Tesco Bondholders Seeing Cut to Junk Join Shopper Exodus

By Tom Beardsworth

Tesco Plc’s (TSCO) battle to retain its investment-grade status is driving up borrowing costs for a company saddled with more than 16 billion pounds ($26 billion) of debt.
Tesco bonds plunged and the cost of insuring them against default soared last week after Moody’s Investors Service cut the biggest U.K. grocer to one level above junk and warned that a further downgrade could follow unless its financial position improves. Cuts were also announced by Fitch Ratings and Standard & Poor’s.
The moves increase pressure on Chief Executive Officer Dave Lewis to raise capital quickly, either by selling assets or offering shares to existing stockholders. At five times earnings before interest, taxes, depreciation and amortization, according to Moody’s, Tesco has the highest financial leverage of any U.K. supermarket.
“There was little comfort for bond investors in terms of concrete actions by
Tesco to lower net debt,” BNP Paribas SA credit analyst Norbert Ling said in a note to investors after Tesco announced a drop in first-half profit on Oct. 23. “Tesco’s commitment to an investment-grade rating is a soft commitment at best.”
The extra yield investors demand to hold Tesco bonds due in 2022 instead of similar-maturity government debt jumped 50 basis points to a record 283 on Oct. 24. The spread on five-year bonds rose 44 basis points to 253, also an all-time high.

Source: Unilever via Bloomberg

Dave Lewis, Chief Executive Officer of Tesco Plc.

Shares Slump

Credit-default swaps insuring holders of Tesco bonds have surged 41 basis points to 160 since Oct. 22, the worst performer in the Markit iTraxx Europe Index.
Tesco shares have lost half of their value this year amid an accounting scandal and a series of profit warnings, as the company loses market share to German discounters Aldi and Lidl, as well as upmarket Waitrose Ltd., the grocery unit of John Lewis Partnership Plc. Wm Morrison Supermarkets Plc (MRW) shares have lost 42 percent in 2014.
Tesco’s net debt rose 7.1 percent to 7.5 billion pounds in the first half and long-term liabilities increased 18 percent to 16.5 billion pounds, Tesco’s accounts show.
At the same time, Tesco’s enthusiasm for sale-and-leaseback property transactions, while helping to raise money for investment, have left the company with annual rental costs of 1.4 billion pounds.
A Deloitte LLP investigation into Tesco’s accounts after profits were overstated by 263 million pounds is set to be handed to the Financial Conduct Authority.

Huge Challenges

“Even if the FCA concludes its investigation without material negative financial implications, Tesco faces huge operational challenges which continue to put its investment-grade rating at risk,” Sven Reinke, Moody’s lead analyst for Tesco, said in the statement downgrading the company.
Lewis attempted to “make the investment case” for Tesco, pledging to cut costs and “extract the value from the investment capital first before we think about other options.” While the company isn’t working on a rights issue, “we will never say never,” he said. Tesco did not immediately respond to a request for comment on Oct. 24.
Tesco dived 6.6 percent on Oct. 23 and fell a further 1.3 percent the following day, taking the shares to an 11-year low. With a market capitalization of 13.7 billion pounds, the company is worth less than what it owes bondholders.
On Oct. 24, S&P cut Tesco to BBB-, its lowest investment grade. A downgrade to junk could trigger forced selling among holders of its senior unsecured bonds.
“It is very apparent that Tesco are in the last chance saloon of the ratings agencies now,” BNP Paribas’s Ling said.