Italy-Based Food Retailer Esselunga Downgraded To 'BB+' On Increased Debt Burden; Outlook Stable

  • Esselunga SpA's majority shareholders are finalizing a squeeze-out of 30% of the minority shareholders for €1.8 billion. The transaction foresees a reorganization of the wider group, whereby Esselunga will be merged with its holding companies.
  • The 32.5% of La Villata owned by the principal shareholders will be sold to an external investor in exchange for preferred shares to finance part of the acquisition price.
  • Esselunga will raise a material amount of new debt to pay for the majority of the acquisition price. We see Esselunga directly contributing €1.3 billion of the €1.8 billion acquisition price, while its owners contribute €100 million in cash and €435 million by selling their 32.5% stake in La Villata, which we see as debt, to a financial investor.
  • We forecast that at the end of 2020, Esselunga's S&P Global Ratings-adjusted funds from operations (FFO) to debt will weaken to slightly over 20% when considering the €435 million preferred shares as debt, from about 50% at the end of 2019.
  • We are therefore lowering our long-term issuer credit rating on Esselunga to 'BB+' from 'BBB-'. We are also assigning a '3' recovery rating to its senior unsecured debt, indicating our expectation of meaningful (50%-70%; rounded estimate: 65%) recovery to creditors in the event of a default.
  • The stable outlook reflects our expectation that Esselunga's adjusted FFO to debt will remain comfortably above 20%, and that its adjusted cash flow after capital expenditure (capex) and shareholders' distributions over debt will remain above 5%.
MILAN (S&P Global Ratings) March 27, 2020--S&P Global Ratings today took the rating actions listed above. Due to the recently announced transaction, Esselunga's credit metrics will weaken materially from 2019 levels.
Once the squeeze-out of the minority shareholders has been finalized and the subsequent merger of Esselunga with its holdings completed, we expect Esselunga's adjusted debt to increase to €2.5 billion at end-2020, from about €950 million that we forecast at end-2019. The end-2020 figure includes €435 million of preferred shares for La Villata's minority shareholders, which we see as debt. This, together with the company's top-line growth, which we see at about 2%-3% per year, will result in FFO to debt slightly above 20% for 2020, increasing to about 25% the year after. Moreover, the company's moderate cash flow after capex and dividends, which we see at about €150 million-€200 million for 2020 and 2021, somewhat limits the speed of deleveraging. Therefore, we assess Esselunga's balance sheet to be weaker than before, resulting in a one-notch downgrade to 'BB+' from 'BBB-'.
Esselunga's majority shareholders succeeded in squeezing out the 30% of minority shareholders with a transaction that will add more than €1.7 billion of debt to the company's accounts.
This amount includes €435 million of preferred shares at La Villata that we treat as debt. The 30% minority stake has been evaluated at €1.8 billion. Of this €1.8 billion, we take the view that only the €100 million of cash directly provided by the majority shareholders can be excluded from our adjusted debt. The 30% of the acquisition price will be met with a mix of:
  • €100 million cash from the majority shareholders; and
  • €435 million from the sale of 32.5% of La Villata to a financial investor in the form of preferred shares.
While Esselunga will continue to consolidate La Villata, as it owns the remaining 67.5%, in our view the preferred shares are akin to debt financing for this transaction, and we include this amount in our adjusted debt. The preferred notes have a payment-in-kind securities/cash coupon option at Esselunga's discretion. Moreover, after a lock-up of five years, Esselunga could call the preferred notes back, which we assume will be replaced with some form of debt financing or repaid in cash by Esselunga, thereby weakening the credit metrics. We understand that the company does not foresee a put option for the financial investors. Esselunga will contribute to the remaining 70%, which, through additional debt, includes:
  • A €762 million senior unsecured term loan maturing in 2027, which entails financial covenants; and
  • A €550 million bridge facility issued at Esselunga's holding, which management intends to repay in cash as soon as the merger with Esselunga and its holdings occurs (expected to be by year-end 2020).
As part of the reorganization of the group structure, Esselunga will repay €300 million of debt sitting at Supermarkets Italiani, its holding company. This is leverage-neutral with respect to our adjusted credit calculation and metrics, as we were including the parent's debt in Esselunga's adjusted leverage.
We expect Esselunga, as a food retailer, to maintain profit margins slightly above 8% and steady revenue growth of about 2%-3% per year in 2020 and 2021, notwithstanding the tough environment.
We also anticipate that the company will benefit from the COVID-19 pandemic, which is increasing home consumption of food. Esselunga has a presence in the wealthiest region of Italy, with sales per square meter more than double that of the second-largest Italian grocery retailer. Combined with its wide product range, including a superior level of customer experience, we expect this to sustain Esselunga's top-line growth and profit margins. For 2020 and 2021, we see sales growing by about 2%, and expect the EBITDA margin to remain slightly above 8%, in line with the preliminary 2019 results, but lower than the 9.5% recorded in 2018.
The slight erosion of EBITDA is mainly linked to Esselunga's aggressive price positioning, as it is able to offer the lowest shelf price in its trading areas. It is also the result of some expected dilution from increasing e-commerce activity and higher staff costs.
We believe the COVID-19 outbreak in Italy will entail some execution risks in terms of logistics, monitoring clients' traffic, and health risks for Esselunga's workers. However, the pandemic could increase Esselunga's sales in the short term, because of the prolonged Italian lockdown. We believe that demand for Esselunga's food range will remain high, even after the initial stockpiling phase, given that it offers ready–to-eat and ready-prepared foods, and restaurant closures will force people to cook and eat at home more often.
The stable outlook reflects our view that Esselunga will be able to maintain its established market position in its core food retail business, gradually increasing its gross revenues by around 2%-3% on the back of steady new store openings, as well as new product launches and price supremacy. Although we expect some margin dilution related to the increased share of e-commerce, some tougher market conditions, and potentially less efficiency resulting from the COVID-19 pandemic, we expect the adjusted EBITDA margin to remain resilient at about 8.0%.
Moreover, we expect the company's FFO to debt to remain above 20% and cash distribution to shareholders to be limited to the dividends paid to the minorities of La Villata, so that discretionary cash flow (DCF; free operating cash flow minus shareholders' distributions) remains at about around €150 million-€200 million per year in 2020 and 2021.
We would downgrade Esselunga if its FFO to debt were to decline below 20% on the back of potentially higher capex or increased distributions to shareholders, or if the harsher market conditions stemming from the COVID-19 pandemic were to result in a margin and sales drop due to operational difficulties or logistical bottlenecks. Additionally, a material decrease of the company's DCF, which we forecast at around €150 million-€200 million per year, could weigh on the rating.
Moreover, we would consider any additional shareholder interference in Esselunga's financial policies and use of cash, while not in our base case, a deficiency in governance, and would reflect this in our rating on the company.
Finally, if the company's sales were to drop materially due to our current recession scenario for Italy, mainly triggered by the unprecedented COVID-19 outbreak, we would consider lowering the rating. However, this is not part of our base case today, as the food sector is considered essential.
Due to the high level of adjusted debt and the prospect of continued dividends for the minority shareholders of La Villata, we consider an upgrade unlikely over the next two years. Esselunga continues to invest in its physical stores and omni-channel strategies, which will likely curtail any significant improvement in the company's credit metrics in the short term beyond the level we expect.

However, we could think of raising the rating on Esselunga if its FFO to debt were to be above 30% on a sustained basis, thanks to improved cash flow after capex and dividends. An upgrade would also hinge on a positive track record of Esselunga's management adhering to a conservative financial policy, with no private ownership interferences.
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