Fitch Affirms Wesfarmers Ltd at 'BBB+'; Outlook Stable on Homebase Acquisition

(The following statement was released by the rating agency)SYDNEY, January 19 (Fitch) Fitch Ratings has affirmed Australian-based retailer Wesfarmers Limited's (Wesfarmers) Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+'. The Outlook is Stable after the company announced an agreement to acquire UK retailer, Homebase.On 18 January 2016, Wesfarmers announced an agreement with Home Retail Group plc (Home Retail Group) to acquire its 100% holding in Homebase for GBP340m (around AUD705m). The acquisition will be fully debt financed and is expected to complete at the end of the first quarter of the 2016 calendar year, subject to approval by Home Retail Group shareholders and its banking syndicate. Wesfarmers will invest around GBP500m in the Homebase business to transform it to a new Bunnings-branded business over three to five years. Wesfarmers expects the transaction to be earnings per share accretive after three years.Whilst the proposed acquisition will lead to a weakening in Wesfarmers credit metrics, Fitch views the magnitude of incremental debt as manageable within Wesfarmers' current BBB+ rating. We expect Wesfarmers' leverage to peak in FY16 immediately following the debt-funded acquisition, with Net Debt to Operating EBITDA increasing to 1.23x at FY16f from 1.17x at FY15 (which also reflects a AUD861m capital distribution in December 2014). In Fitch's view, Wesfarmers' leverage will then improve over the ratings horizon, with the improvement expected to accelerate following the transformation of the Homebase business. The credit metrics could be restored within historical levels sooner should Wesfarmers adopt a flexible dividend policy, which is historically consistent. Fitch also notes execution risks surrounding the transaction, especially a move into a new international market, however Wesfarmers' management team has a strong track record in turning businesses around and generating growth.KEY RATING DRIVERSDefensive Cash Flows: Wesfarmers' rating is supported by the material contribution from the defensive, mature and stable supermarket sectors. Supermarkets sell products that are essential for everyday life and exhibit low revenue and margin volatility. By diversifying into alcohol, fuel and financial services, the Coles grocery and convenience store division has succeeded in trapping a greater share of its customer's spending.Leading Market Share: Wesfarmers benefits from a strong market position and low competition in segments that contribute more than 80% of its consolidated EBIT. Coles and its main competitor, Woolworths Limited (Woolworths), account for a majority of supermarket sales and alcohol retail sales in Australia, as well as a large proportion of retail petrol sales. This market structure gives Coles and Woolworths significant market power and the ability to drive down input costs, passing on any cost increases to customers.Diversified Earnings Stream: Wesfarmers' earnings are diversified by industry and geography, with its retail business spanning all eight states and territories in Australia. Wesfarmers' big-box discount retail businesses provide it with some counter-cyclicality, and the divestiture of the insurance business in FY14 has reduced tail risk. While most of the retail businesses have seen strong earnings growth in the past 24 months, this has been partly offset by a decline in earnings from the Resources, CEF (Chemical, Energy and Fertilisers), and Industrial & Safety sectors.Deterioration of Credit Metrics: The GBP340m debt-funded acquisition of the UK's Homebase business, as well as the increase in off-balance sheet debt to reflect future operating lease payments on Homebase's network, is expected to negatively impact Wesfarmers' credit profile over the medium-term. In Fitch's view, Wesfarmers' leverage will peak in FY16 immediately following the acquisition and will improve over the ratings horizon given the strength of its Australian business. Furthermore, Fitch notes Wesfarmers' flexible dividend policy, which is based on current and projected cash position, capex requirements, retained earnings, franking credits, debt levels and business and economic conditions generally, which could see leverage return to more historical levels sooner.Retail Price Deflation: The revenue from Wesfarmers' supermarket business, Coles, is exposed to deflationary risks owing to the on-going price-based competition with rival Woolworths. Wesfarmers' supermarket earnings are highly sensitive to fluctuations in its gross margins. However, this risk is mitigated by product inelasticity in the supermarket space and the strong market presence of Wesfarmers' retail businesses, which permit a pass-through of the majority of cost increases and also assist Coles in negotiating lower prices from its suppliers.KEY ASSUMPTIONSFitch's key assumptions within the rating case for Wesfarmers include:- Revenues for FY16 will be around AUD66-67bn, with an EBIT margin of around 7%;- Homebase to be consolidated from 4Q16;- Homebase EBITDA margin to increase by single digits over the rating horizon; and- Base Capex of around AUD2.3bn per annum, with the additional GBP500m relating to the investment in Homebase to be incurred in FY17, FY18 and FY19.RATING SENSITIVITIESPositive: A rating upgrade is unlikely in the near future as Fitch does not foresee a reduction in leverage below the trigger. Future developments that may, individually or collectively, lead to a positive rating action include:- FFO Adjusted Net Leverage (Leverage) reduces to below 2.5x (FY15: 3.82x); and- FFO Fixed Charge Cover (Coverage) exceeds 4x; all on a collective sustained forward-looking basis.Negative: A rating downgrade may occur should:- Leverage exceed 3.7x;- Coverage falls below 2.5x; or- EBITDAR margin falls below 10%;all on an individual or collective sustained forward-looking basis.Contact: Primary AnalystDavid CookDirector+61 2 8256 0363Fitch Australia Pty Ltd., Level 15, 77 King Street, Sydney, NSW 2000, AustraliaSecondary AnalystKelly AmatoAssociate Director+61 2 8256 0348Committee ChairpersonVicky MelbourneSenior Director+61 2 8256 0325Media Relations: Leni Vu, Sydney, Tel: +61 2 8256 0304, Email: leni.vu@fitchratings.com.Additional information is available on www.fitchratings.com.Applicable Criteria Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362Additional Disclosures Dodd-Frank Rating Information Disclosure Form https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr _id=998038Solicitation Status https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=998038Endorsement Policy https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&det ail=31ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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