend are supportive for its credit profile.

Although the company faces severe challenges in its UK home market, the Ba1 ratings of Tesco and its guaranteed subsidiaries continue to reflect (1) its strong business profile, which is underpinned by the company's sustained market leadership in the UK food retail sector with about 29% market share; (2) leading positions in the growth channels online and convenience stores; and (3) good geographic diversity outside of the UK.

RATIONALE FOR STABLE OUTLOOK

The stable outlook reflects Moody's view that Tesco is taking decisive action to improve its competitive position in the UK and to address its high leverage. However, longer-term structural changes in the UK retail grocery market will continue to affect Tesco for a number of years. A successful turnaround requires the company to stabilise sales, stemming UK market share losses and addressing the falling sales densities at its large out-of-town supermarkets. To maintain the current rating, Moody's expects Tesco to reduce its adjusted debt/EBITDA ratio to below 5.5x over the next 12 -- 18 months and for its retained cash flow (RCF)/net debt to fall not sustainably below 10%.

WHAT COULD CHANGE THE RATING UP/DOWN

Given today's rating action, a rating upgrade over the short term is unlikely. However, over time, Moody's could upgrade the rating if Tesco's operational strategy and intended capital measures lead to a sustainable recovery of the company's operating performance in the UK such that like-for-like sales increase and the trading margin improves to at least 3%. An upgrade would also require the company to continue strengthening its corporate governance and demonstrate a commitment to a conservative financial policy. Quantitatively, an adjusted debt/EBITDA ratio of 4.5x or below and a RCF/net debt ratio at least in the mid-teens would put positive pressure on the rating.

Moody's would consider downgrading Tesco's rating if the company's strategy fails to stabilise the operating performance or to generate asset disposal proceeds as intended, thereby preventing Tesco from tangible progress towards reducing its adjusted debt/EBITDA ratio to below 5.5x over the next 12 -- 18 months. Additionally, the rating would come under downgrade pressure if the final outcome of the legal investigations by the Serious Fraud Office and Financial Reporting Council into the company's accounting practices has material negative implications for the company's corporate governance and financial profile or if Tesco's sound liquidity were to weaken.

PRINCIPAL METHODOLOGIES

The principal methodology used in these ratings was Global Retail Industry published in June 2011. Other methodologies used include Loss Given Default for Speculative-Grade Non-Financial Companies in the U.S., Canada and EMEA published in June 2009. Please see the Credit Policy page on www.moodys.com for a copy of these methodology.

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