OREANDA-NEWS. Fitch Ratings has affirmed UK-based retailer Marks and Spencer Group plc's (M&S) Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB-', and Short-Term IDR at 'F3'. The Outlook on the Long-Term IDR is Stable.

The ratings remain supported by M&S's strong brand, stable customer base, large scale, reputation for high quality and our expectation that the group will maintain stable-to-mildly improving credit metrics over the next two years.

Although M&S's food operations are holding up well, the ratings are constrained by certain factors such as the intensely competitive environment facing the group's general merchandise division on the back of consumers' preference to shop in digital and in convenience formats. This has resulted in some market share loss, which in our view will be very difficult to win back in the short term. Other factors are ongoing difficulties in parts of its international operations, exposure to discretionary spending, changing consumer spending habits as consumers spend a higher portion of their income on "experiences", inherent demand cyclicality, unpredictable weather, seasonality and fashion risks.

KEY RATING DRIVERS
Strong Brand & Customer Base
In our view M&S will be able to continue to adapt and change against a background of intense competition, which supports the ratings at the current level. M&S benefits from strong brand recognition, a fairly stable customer base and large scale of operations. With a reputation and focus on quality, it is the largest retailer in its peer group (by revenue), with 32 million customers, of which seven million are registered with M&S.com. The group has recently been able to sustain its food market share at around 4% in light of its niche position in a fiercely competitive food retail marketplace, which has partially offset market share loss in general merchandise, which fell across all main product lines.

Steady Revenue & Profit Margins
Overall we expect M&S to continue to operate within our guidelines for the current ratings, as reflected in today's rating affirmation. Fitch expects group revenue to increase modestly between 1% and 2% and group EBIT margins to remain steady at around 7% over our two-year rating horizon to FY18, with any gains from gross margin being offset by continued challenges faced by its international franchise and general merchandise business. This will slow the rate at which M&S can improve its EBIT margin, which was at a high of 12% at FYE07 (vs. 7.4% in FYE15).

Challenges in Food Remain
Fitch expects trading conditions to remain challenging for the group's food operations. Innovation should, however, help M&S maintain its leadership in convenient quality food. Competition is fierce, with new entrants challenging food retailers at all levels. M&S is not immune to this trend, nor is it fully protected from changing consumer habits. Reinvesting profits into innovative new products to keep shoppers engaged has been successful so far, but in our view may not be sustainable in the long run.

General Merchandise Market Share Declines
In our view winning back market share will be tough for M&S, which continues to suffer from falling like-for-like (lfl) sales in general merchandise. Despite some success in Autograph brand, fierce competition, some issues around product ranges, and lack of innovative design have been contributing factors. Having been through three changes of management in the past few years, general merchandise is now the chief focus for management. A new Design Director for clothing was appointed in September 2015 and the group has started to see some success from its renewed focus on purchasing and distribution, which should help steer operational performance over the next two years. Over the longer-term, the group's ability to adjust its cost structure, of which the store base is an important part, will be key to sustaining profitability in light of changing consumption habits.

Continuing Support to International Operations
While M&S's international operations contribute just 9% towards group EBIT, Fitch expects this segment to continue to rely on support from the group, as geopolitical tensions remain. Russia, Ukraine and Turkey are offsetting the recovery in other markets. M&S has stated its intention to continue to support its overseas businesses, although we do not exclude the possibility that it may change.

Strategy & Management Key to Future
In our view developing and implementing a robust strategy is key to maintaining the group's current market share in food and to revitalising the general merchandise offering. We view execution risk as moderate while the strategy will take time to implement and bear fruit. Under its new leadership since 1 April 2016, the newly appointed CEO Steve Rowe will announce his strategic plan with the annual results due mid-May. This will be of high importance, particularly in relation to how Mr Rowe will address falling lfl sales in general merchandise, which we view as a key rating driver.

Steady Credit Metrics
Fitch expects funds from operations (FFO) margin to remain steady at around 10% over the rating horizon to FY18. This is sufficient to cover assumed capex of around GBP550m and dividends of around GBP300m, resulting in a free cash flow (FCF) margin of around 1.5%-2%, which should leave room for mild deleveraging.

We expect FFO adjusted net leverage to trend towards 3x by FY18, improving the headroom under the group's ratings. However, any operational weakness compressing profit margins, additional investments, or further return of shareholder funds that are not funded by other sources of cash, could erode this financial headroom.

Financial Services
Consumer finance is an integral part of the group's retail offering, fostering customer loyalty and subsidising store sales. M&S offers banking services in partnership with HSBC with no recourse to future losses from exposure to consumer finance, as they are offset against future profits of the partnership. M&S has accounted for its share relating to payment protection insurance mis-selling, which is netted off against earnings, resulting in a GBP46m profit contribution in FY15. Fitch conservatively excludes M&S Bank income from its forecasts because of potential liabilities from mis-selling.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Group revenue to conservatively increase 1.5%-2% per year to FY18, based on flat growth across both UK and international.
- Group EBIT margins (combining food and non-food retail operations) steady at around 7% during our two-year rating horizon, with gains in general merchandise offset by international.
- Capex of around 5% of revenue (maintenance capex is GBP100m of total GBP550m).
- Free cash flow (FCF) margin of around 1.5%-2% of revenue.
- Restructuring costs of around GBP30m per year to FY18, related to closure of general merchandise sites

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Stabilisation of Group EBIT margin above 7% (FY15: 7.4%) due to recovery in market share in general merchandise on a sustained basis, together with cost base improvements
- FFO fixed charge cover sustained at or above 3.5x (FY15: 3.3x)
- FFO adjusted net leverage below 3.0x (FY15: 3.5x)

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Group EBIT margin declining to below 5.5% due to continued pressures in general merchandise and accelerated structural shift into lower-margin food retail operations
- FFO fixed charge cover below 2.5x
- FFO adjusted net leverage above 4.0x
- Negative FCF margin (as defined by Fitch post capex and dividends) due to adverse developments in working capital, larger-than-expected investment requirements and more aggressive shareholder returns (FY15: 1.3%)

LIQUIDITY
Fitch considers M&S's liquidity as satisfactory with estimated GBP1.1bn available under committed facilities, which together with forecasted readily available cash of GBP215m for FY16 (which Fitch adjusts by GBP50m for restricted cash) should be adequate to cover short-term debt of GBP342m, including USD500m 6.25% bonds due 2017. In addition, M&S at FYE15 had GBP1.9bn headroom to issue new bonds, although subject to market conditions, under its GBP3bn EMTN programme. No bonds were issued during FY16.