OREANDA-NEWS. Fitch Ratings has affirmed Pick n Pay Stores Limited's (Pick n Pay) National Long-Term Rating at 'A(zaf)' with a Stable Outlook and National Short-Term rating at 'F1(zaf)'. In light of the change in Fitch's regulatory status in South Africa, and for commercial reasons, Fitch has chosen to simultaneously withdraw Pick n Pay's ratings.

The affirmation reflects Fitch's expectation of continuing good turnover growth and improving EBIT margins as the group implements its second stage of its long-term turnaround programme. Pick n Pay delivered a solid trading performance for the year ending 28 February 2016 (FY16) despite the economic difficulties it faced in its core market. The continued focus on its turnaround plan has helped drive both turnover growth (benefiting from increased capex supporting new stores openings) and increasing margins (with both cost of sales and trading expenses effectively managed). The group's effective working capital management and optimisation of operating costs has delivered lower levels of debt and improved credit metrics which supports the rating and Stable Outlook.

KEY RATING DRIVERS

Strong Operating Performance

Fitch expects annual turnover growth to remain healthy (above 7%) in FY17 supported by management's strong forecast capex spend for FY17 (ZAR2.1bn or 2.7% of turnover) with the majority of this investment aimed at new space and refurbishments. Pick n Pay delivered a strong growth in turnover of 8.2% for FY16, benefiting from an increased performance on a like-for-like basis (contributing 3.8% of the growth) as well as new store openings. This was a strong result in a period where the group faced tougher economic conditions in South Africa together with impacts from the sustained drought conditions and a weaker local currency, while consumers were faced with the burdens of higher interest rates and increased energy and utility costs.

Pick n Pay continues to sacrifice gross margin improvement in order to restrain selling price inflation to 3.1% compared with CPI food inflation of 5.3%. To enable this, the group continues to extract operational efficiencies and cost savings through its increasingly centralised logistics and distribution platform. Combined with lower price inflation, the group has been successful with its continued development and investment into the Brand Match and Smart Shopper programmes supporting footfall.

Steady Margin Improvement

We expect some improvement in the EBIT margin over FY17-20. However, we believe this is likely to be measured given the difficult market conditions facing sector participants and the highly competitive nature of the mature South African market. The group's EBIT margin improved to 2.1% in FY16 (FY15:1.9%) with the positive impact of a higher gross margin and certain lower trading expenses (as a percentage of turnover), notably employee costs and merchandising and administration costs.

Significant Store Expansion

In FY16, Pick n Pay opened 175 new stores, which contributed 4.4% to turnover growth for the year. The store openings helped to increase the group's exposure to new regions in its home market where Pick n Pay had not been previously active. The group's new stores were across multiple formats, with growth opportunities from both clothing and notably convenience formats, with the latter channel having grown between 15%-20% for each of the past six years in South Africa.

Steady Geographical Diversification

The group continues to focus on a measured approach to its increased geographical diversification with 14 stores opened in its Rest of Africa division and delivering 8.8% growth in turnover. In 2017 the group is opening its first stores in its newest market, Ghana, and recently announced its intention to enter into a joint venture arrangement with AG Leventis (Nigeria) Plc, which has established FMCG experience in Nigeria together with warehousing and logistics capabilities.

Nonetheless, compared with its closest sector peers, Pick n Pay remains more highly reliant on the domestic South African market given its measured approach to diversification with its Rest of Africa division generating 4.3% of turnover in FY16 (FY15: 4.5%).

Effective Capital Management

Pick n Pay had a significantly positive cash flow impact in FY16 from its effective management of its working capital; despite increases to its inventory and trade payables (due to new stores and franchisees) the group was still able to generate a significant capital inflow through management of its trade payables. This cash inflow has allowed the group to generate positive free cash flow (FCF) over the past three years (FY16: 1.1% of turnover). Despite our expectations of elevated capital expenditure we expect FCF to remain mildly positive over the rating horizon.

Strong Financial Structure

The increased profitability and lower debt has led to better leverage metrics with FFO adjusted net leverage (factoring in the capitalisation of operating leases by a multiple of 6x as is typically the norm for South Africa-based corporates) improving to 2.5x (FY15: 2.7x). In our forecasts we expect limited strengthening in leverage without significant improvement in the trading margins for Pick n Pay. We expect FFO fixed charge cover metrics (FY16: 2.2x) to remain relatively unchanged and in line with rated peers in the sector.

RATING SENSITIVITIES

Not applicable as the ratings have been withdrawn