UPDATE: S&P Cuts Tesco plc to Junk; Outlook Stable

(Updated - January 14, 2015 7:42 AM EST)

Standard & Poor's Ratings Services today lowered its long-term corporate credit rating on U.K.-based international retailer Tesco PLC to 'BB+' from 'BBB-'.

We also lowered our short-term rating on Tesco to 'B' from 'A-3'. We removed the ratings from CreditWatch, where we placed them with negative implications on Dec. 10, 2014. The outlook is stable.

At the same time, we lowered our issue ratings on Tesco's unsecured notes to 'BB+' from 'BBB-'. The recovery rating on these notes is '3', indicating our expectation of meaningful (50%-70%) recovery in the event of a payment default.

The downgrade reflects our view that, given the structural changes and competitive pressures that Tesco is facing in the U.K. market, the credit supportive financial policy measures announced by Tesco's management are unlikely to sufficiently improve the group's financial risk profile to maintain an investment-grade rating.

In our view, the dividend cancellation, cuts to future capital expenditure, and potential disposal of the dunnhumby business, if achieved, should enable Tesco to improve its cash position by more than £3 billion over the next financial year ending 2016. At the same time, however, we expect market conditions to remain highly competitive for retailers, particularly in the U.K., which accounts for about two-thirds of Tesco's retail sales and profits. We anticipate that increased competitive and price pressures in the U.K. from both traditional and discount retailers could suppress any benefits from various management strategies oriented toward improving trading performance. Accordingly, we anticipate that Tesco's profitability will continue to remain under pressure as market competition in the U.K. remains high.

We forecast that Tesco's adjusted EBITDA margins will normalize at around 7%. Despite the substantial decline of more than 250 basis points compared to financial year ending 2014, this remains in line with our criteria's definition of "average" profitability for the food retail sector. However, a further significant drop in margins could weigh on our assessment of Tesco's business risk profile.

We assess Tesco's business risk profile at the lower end of the "strong" category under our criteria. Our business risk assessment is supported by the group's competitive advantage and its scale, scope, and diversity, including its strong position in the growing U.K. online retail market. Although the group's share of the U.K. market has declined, it is far larger, at more than 28%, than the market shares of its nearest competitors. Tesco also benefits from its geographic diversification, in particular its presence in Southeast Asia and Europe. However, in our view, the various structural changes and unrelenting competitive pressure in the U.K. retail market have somewhat eroded Tesco's business risk profile, which we now assess at the lower end of the "strong" category.

Considering our forecast of adjusted EBITDA of just over £4 billion for the next financial year, this will likely result in adjusted debt to EBITDA of less than 4.5x and adjusted funds from operations (FFO) to debt of around 15% in FY 2016. These metrics are commensurate with an "aggressive" financial risk profile as defined by our criteria. Our assessment of Tesco's financial risk profile as "aggressive" also takes into account the retailer's sizable debt on a lease- and pension-adjusted basis.

We derive an anchor of 'bb+' for Tesco, reflecting the combination of its "strong" business risk profile (albeit at the low end of this category) and "aggressive" financial risk profile, in accordance with our criteria. The anchor is not affected by modifiers.

Our base case assumes:

• The U.K. economy's growth of about 3% to decline modestly in the next few years, but remain well above the 2% mark. The economy is gently cooling and recent survey data suggests that U.K. growth is likely to continue at a slightly slower pace in the coming quarters. That said, extremely competitive trading conditions will likely preclude Tesco from benefitting meaningfully from the economic revival in the U.K.
• Negative like-for-like sales growth in the U.K. for FY2015 and FY2016. We do not expect operating performance to meaningfully improve in FY2016. The group's revenues could also fall as new retail spaces contribute less. Overall, we anticipate the group's reported top line will contract by more than 3% in FY2015 and 2% in FY2016.
• A substantial decline in Tesco's gross margins in FY2015 due to a combination of weak topline revenue and high price competition. Gross margins for FY2016 may not improve materially but the pace of decline should moderate.
• Cash flow benefits from restructuring and cost reduction are unlikely to be meaningful before FY2017.
• A reduction in capital expenditure (capex) to £1 billion.
• No dividends in FY2016.

Based on these assumptions, we forecast the following credit measures over the FY2015 and FY2016:

• An adjusted EBITDA margin of about 7%;
• An adjusted debt to EBITDA margin of more than 5x for FY2015, improving to less than 4.5x in FY2016 as a result of management's financial policy measures;
• An adjusted FFO-to-debt ratio of about 13% for FY2015, improving to 15% in FY2016;
• Negative discretionary cash flow (DCF) in financial year 2015, but turning positive in 2016 to around 7%-8% adjusted DCF to debt, as a result of capex cuts and the cancellation of dividends.

The stable outlook reflects our expectation that Tesco's management will implement the operational initiatives and financial policies it has announced, enabling the group to reduce debt, improve adjusted debt to EBITDA to less than 4.5x, and increase adjusted FFO to debt to more than 15% over the next financial year ending 2016. Despite continued tough trading conditions, the group should be able to maintain its standing as the largest food retailer in the U.K. and achieve adjusted EBITDA margins of around 7%.

We could lower the ratings on Tesco if its management is unable to implement the financial policies it has announced, which focus on reducing leverage.

We could downgrade Tesco if it continues to underperform and management fails to reduce debt through financial policy measures within the next financial year. This could result in adjusted debt to EBITDA staying at more than 5x and adjusted FFO to debt remaining below 12%.

Rating pressure could also arise from a downward revision of our assessment of the group's business risk profile. This could occur if, as a result of unrelenting competitive pressures, Tesco is unable to improve its operating performance and this leads to a further decline in the group's profitability.

We could raise the rating on Tesco if management executes further credit-enhancing financial policies to reduce debt. To have a positive credit impact, these targeted debt reduction measures would have to contribute to a sustainable improvement in Tesco's financial risk profile.

We consider an adjusted FFO-to-debt ratio sustainably higher than 20% and an adjusted debt-to-EBITDA ratio of less than 4x as commensurate with a higher rating, absent any material weakening of Tesco's business risk profile.

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