S&P: U. K. Home Improvement Retailer Kingfisher Outlook Revised To Negative On Weak Cash Flows; Ratings Affirmed

S&P Global Ratings today revised its outlook on U. K. DIY retailer Kingfisher PLC to negative from stable. We affirmed the long-term issuer credit rating and issue rating on Kingfisher's senior unsecured debt at 'BBB'. We also affirmed our 'A-2' short-term rating on Kingfisher and its core subsidiary Kingfisher International Products Ltd. (KIPL).

The outlook revision reflects that we could consider a downgrade in the next 12-24 months amid the elevated risk that Kingfisher's FOCF generation will remain weak. In FY2018--the second year of the One Kingfisher transformation program--the group posted a like-for-like decline in sales of -0.7%, and reported free operating cash outflows of ?80 million, primarily reflecting working capital financing of ?374 million (it had a ?17 million inflow from change in working capital the year before). Combined with about ?491 million capital return to shareholders, of which ?260 million was spent on share buybacks, adjusted FOCF to debt in FY2018 fell to about 8% from over 30% the year before, and reported cash declined to ?230 million from ?795 million in the same period.

Notwithstanding the weakness in cash generation in FY2018, management has taken several steps that should contain growth in net working capital. We estimate this outflow will total ?50 million in FY2019, with an additional upswing of close to ?100 million to finance intra-year peak requirements. Our forecast reflects the following considerations:A large share of the investment in inventories in FY2018 is aimed at funding the expansion of unified and unique ranges in the group's product portfolio;A stock of fast-selling non-unified range items will be reduced in the course of this year;The excess stock necessary to accommodate final stages of transition to the new IT platform will gradually decline as the transition is completed this year; andWe anticipate that financing the stock for Praktiker stores acquired in 2017 in Romania will normalize from FY2019, although we note that this was not a material part of the inventory movement. However, as the group enters its third year of transformation--which will see a ramp-up in new products and advances in the reorganization of its supply and distribution chain--working capital may not improve as much as we anticipate. This could put pressure on the ratings; headroom has already been eroded by the sharp decline in cash generation and cash balances in FY2018, which limits the group's flexibility to absorb further unexpected operating setbacks.

We therefore see the group's ability to restore its cash generation and maintain credit metrics comparable to historical levels as depending on management containing investment in working capital, alongside success in initiatives that support growth in revenue and profitability.

Given that Kingfisher plans to increase its transformation-related costs to ?180 million in FY2019 from ?129 million in FY2018, we do not forecast any material improvement in either absolute operating profit or EBITDA margin this year. We estimate that the group will improve profitability in FY2020 as transformation spending abates, and it starts to reap benefits.

Our ratings on Kingfisher take into account its sizable debt on a lease-adjusted basis while, excluding leases, the company reports a net cash position. Our base case estimates that Kingfisher's adjusted leverage will be around 1.9x at the end of FY2019, reflecting largely flat S&P Global Ratings-adjusted debt and adjusted EBITDA of about ?2.5 billion and ?1.3 billion, respectively.

Kingfisher benefits from its leading position in the home improvement retail market in the U. K. It is one of the largest DIY retailers in Europe, and globally, by sales. The ratings continue to reflect the benefits of geographic diversity, with about 45% of Kingfisher's revenues generated in its domestic market, the U. K. and Ireland, and well-entrenched positions in home improvement retail markets in Poland, France, and Romania. The group has a significant competitive advantage through its purchasing power and diverse store network. On the other hand, it operates solely in the DIY and home improvement segment of the retail market, which is highly discretionary, cyclical, and seasonal. The market is extremely competitive and has been disrupted by the advancement of new technologies and proliferation of online retailing, especially in France and the U. K., where the group generates more than three-quarters of its revenues and operating income. It also depends heavily on the weather and the housing market. Sizable restructuring and space rationalization spending--the latter stemming from extensive store estate and resulting operating lease commitments--constrain Kingfisher's profitability.

Our base case assumes that Kingfisher's cash flow will remain weaker than historically, but will be sufficient over the next two years for Kingfisher to post S&P Global Ratings-adjusted funds from operations (FFO) to debt above 35%, debt to EBITDA significantly lower than 3x, and FOCF to debt of at least 20%. The group's earnings generation in FY2018 underpins our view. Kingfisher posted ?11.7 billion revenues and ?1.3 billion adjusted EBITDA in FY2018, somewhat stronger than our base case. Adjusted debt to EBITDA and adjusted FFO to debt of 1.9x and 39%, respectively, were largely in line with our expectations. However, after one year of FOCF to debt being lower than our forecast, headroom under the current ratings is very limited.

In our base case, we assume:Moderate U. K. real GDP growth, forecast at 1.0% in 2018 and 1.3% in 2019, with consumer price inflation (CPI) of 2.4% and 1.9%. We anticipate that foreign-exchange-rate headwinds will continue, some of which retailers will be able to pass on to consumers and suppliers. We also expect a slowdown in U. K. real consumption growth to 0.8% in 2018 and 1.0% in 2019. Similarly, we expect soft macroeconomic conditions in France, with GDP growth of 1.8% in 2017 and 1.7% in 2018 and benign CPI of 1.3%-1.5% over the same period. Modest sales growth of 1.2%-1.8% annually to about ?12.0 billion by FY2020 from ?11.7 billion reported in FY2018. We think the stable to modestly growing sales in France in the last quarter of FY2018 will continue over the next two-to-three years, while Screwfix's store expansion and positive like-for-like sales growth will offset the revenue decline in the B&Q segment in the U. K and Ireland. Likewise, international markets will contribute to overall growth in revenues. Adjusted EBITDA margin of 11.0%-11.5% in FY2019 (11.4% in FY2018) reflecting ongoing and intense pricing pressure; rising labor costs and unfavorable foreign-currency effects on input costs; and elevated pressure on gross and operating margins from the transformation plan. This is notwithstanding the measures that Kingfisher is implementing to support gross and operating profitability, such as centralizing its IT platform and procurement function, advancing in shifting its product mix toward "unified" and "unique" products, and reducing the cost of goods not for resale. We estimate that Kingfisher will raise its adjusted EBITDA margin to about 12.4% by FY2020 as spending on transformation phases out. Net investment in working capital of up to ?50 million in FY2019 and up to ?20 million in FY2020 (compared to ?374 million in FY2018) on expansion of the Screwfix store network and footprint in Poland, Romania, and elsewhere. Also, while Kingfisher transitions to a centralized supply and distribution chain, underpinned by a full rollout of its new IT platform, it will need to run higher stock levels than historically. Annual capex of up to ?425 million in FY2019 and ?425 million-?450 million thereafter, mainly to fund One Kingfisher, new store openings, investments in IT and digital platforms, and existing store maintenance and refurbishment. This will account for one-third of total expenditure. Largely flat ordinary dividends of ?230 million-?235 million annually. However, the company intends to continue buying back its shares within the remaining ?140 million limit until the end of FY2019.Based on these assumptions, we arrive at the following credit measures over the forecast period to Jan. 31, 2020:Adjusted debt to EBITDA at about 1.7x-1.9x;Adjusted FFO to debt of 35%-45%;Adjusted FOCF to debt of 20%-25%;Reported FOCF of about ?200 million-?250 million in FY2019, rising to about ?300 million in FY2020; andReported discretionary cash flow close to neutral in FY2019, increasing to ?50 million-?100 million in FY2020.The negative outlook reflects that we could lower the rating on Kingfisher over the next 12-24 months. We believe the discretionary, highly competitive, and weather-sensitive DIY and home improvement market will remain difficult across Kingfisher's largest markets. Alongside substantial transformation-program spending, this could further weaken the group's cash generation and its credit metrics. If cash flows and liquidity are weaker than we estimate in our base case, this could lead to reduced flexibility to absorb unexpected operating setbacks, particularly in light of its ongoing investments and share buyback program.

We could lower the rating on Kingfisher over the next 12–24 months if execution risks in either the scope of the One Kingfisher transformation program or its speed of implementation materialize and lead to continued weakness in cash generation. This, alongside the difficult trading environment, could result in a pronounced decline in sales, profitability, or cash generation, in particular weakening its ability to contain investment in working capital, such that the company fails to restore its reported FOCF from the negative ?80 million posted in FY2018.

We could downgrade Kingfisher if FFO to debt approaches 30% or FOCF to debt approaches 15%. A downgrade could also occur if Kingfisher's financial policy were to become more shareholder-friendly, and the group were reluctant to cut back share buybacks, which would exacerbate operational setbacks, even temporarily, and weaken its credit metrics.

We could revise the outlook to stable if the company gains traction from its various operating initiatives resulting in positive top-line performance while profitability remains robust and working capital well-contained, such that earnings and cash generation is at least in line with our base case. This should allow the company to maintain adjusted debt to EBITDA of about 2x and FFO to debt of at least 35%, while maintaining FOCF to debt of at least 20%. Kingfisher's ability to manage its working capital over the next 12 months such that it posts reported FOCF in excess of ?200 million would support a revision of the outlook to stable.
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