OREANDA-NEWS. Fitch Ratings has affirmed Australia-based retailer Wesfarmers Limited's (Wesfarmers) Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+'. The Outlook is Stable.

Wesfarmers' retail businesses have continued their strong performance, with EBIT growth of 9.2% in the six months to December 2015. However this has largely been offset by weakness in the Resources business - due to low prices for coal exports and losses on its currency hedge book - and difficulties in the Industrial and Safety sector.

KEY RATING DRIVERS
Defensive Cash Flows: Wesfarmers' rating is supported by the material significant contribution from the defensive, mature and stable supermarket division. Supermarkets sell products that are essential for everyday life and exhibit low revenue and margin volatility. By diversifying into alcohol, fuel and financial services, the Coles grocery and convenience store division has succeeded in trapping a greater share of its customer's spending.

Leading Market Share: Wesfarmers benefits from a strong market position and low competition in segments that account for more than 80% of its consolidated EBIT. Coles and its main competitor, Woolworths Limited (Woolworths), account for a majority of supermarket sales and alcohol retail sales in Australia, as well as a large proportion of retail petrol sales. This market structure gives Coles and Woolworths significant market power and the ability to drive down input costs, passing on any cost increases to customers.

Diversified Earnings Stream: Wesfarmers' earnings are diversified by industry and geography, with its retail business spanning all eight states and territories in Australia and, following completion of the Homebase acquisition, in the UK. Wesfarmers' big-box discount retail businesses provide it with some counter-cyclicality, and the divestiture of the insurance business in the financial year to June 2014 (FY14) has reduced tail risk. While the Industrial division has experienced a decline in earnings over the past year, due mainly to losses in the Resource sector and restructuring costs in other areas, this has been offset by strong performance in the retail businesses.

Little Change in Credit Metrics: The GBP340m debt-funded acquisition of the UK's Homebase business, the increase in off-balance sheet debt to reflect future operating lease payments on Homebase's network, and the decline in EBIT margin in 1H16 will weigh on Wesfarmers' credit profile over the medium term. This follows the debt-funded acquisition of the remaining 50% of the Coles credit card joint venture and capital return in June 2015. Overall, there is little change in credit metrics despite this activity. In Fitch's view, Wesfarmers' leverage will peak in FY16 and will improve through FY19 given the strength of its Australian business. Fitch's forecasts also take into account Wesfarmers' flexible dividend policy, which is based on current and projected cash position, capex requirements, retained earnings, franking credits, debt levels and business and economic conditions generally.

Retail Price Deflation: The revenue from Wesfarmers' supermarket business, Coles, is exposed to deflationary risks due to the on-going price-based competition with rival Woolworths. Wesfarmers' supermarket earnings are highly sensitive to fluctuations in its gross margins. However, this risk is mitigated by product inelasticity in the supermarket space and the strong market presence of Wesfarmers' retail businesses, which permit a pass-through of the majority of cost increases and also assist Coles in negotiating lower prices from its suppliers.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Wesfarmers include:
- Revenues for FY16 will be around AUD65bn-66bn, with an EBIT margin of around 5.5%;
- Homebase to be consolidated from 4Q16, with Homebase EBITDA margin to increase by single digits until FY19;
- Flexible Wesfarmers dividend policy; and
- Base capex of around AUD2.2bn a year, with additional GBP500m relating to the investment in Homebase to be incurred in FY17, FY18 and FY19.

RATING SENSITIVITIES
Positive: A rating upgrade is unlikely in the near future as Fitch does not foresee a reduction in leverage below the trigger on a sustained basis. Future developments that may, individually or collectively, lead to a positive rating action include:
- FFO-adjusted net leverage (leverage) reduces to below 2.5x (FY15: 3.47x); and
- FFO fixed-charge cover (coverage) exceeds 4x (FY15: 2.50x).

Negative: A rating downgrade may occur should if on a sustained basis:
- Leverage exceed 3.7x;
- Increased volatility or material decline in coverage from around 2.5x; or
- EBITDAR margin falls below 10% (FY15: 11.74%).