OREANDA-NEWS. The credit profiles of Europe's two largest supermarket operators - Carrefour and Tesco - are likely to continue diverging for at least the next 12 months, based on the different competitive and operating conditions in their core markets, Fitch Ratings says.

In our view what is happening to Tesco today in the UK is comparable with Carrefour three years ago in terms of operating underperformance and issues around its format strategy in France, while facing tough competition from hard discounters.

Carrefour's core French operations have now recorded two years of positive like-for-like sales (excluding petrol and calendar effects) and EBIT growth. The retailer responded to competition in its home market by cutting prices in 2012 which, helped by targeted promotions, improved product mix and store refurbishments is driving footfall and keeping hard discounters at bay. Various purchase partnerships agreed between the major food retailers in 2014 also improved their purchasing power against major brand manufacturers, allowing them to protect profitability despite a competitive market.

Competition is fierce in the UK, exacerbated by the rising market share of hard discounters and changing consumer shopping habits favouring online and convenience store formats. Tesco has seen positive like-for-like sales growth recently in both the online and convenience segments, where it holds leading market positions. However, it is also the market leader in large format stores, where excess capacity is weighing heavily on performance. Further measures to differentiate its range and services from discounters and to improve its brand perception are likely to be critical to defending its market position.

Tesco leases around 60% of its stores and lease agreements in the UK are typically long-term with no break clauses, especially in the large formats. Moreover rents in the UK are also often linked to the retail price index. A high lease bill will weigh on UK profits unless we see a significant uptick in sales growth.

Tesco has started to address the issue of excess space and an unfavourable cost base associated with lease obligations. It closed 43 stores, stopped new developments and unwound three joint ventures with British Land in March to regain sole ownership of 21 supermarkets and insulate more of the business from indexed rent reviews. However, this is only a small first step and we believe renegotiating and rebasing rents on a broader scale will take time. UK supermarkets are also looking at more innovative ways to reduce excess space, such as catalogue retailer Argos' recent deal to open outlets in Sainsbury's stores, but these opportunities are likely to be limited.

The differing prospects for the retail giants are reflected in two rating actions taken last week, when we upgraded Carrefour to 'BBB+'/Stable Outlook and downgraded Tesco to 'BB+'/Negative Outlook.

Tesco's near-term pressures on profitability means that further cash preservation measures, such as asset disposals and lower dividends, will probably be the key route to deleveraging the business. Excluding any potential disposals, we expect FFO adjusted net leverage to peak at 5.6x and FFO fixed charge cover to bottom out at 1.6x in FY16. Despite this spike in leverage, the group's ratings will be underpinned by strong liquidity, which supports the execution of the strategic changes.

Carrefour's financial metrics improvement is now supported by a business profile that has been addressed. Its financial flexibility is supported by the group's strict financial discipline that is reflected in a prudent shareholder policy, an improvement in FFO fixed charge cover to 2.7x in 2015 (2014: 2.3x), a public commitment to improve cash flow generation and well-spread debt maturities.