OREANDA-NEWS. Fitch Ratings has affirmed Dutch food retailer Royal Ahold NV's (Ahold) Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB'. The Outlook is Stable.

The affirmation reflects our view that on a standalone basis Ahold will maintain adequate rating headroom at the 'BBB' level, despite its business model remaining under competitive pressure and a fairly aggressive financial policy (reflected in over EUR3.5bn in share buy-backs and capital repayments over 2013-2015).

While the US and Dutch food retail markets remain competitive, we expect the group's investment in improving customer service, in fresh produce sales and reduced assortments will help maintain group EBIT margins at around 3.8% in 2016, above the 3% average for EMEA food retail. The ratings remain constrained by limited product and geographical diversification.

We expect leverage (on a lease adjusted funds from operations (FFO) net leverage basis) to marginally rise to around 3.3x at end-2016, from 3.1x at end-2015. This is due to muted projected like-for-like (LFL) revenue growth, a pre-merger EUR1bn capital return special dividend gross pay-out to Ahold's shareholders or possible future equivalent share buy-backs if the merger does not go through, and no debt reduction. This would still remain in line with our sensitivity for a 'BBB' rating, although financial headroom would reduce.

Ahold has said it expects to complete its merger with Delhaize Group SA (Delhaize) by mid-2016, but it is still in discussions with the US Federal Trade Commission (FTC) regarding store closures, which could number around 80 in total. The merged group will operate under the name Ahold Delhaize Group.

KEY RATING DRIVERS

Business Model Adaptation

We conservatively forecast moderate single-digit LFL sales growth in 2016, aided by an improving economic environment in both the US and the Netherlands along with management's measures to adapt its core US and Dutch business model. We expect Ahold's activities to remain challenged by fierce competition as sector players are also adapting their activities to evolving consumer needs. In particular, management's initiatives have so far led to only mildly increasing LFL sales growth (up 0.8% in US in 1Q16).

Continuing Cost Saving Programme

Ahold has delivered around EUR1.2bn of cost and efficiency improvements in the four years to end-2015 through improving commercial practices, operational efficiencies and overhead reduction. This programme will be maintained in 2016, when Ahold forecasts a further cost improvement in 2016 of EUR350m based on efficiency and cost-saving measures (this figure does not include cost savings associated with its planned merger with Delhaize). As we expect only mild growth in EBIT in 2016/2017 we assume the majority of such cost savings will be reinvested in the business in order to further improve the group's competitiveness.

Operating Margin Now Stabilising

Ahold's profitability has been on a falling trend over 2013-2015 but is now stabilising. Due to its strong cost optimisation programme and mildly improving LFL sales trend, Fitch expects Ahold's standalone EBIT margin to remain unchanged in 2016, albeit still at a high 3.8% relative to the sector, before slightly increasing to 3.9% by 2018-2019. This would be above the average for EMEA food retail but lower than the 4.5% peak in 2011.

Our expectation of broadly stable profitability over the next three years reflects our view that Ahold will need to continuously reinvest all cost savings to maintain its market position in a highly competitive environment and to fund the development of its online sales channel. While boosting sales, the growing share of less profitable online sales in total revenues would constrain future profit margin expansion.

Limited Geographic Diversification

We expect the US and Dutch markets to continue to represent the majority of Ahold's operations in the medium term. Ahold's limited scale and geographic diversification outside mature, highly competitive markets act as a rating constraint, as it limits sales and profit growth prospects. Market entry success is likely in culturally similar countries such as Belgium (19 stores) and Germany (five stores), but these markets are mature and highly competitive, particularly from discount retailers such as Aldi and Lidl.

Still Strong Cash Flows

Despite flat operating margins and increased interest costs, we expect Ahold on a standalone basis to continue to generate good free cash flow averaging 1.3% of sales per year over FY16-FY19 (versus 1.8% over the past three years). This gives the group some financial flexibility in its operations with the option to either afford some margin sacrifices, increase capex or pay down debt. This flexibility remains one of the key pillars of the 'BBB' rating.

M&A, Returns to Shareholders

A shareholder-friendly policy, which has driven EUR3.5bn share buybacks and capital repayments between 2012 and 2015, mirrors management's liquidity optimisation strategy. Under our assumptions for 2016, on a standalone basis we include a further EUR1bn share buy-back. This financial strategy would lead to a mild increase in lease-adjusted FFO net leverage, which we expect to be in the 3.0x-3.5x range over 2016-2019, compared with 2.5x-3.0x over 2011-2013.

Reduced Financial Headroom

Tightening headroom reflects our expectation of a higher lease-adjusted FFO net leverage due to shareholder-friendly activity in 2016, while we expect the group's business profile to continue to experience greater pressure than other 'BBB' rated food retail companies such as Carrefour (BBB+/Stable) and Kroger (BBB/Stable). Mitigating factors remain Ahold's strong financial flexibility (share buybacks and M&A can be reduced) and a fairly strong FCF generation capacity.

With the merger with Delhaize being structured as a share exchange with no additional debt, we project broadly stable leverage with lease-adjusted FFO net leverage at 3.0x (Ahold 2015 stand-alone: 3.1x) on completion, and moderate de-leveraging towards 2.7x by 2018 (excluding potential asset divestments and depending on future remuneration policy to shareholders).

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer on a standalone include:

- Low single-digit organic sales growth in both the European and US operations

- Stable EBIT margin in 2016, back to around 3.9% in 2017 as cost savings from restructuring programme (targeted at EUR350m in 2016) are progressively achieved but largely reinvested in the business

- FCF margin fairly stable, averaging 1.3% per year over the next four years

- Capex equal to 2.4%-2.5% of sales from 2017

- Exceptional cash restructuring charges of EUR100m split between 2016 and 2017

- EUR1bn capital return to Ahold's shareholders in 2016 and moderate increase in dividend pay-out

RATING SENSITIVITIES

These apply to Ahold on a standalone basis:

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

- Material diversification of activities outside core markets

Positive LFL sales growth in core markets and EBIT margin maintained at above 4.5%. This would also reflect a successful integration in the US and Holland/Belgium, which represent the group's core sales and profits

- FFO fixed charge coverage above 3.0x (2015: 2.8x)

- Lease-adjusted FFO net leverage consistently below 2.5x

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- EBIT margin falling consistently below 4%, due to intense competition in core markets

- FFO fixed charge coverage falling below 2.5x

- Lease-adjusted FFO net leverage consistently above 3.5x, driven by either sustained operating underperformance or a more aggressive financial policy

LIQUIDITY

As of end-2015 Ahold benefited from an undrawn committed credit facility of EUR1bn due 2021 and Fitch-adjusted available unrestricted cash of EUR1.4bn. The group's debt maturity profile is also comfortable with limited maturities within the next five years. Overall the average maturity of debt at end-2015 was between eight and nine years.