Fitch Affirms Metro at 'BBB-'/Negative Outlook on Galeria Kaufhof's Sale
The rating action follows the completed disposal of Galeria Kaufhof AG (Kaufhof), which Fitch views as mildly positive as it increases near-term financial flexibility. It also enables management to better focus on turning around the remaining businesses and frees up liquidity to fund the planned increase in investments necessary to support the ongoing transformation plan. However, we expect some further dilution in Metro's already low profitability and should have a limited positive impact on its currently weak financial metrics.
As Metro's asset reorganisation phase comes to an end, the group will become fully reliant on a successful operational turnaround to improve its weak financial profile. The Negative Outlook continues to reflect uncertainty over the improvement in Metro's financial metrics over the medium term, notably due to its exposure to a volatile Russian market and the execution risks of management's turnaround plan.
KEY RATING DRIVERS
Galeria Kaufhof's Disposal
The group's department stores activities represented 4.9% and 11.2% of its revenues and reported EBIT before special items in FY14 (financial year ended September 2014). Therefore adjusting for the divesture, Fitch expects group operating margin to decrease by 40bps to 2.3% and FFO adjusted net leverage to decrease by only 0.2x to 4.6x at FYE15.
However, the decrease in net debt arising from this divestment, accelerating a trend which started in 2012, and the reduction in the group's complexity allowing management to concentrate on the turnaround of its remaining activities are positive credit factors. Furthermore, it frees up additional financial flexibility to fund the planned strong increase in investments, which Fitch views as a critical support to the ongoing transformation plan.
Exposure to Russia
Fitch expects the sharp rouble depreciation and the ongoing deterioration of trading conditions will diminish Russia's contribution to group EBIT in FY15. Fitch estimates Russian operations (mainly Metro Cash & Carry (MC&C)) contributed at least 25% of group EBIT in FY14. Metro's exposure to Russia will increase following Kaufhof's divesture. Should the Russian turmoil continue over the medium term, MC&C's worsening operating performance could seriously hamper the group's recovery in profit and financial metrics from the currently weak levels.
Still Weak Operations
Metro's 9MFY15 results confirm the successful turnaround of consumer electronics activities Media-Saturn, with positive like-for-like sales and profit trends. In contrast, MC&C and the German hypermarket chain Real are still halfway through their transformation plans and continue to exhibit a weak operating performance.
Despite Fitch's positive view over management's strategy, we assume group EBIT margin will remain below 3% until FY18. Although Fitch acknowledges that cash and carry is intrinsically a lower margin business than food retail, this is weak compared with 'BBB-' rated peers. Our forecast assumption primarily reflects uncertainty over management's ability to successfully transform the business model of its core activities in a persistently difficult trading environment that is characterised by keen competition and fast-changing consumer habits.
Negative Free Cash Flow
Fitch projects Metro's free cash flow (FCF) generation will remain negative over the next four years. This reflects management's willingness to accelerate investments, including capex, together with Fitch's cautious view over the pace and extent of Metro's turnaround capacity. Metro's inability to fund its investment plan from internally generated cash is mitigated by its sound liquidity, which Fitch expects to further strengthen following the Kaufhof' and MC&C Vietnam disposals.
Turnaround Plan, Credit Metrics
Following Kaufhof's disposal in FY15 and planned MC&C Vietnam disposal in FY16, Fitch projects the group's FFO adjusted net leverage to decrease to 4.5x at FYE16. This remains high in comparison with 'BBB-' rated peers and is a major constraint on the group's ratings. Metro is returning to a strong investment mode with management's announcement of approximately EUR2bn investment spending per annum in the near future. This makes a meaningful improvement in credit metrics fully reliant on the turnaround of Metro's remaining activities, of which the success remains uncertain at this stage.
Fitch's key assumptions within our rating case include:
- Low single-digit revenue growth supported by a limited increase in like-for-like sales and expansion
- EBIT margin down to 2.3% in FY15 (FY14: 2.7%) due to lower MC&C Russia contribution and the margin-dilutive impact of Kaufhof's disposal
- Annual budget for capex and bolt-on acquisitions of EUR2bn per annum, with around 85% of it dedicated to capex
- Negative FCF over the next four years, reflecting our expectation that profit recovery fails to offset higher capex and normalised dividend payments
- EUR2.5bn cash proceeds from asset sales in FY15, around EUR1bn proceeds in FY16 and average EUR500m per annum thereafter
Positive: Future developments that may, individually or collectively, lead to the Outlook being revised to Stable include:
-Improving trend in group EBIT margin from FY16 as a tangible sign of successful business transformation strategy
-FFO fixed charge cover being maintained at or above 1.8x (FY14: 1.8x)
-Lease-adjusted FFO net leverage trending towards 4.0x (FY14: 4.8x)
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
- Steady deterioration in trading performance or inability to extract efficiencies leading to EBIT margin consistently below 2.5%
-FCF generation consistently below -1% of sales
-FFO fixed charge cover consistently below 1.8x
-Maintenance of lease-adjusted net FFO leverage above 4.5x