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Thursday, December 23, 2010

New Credit Rating: Tesco



Morningstar is initiating credit coverage of Tesco with a BBB rating. Our rating reflects the company's narrow economic moat, which is derived from its strong market share positions and its dominant scale, partially offset by weak but improving credit metrics.

Tesco is the third-largest retailer in the world and operates multiple retail formats spanning 14 markets. The company is the leading food retailer in the United Kingdom, where it operates about 2,500 of its nearly 4,900 stores and holds more than 30% share of the grocery market. Tesco has expanded into the nonfood market through hypermarkets and online operations. Internationally, the firm has a large presence in many Eastern European countries and parts of Asia. Tesco entered the U.S. market in late 2006. The financial crisis and economic downturn have severely crippled the U.K., where the company derives more than half its sales and three fourths of its operating profits. In addition to deteriorating economic conditions in its home market, the firm had been losing market share to hard discounters Aldi and Lidl as well as peers like Asda and Morrisons. Nonetheless, we expect the firm to be able to use its scale advantage to push prices lower and remain competitive in the marketplace.

Like most supermarket operators, Tesco generates a low free cash flow margin, which averaged 1.3% of sales during the past five years. We forecast that free cash flow generation will remain constrained, averaging 1.0% over the next five years. Tesco has significant debt maturities over the next three years, which results in a low Cash Flow Cushion of 75%; however we expect the firm will be able to refinance maturing debt with long-term debt.

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