One step forward, one step back as Tesco's debt cut to "junk"

LONDON, United Kingdom - The downgrading of Tesco's debt to "junk" status could limit its negotiating power on potential asset sales as Britain's biggest retailer embarks on the long-awaited recovery plan designed to reverse its sliding fortunes.

On Thursday Tesco's shares had risen as much as 15 percent in their biggest one-day gain since 1988 after the grocer reported much better-than-feared Christmas trading and new boss Dave Lewis detailed plans to slash costs and sell assets to fund lower prices and recover lost market share.

However, the shine was taken off Tesco's day when, after the stock market closed, ratings agency Moody's downgraded the company's debt to non-investment grade, or junk, on expectations that profits will remain challenged by changes in the British grocery market.

The move marks another fall from grace for Britain's biggest private employer, a staple of British pension funds that was rated A1 by Moody's in 2008. Tesco is still reeling from an accounting scandal and issued four profit warnings last year.

Shares in Tesco fell up to 2.5 percent on Friday morning while its bonds largely shrugged off the news, which had been anticipated.

"It's not particularly helpful for Moody's to downgrade them to junk on the day it looks like they are starting to recover," Richard Dunbar, investment director at Aberdeen Asset Management told BBC radio. "There were some straws in the wind that would suggest the company is starting to do things right."

Clive Black, retail analyst at Shore Capital, said the time to have downgraded Tesco's debt would have been 12-18 months ago, "not now, when management is actually doing something about its risk profile".

Tesco's debt at the half-year stood at 7.5 billion pounds ($11.4 billion), and of its outstanding liabilities, it faces peak repayments in 2016, 2017 and 2019.

Independent retail analyst Nick Bubb said that in Tesco's meeting with analysts on Thursday finance chief Alan Stewart seemed resigned to losing his fight with the ratings agencies to retain an investment-grade rating.



SQUEEZED MARGINS

"Borrowing costs will rise, at a time of squeezed operating margins, and Tesco's negotiating leverage on future business disposals will be much reduced," he said.

Tesco said on Thursday that it had appointed Goldman Sachs to explore options for data-gathering business Dunnhumby, which could include a stock market flotation or a sale.

Some analysts say that Tesco may also need to sell or spin off assets in Asia or eastern Europe to raise cash, though Lewis said on Thursday there was no need for a fire sale.

He also emphasised that Tesco's liquidity and funding were "very secure", noting that one of his first moves when he became CEO last September was to establish a 5 billion pound credit facility.

Stewart said that the company would work hard to regain its investment-grade status if it were downgraded but it would not set a deadline for doing so.

Because many major investors are not allowed to own bonds below investment grade, known as junk bonds, the ratings downgrade could force some to sell their holdings.

Moody's said that Tesco could return to an investment grade rating if its operating performance recovered in the UK, with like-for-like sales increasing and its trading margin improving to at least 3 percent.

The ratings agency said Tesco would also need to continue strengthening its corporate governance and demonstrate a commitment to a conservative financial policy, with an adjusted debt-to-core earnings ratio of 4.5 times or below.

Other agencies have also taken action. S&P warned in December that it may also downgrade Tesco to high-yield "junk" status after placing its BBB- rating on credit watch negative. Fitch rates Tesco at BBB- with a negative outlook.

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