Fitch lifts Tesco's outlook, holds debt rating

Credit agency Fitch has revised Tesco's debt outlook to 'stable' from 'negative' and confirmed the supermarket group's long-term default and senior unsecured rating at 'BB+'.

Fitch said the improved outlook was due to its expectations of a progressive recovery in Tesco's core UK market, after a stabilisation in the retailer's operating performance for the yea to end-February.

The grocer has also strengthened its balance sheet mainly through the sale of its Korean operations, improving working capital and capex, pausing of the dividend, efforts to increase freehold assets and closure of the UK defined benefit pension scheme.

"Assuming that strict financial discipline will be maintained over to FY19, Fitch believes its regained financial flexibility will enable Tesco to keep financial metrics comfortably in line with a 'BB+' credit profile while management continues to implement their turnaround strategy in the UK and to repair the group's business model," it said.

Fitch still sees execution risk with chief executive Dave Lewis' turnaround in the cut-throat food retail environment.

The credit agency said it viewed the size of Tesco's UK operations as "a key competitive advantage in implementing its volume-driven recovery strategy, as the retailer can extract scale benefits from suppliers, which in turn should support pricing power".

Fitch assumes a gradual rebuilding of retail group EBIT margin towards 2.5% by the 2019 financial year, driven by the group's core UK operations.

"Fitch expects that 2015 would have been the UK food retail sector's low point in profitability but projects the trajectory of recovery to be uneven. Driven by increasing volumes observed in 2015, Fitch views pricing as a key driver for the sector performance, together with an increasing need for retailers to sufficiently differentiate their offerings to attract shoppers, particularly to the larger shopping formats."

It sees price deflation easing over the next 12 months, but not disappearing, as discounters continue to build market share.

The main risk would be that Tesco finds it is unable to withstand the persistent competitive pressure in the UK and cannot restore retail EBIT margin to levels sustainably above 2%.