Marks & Spencer Downgraded To ‘BB+’; On Watch Negative On Decline In Nonfood Sales Amid COVID-19 Uncertainties

  • We see significant downside risks to U.K.-based Marks & Spencer (M&S or the group) from COVID-19 related restrictions and social distancing measures. These will materially reduce sales in its clothing and home division, only partially mitigated by online sales and the anticipated resilience of the food segment.
  • Although M&S will not make the final dividend payment and plans to cut costs and investments to preserve cash, a steep decline in sales, earnings, and cash generation will weaken the group's credit metrics considerably.
  • We are therefore downgrading M&S and its senior unsecured debt to 'BB+' from 'BBB-' and putting all ratings on CreditWatch with negative implications. 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 payment default. We apply an unsecured debt rating cap at '3' due to the unsecured nature of the rated debt and uncertainty regarding potential changes in the capital structure before a hypothetical default.
  • The CreditWatch indicates still-significant downside risks given the uncertainty as to when COVID-19 will peak and whether the pandemic will persist beyond second-quarter 2020, leading to a prolonged weakening of M&S's credit ratios or liquidity.
LONDON (S&P Global Ratings) March 26, 2020--S&P Global Ratings today took the rating actions listed above. S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession.
The coronavirus outbreak will result in a sharp drop in nonfood and international sales, only partially offset by e-commerce and resilient food sales.
The downgrade reflects our view that M&S's earnings and cash generation will decline sharply at least over the remaining part of this calendar year. We believe the outbreak of coronavirus will cause a substantial decline in non-food sales in the U.K. and also internationally. Although the U.K. government has mandated that shops selling "non-essential goods" including clothes should be closed, most M&S stores in the U.K. selling food are expected to remain open (as of this date). At the same time, through its Clothing & Home (C&H) sections in co-located stores, M&S is likely to offer a range of essentials en route to food halls. Despite this, we foresee a contraction in footfall because of the introduction of movement restrictions and social distancing measures.
M&S will likely be supported by its well-developed online offer for clothing and home products, although the benefits will be limited if consumer discretionary spending wanes. We expect the food segment to remain resilient, although not as strong as other full-scale grocers such as Tesco, whose product mix includes more non-perishable and long-life foods and a wider assortment of household essentials. We believe demand for M&S'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. From September 2020, M&S's food sales should also benefit from the launch of its partnership with Ocado, the U.K.'s fastest growing pure-play online retailer. However, in our view, these supportive factors will only partially relieve the pressure on the group's topline, which we forecast will decline by over 5% in the financial year ending March 31, 2020, and 5%-10% in FY2021 depending on the duration and the spread of the coronavirus outbreak. We expect any rebound in operating performance to be gradual, reflected meaningfully only as of FY2022 results.
Cash-preserving measures and available facilities will support M&S's adequate liquidity, but prolonged distressed trading will reduce internal cash generation.
The group recently announced measures to preserve its liquidity buffer, including the suspension of the FY2020 final dividend payment, a capital expenditure (capex) reduction for FY2021, a redeployment of staff from C&H to Food, and cuts to the budget for stock purchases. M&S also maintains a healthy cash balance of about £185 million as of March 2020, supported by a committed £1.1 billion revolving credit facility (RCF) currently undrawn and a number of uncommitted facilities.
However, despite its adequate liquidity base currently, prolonged distressed trading could potentially lead to a cash drag on the group's finances. Periodic rent payments and workforce salaries are relatively fixed costs, which could undermine M&S's cash generation ability. The U.K. government's decision to extend the business-rates holiday to all retail businesses in Great Britain should also help M&S save around £150 million-£180 million. The group could also benefit from other supportive government measures and a lending facility from the Bank of England, which helps support liquidity among larger firms.
There is no imminent refinancing risk, but weak earnings could reduce covenant headroom.
M&S's refinancing risk is relatively limited because most of its debt is maturing on or after FY2023, with only £300 million medium-term notes (MTN) coming due toward the end of FY2021. However, M&S's RCF contains a maintenance financial covenant of EBITDA to net interest--including the operating lease-related portion--and right-of-use depreciation at minimum 2.6x. Under our base case, we estimate that covenant-adjusted EBITDA could decline to about £1,000 million in FY2020 and FY2021, from £1,300 million at first-half 2020. While we expect the group should be able to comply with the next covenant test for FY2020, we note a substantial reduction in headroom. Furthermore, covenant headroom may be constrained if the group experiences a worse-than-expected drop in sales due to the prolonged nature of the pandemic, or if it is not successful in cutting costs.
Restrictions on people's movements and store opening times in the U.K. and internationally are putting a severe dent in economic activity and could result in a longer path to recovery than earlier crises.
COVID-19 is affecting all aspects of life. Travel is being curtailed. Schools, restaurants, and shops are being closed. Mass gatherings are being postponed. Offices and factories are being shuttered as companies move to remote work. And, most recently, cities and parts of countries are in or moving toward lockdowns with all but basic societal functions on hold.
All this will severely affect discretionary demand in the near term, and weigh on retail throughout 2020. We believe that significant downside risks remain given the uncertainty about when the spread of the virus will peak and whether the pandemic will persist beyond second-quarter 2020; the effects on the global economy and consumer spending could certainly persist well beyond the second quarter.
In resolving the CreditWatch, we will evaluate new information regarding the spread of COVID-19 and the effect it is having on M&S's earnings, liquidity, and cash flows.
We could affirm the 'BB+' ratings once we have more certainty regarding the duration and severity of COVID-19 and its effect on trading activities, consumer demand, and M&S's operating performance, liquidity, and cash flow. We could also consider an affirmation if food performance proves stronger than we currently expect, or if consumer spending on general merchandise rebounds in the second half of FY2021 and we saw the group reducing costs, thereby maintaining S&P Global Ratings-adjusted debt to EBITDA below 4.0x, S&P Global Ratings-adjusted funds from operations (FFO) above 20%, and adequate liquidity.
We could downgrade M&S to 'BB' or lower if COVID-19 and any resulting restrictions and social distancing measures looked likely to extend into second-half 2020. This would further weaken the group's ability to restore its credit metrics and sustain comfortable headroom under its maintenance covenants. In particular, we could downgrade M&S if its adjusted debt to EBITDA remains higher than 4x, adjusted FFO to debt falls below 20%, or adjusted free operating cash flow (FOCF) to debt falls below 10%. We could also lower the rating if liquidity weakens, primarily because of tightening covenant headroom.
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