MARC has revised its rating outlook on the MARC-1(cg)/AAA(cg) and MARC-1ID(cg)/AAAID(cg) ratings on Tesco Stores (Malaysia) Sdn Bhd’s (Tesco Malaysia) RM3.5 billion Conventional and Islamic Commercial Paper and Medium Term Notes (CP/MTN) Programme to Negative from Stable. Tesco Malaysia has issued RM700 million under the CP/MTN Programme as of todate. The ratings on Tesco Malaysia’s issuances are underpinned by guarantees extended by Tesco PLC.  The rating outlook revision follows from Tesco PLC’s continuing negative free cash flows precipitated by aggressive debt-funded international expansion as well as shareholder-friendly capital management initiatives.

Tesco PLC is the largest food retailer in the United Kingdom (U.K.) with an estimated 20% grocery market share and ranks among the top three grocery retailers in the world. The Group recorded a revenue of £47.3 billion and an operating profit of £2.8 billion for FY2008 ended on 23 February 2008, increases of 10.9% and 5.4% respectively from FY2007. International sales grew by 24.5% in FY2008. Tesco PLC also reported a strong start in the first 5 weeks of FY2009 recording 13% growth in consolidated sales.

Nevertheless, MARC remains concerned about the effect of the heavy capital expenditures on Tesco’s financial profile. Despite generating strong net cash from operating activities amounting to £3.3 billion in FY2008, free cash flow was negative. Tesco PLC’s £5.0 billion sale and lease back programme has not provided much support for its capital expenditure requirements as it has been primarily focused on returning value to shareholders.

Tesco PLC had on 14 May 2008, announced the acquisition of 36 stores from E.Land Group in South Korea for a total consideration of £958 million. The acquired stores, are to be converted to its Homeplus format within 12 months and will substantially improve Tesco PLC’s market position vis-à-vis Shinsegae Co.’s E-Mart chain of discount stores. Tesco PLC recorded £2.7 billion sales in FY2008 in South Korea, its biggest market outside the U.K. The Group had a total of 3,729 stores worldwide at the end of FY2008 and plans to invest a further £4.2 billion to open another 863 stores in FY2009. Tesco PLC’s capital spending rose to £3.9 billion in FY2008 up from the £3.0 billion reported in FY2007. 

Current indications are that the financial impact of the impending acquisition will be within rating tolerances, given Tesco PLC’s manageable debt maturity profile and substantial liquidity. Of total borrowings of £8.1 billion, £2.1 billion, including finance leases will mature in FY2009. Tesco PLC had £1.8 billion in cash and cash equivalents, £360 million worth of short term investments and £1.6 billion of undrawn committed facilities as at 23 February 2008.

MARC will continue to monitor the longer-term effect of the higher interest expenses for debt-funded expansion and higher lease commitments on Tesco PLC’s profitability. The outlook may be revised to stable from negative if Tesco PLC demonstrates improvement in free cash flow generation through increased cash flow from operations and/or moderation of its cash outflows with respect to its capital management initiatives and debt-financed investments.

Tesco Malaysia, a 70% owned subsidiary of Tesco PLC, is currently a leading domestic hypermarket operator. The company operates 21 stores in Malaysia with total retail space amounting to 176,426 m2 as at 20 May 2008. Tesco Malaysia is in the midst of finalising its accounts for FY2008 ended February 2008, after posting its first operating profit since inception of RM17.9 million in FY2007.