OREANDA-NEWS. Fitch Ratings has revised the Outlook on Metro AG's (Metro) Long-term Issuer Default Rating (IDR) to Negative from Stable and affirmed the IDR and senior unsecured rating at 'BBB-'. Fitch has also affirmed the unsecured rating of the notes issued by Metro Finance BV at 'BBB-'. The notes are guaranteed by Metro AG.

The Negative Outlook reflects uncertainty over the improvement in Metro's financial metrics over the medium term, absent of further significant cash preservation measures as the financial metrics are already weak for the current IDR. In our view management's ability to successfully execute on its turnaround plan, resulting in a significant improvement in profit generation will be a key factor behind Metro's ratings over the next two years. Further negative developments in Metro's major Russian operations and increased competition in other markets where Metro operates could compromise the group's recovery.

Metro's IDR remains underpinned by its scale, business and geographic diversification as well as by its financial flexibility stemming from asset disposals. Fitch also factors in the first positive signs of management's strategic transformation plan. This is aimed at adapting the various divisions' business models to the new consumer environment, while refocusing its operations on core or promising markets.

KEY RATING DRIVERS

Fragile Sales Improvement
Metro's transformation plan has begun to take effect: group like-for-like sales stabilised in 2014, driven by its two largest divisions Media Saturn (MS, 33% of FY14 group sales) and Metro Cash & Carry (MC&C, 48%). Despite an improving economic environment and lower oil prices in western Europe (including Germany), 71% of FY14 group sales, the sustainability of the sales trend is uncertain.

The group's business model has to adjust rapidly in a highly competitive environment and a large part of its emerging markets operations, which in particular drove MC&C's FY14 positive sales performance, could suffer from economic headwinds in FY15.

Exposure to Russia
Fitch estimates that the group generated at least 25% of its recurring EBIT in Russia in FY14, mostly through its MC&C business and, to a lesser extent, its MS division. Due to the sharp rouble depreciation, we project Russia's contribution to group EBIT to decrease in FY15. Should the Russian turmoil continue in the medium term, it could hamper the group's recovery in profit and financial credit metrics from their current weak levels.

Geographical Refocusing
Metro's focus on its core markets is positive, as it allows the group to reallocate operational and financial resources towards countries where it has high market shares and/or strong growth potential. In particular, Real hypermarkets now exclusively concentrate on Germany and Metro is exiting non-core MC&C markets. Non-core asset disposals also allow more financial flexibility to fund either debt reduction or the investments necessary to the group's transformation plan, supporting its investment-grade rating.

Low Operating Profit Margin
We view positively Metro's recurring EBIT margin stabilisation in FY14, at 2.7%, which was driven by a 200bps increase in MS's EBIT margin. The consumer electronics division benefited from cost restructuring and a recovery in sales volume. The latter was boosted by the division's multichannel strategy, which successfully offset reduced selling prices. Margin uplift at group level will depend on Metro's capacity at sustaining the performance of its MS division while, beyond cost restructuring measures, generating positive like-for-like sales growth in its other divisions amid high price competition.

Negative FCF
Fitch expects negative free cash flow (FCF) over the next four years. In FY13 and FY14 cash flow generation was protected by lower dividends, limited capex or one-off working capital inflows. In the medium term, Fitch expects FCF to be held back by marginal progress in FFO generation, while capex and dividend payments normalise. Metro's projected low FFO generation capacity primarily reflects continuing restructuring costs and still weak profitability. This may not be fully offset by EBITDA uplift in other parts of the group and lower debt costs.

Weak Credit Metrics
Metro's financial profitability and financial structure are weaker than 'BBB-' rated peers, with lease-adjusted funds from operations (FFO) net leverage at 4.8x and FFO fixed charge cover at 1.8x at FYE14. Assuming little flexibility on capex and dividends, we do not expect any material improvement in the next two years since any meaningful improvement in Metro's financial profile relies on the successful turnaround of its operations leading to stronger profitability. Proceeds from asset sales (either non-core businesses or property) and slowly improving profits outside of Russia could only be sufficient to balance out the negative impact of both lower translated profits from Russia and high capex on FFO and net debt.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case include:
-Revenues fall in FY15 due to divestments and rouble depreciation, with low single-digit growth thereafter
-EBIT margin down to 2.6% for the next two years (FY14: 2.7%), before recovering towards 2.8% in FY17
-Negative FCF over the next four years, as profit recovery from FY16 fails to offset higher dividends and capex
-EUR1bn plus proceeds from asset sales in FY15, and average EUR500m per annum thereafter

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to the Outlook being revised to Stable include:
-Stabilisation of group EBIT margin at or above 2.7%, reflecting continuing success of its turnaround strategy and/or lower-than-expected impact from Russia on group operating performance
-Break-even FCF generation at group level
-FFO fixed charge cover being maintained at or above 1.8x
-Lease-adjusted FFO net leverage trending towards 4.0x

Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
-A further sharp contraction in performance or a fall in group's EBIT below 2.5%
-FCF generation below -1% of sales
-FFO fixed charge cover below 1.8x
-Maintenance of lease-adjusted net FFO leverage above 4.5x.