Fitch Ratings has affirmed WD FF Limited's (Iceland; previously Lannis Ltd) Long-Term Issuer Default Rating (IDR) at 'B'.
The Outlook is Negative. Fitch also affirmed the senior secured instrument ratings issued by Iceland Bondco plc at 'B+'/'RR3'.
The Negative Outlook reflects higher leverage than commensurate with the rating and temporary weaker profitability, which we expect to recover by the financial year ending March 2025 (FY25) as the company implements its energy hedging plans. It also captures execution risk on cost savings ahead of the refinancing of notes maturing in March 2025. This is balanced by a healthy liquidity position, supported by capex flexibility and fixed interest rate debt.
Iceland remains highly exposed to capital market conditions at the time of refinancing, although management retains flexibility to potentially refinance its debt at a lower amount. Should operational turnaround and debt capital markets prove elusive by 2H23, this could be indicative of off-market refinancing risks leading to at least a one-notch downgrade.
The 'B' rating also reflects Iceland's specialist business model focused on the frozen food and value-seeking consumer segments, which have been resilient through business cycles. Fitch believes this segment will somewhat benefit from a recessionary environment.
Key Rating Drivers
Higher Leverage Upon Refinancing: Fitch expects high funds from operations (FFO) adjusted gross leverage at 7.5x in FY25 when the GBP550 million notes mature. Iceland remains highly exposed to capital market conditions at the time of refinancing. Our forecast incorporates a reduction in leverage from around 8.5x in FY22-23 as profitability recovers amid energy cost hedging, which is still subject to execution. We assume no voluntary debt prepayment, as we expect the company will favour a healthy liquidity position in the current uncertain economic environment and potentially refinance its debt at a lower amount. We expected deleveraging to 7.5x by FY24 under our previous rating case in January 2022.
Energy Cost Drags Profits: We have lowered Iceland's EBITDA forecast for FY23 to around GBP90 million, from around GBP125 million (after GBP15 million adjustment for leases in line with our criteria) previously. We expect around a 200bp negative impact on the EBITDA margin from materially higher but now fully hedged energy costs in FY23. Overall, we expect a 100bp hit to the EBITDA margin in FY23, with the energy impact mitigated by around GBP50 million cost savings and some uplift in sales as consumers feel the squeeze on their incomes and trade down. We deconsolidate the restaurants business from our forecast.
Profitability Pressures: We expect cost pressures to continue, in terms of cost of goods inflation and national living-wage increases. We expect Iceland to implement various cost-saving measures, following GBP11 million in 1Q23, to offset some of the cost inflation. Cost inflation is harder to absorb for smaller-scale grocers such as Iceland that operate with thinner EBITDA margins (3.4% in FY22) than large and more diversified mainstream grocers (around 5%-6%). Management has indicated it has maintained broadly stable buying margins so far, but this could become harder, given supplier-cost inflation and in light of Iceland's value offer and competitive landscape.
We expect for EBITDA margin to gradually recover to 3.6% over the rating horizon as energy hedging deals, still subject to execution risk, provide full benefit by FY25.
Opportunistic Financial Behaviour: Iceland's cash funding of the share purchase from Brait (GBP109 million, fully paid in FY21) and non-core investments signalled opportunistic financial behaviour in the context of the company's high leverage. Iceland has not diverted further funds to its non-core restaurant business, following an initial GBP31 million that was up-streamed in 3Q21. However, it is likely that the restricted group would support the restaurant business if needed.
Its two-family ownership, following the share buyback from Brait, should allow a longer-term strategic focus. We do not assume any further material outflows to support, or material earnings contribution from its restaurant business under our rating case. The restaurant business has not been included in the restricted group, and we assume no additional debt to be serviced from the restricted group in future.
Lower Free Cash Flow Generation: We expect Iceland to generate broadly neutral free cash flow (FCF) amid lower profit forecast and compared with 1% FCF under our previous forecast. Low maintenance capex of around GBP15 million provides flexibility. Generally, we expect capex to be lower than FY18-20 when Iceland invested in its distribution network, depots, online and IT infrastructure. We expect prudent balancing of capital allocation between modernisation of its stores, business growth and maintaining healthy cash balance in the current uncertain environment.
Value Positioning May Benefit: Changing behaviours, whereby consumers increasingly look for value and shop around for deals, puts Iceland in a good position to gain market share. Iceland is UK's second-largest frozen food retailer after Tesco. Iceland grew its sales during the global financial crisis.
Iceland mildly increased its share in the UK grocery market between 2008 and 2022, despite competitive pressures and the rapid growth of discount stores. This was achieved by greater differentiation in its product offering, improved pricing, investment in its stores and formats, and improved brand positioning with regard to the environment and sustainability. We expect the UK food industry to continue to have stiff competition.
Derivation Summary
Iceland's business risk profile, as a mostly UK-based specialist food retailer, is constrained by the company's modest size and lower diversification compared with other Fitch-rated European food retailers, such as Tesco Plc (BBB-/Stable) and Bellis Finco Plc (ASDA; BB-/Negative). Both peers have higher market share, larger scale, and greater diversification than Iceland.
Iceland's EBITDAR leverage, which we expect to reduce from around 8.5x in FY23 to slightly below 7.0x in FY25, is much higher than Fitch-rated UK peers (ASDA: just below 6.0x trending to 5.0x; Tesco: around 3.5x).
Iceland is larger than Picard Bondco S.A. (B/Negative), a French specialist food retailer also active in frozen foods, but its profitability is materially weaker (EBITDAR margin of about 5.5% versus Picard's above 17%) and FFO. Picard operates mostly in the higher-margin premium segment and benefits from strong brand awareness. Picard's financial leverage is similar to Iceland's on FFO-adjusted gross leverage basis at above 8.5x in FY23-FY25, but it has better deleveraging capability and a stronger business profile.
Key Assumptions
Fitch's Key Assumptions Within its Rating Case for the Issuer:
Retail revenue (excluding restaurants) growth of 4.5% in FY23 and 3% in FY24 driven by trade-down, partial cost inflation pass-through and Food Warehouse store openings offset by core Iceland store closures. Growth of about 1% thereafter.
15 Food Warehouse store openings over FY23-FY24, increasing to 25 stores per year in the following two years, partly offset by core Iceland store closures of 20 per year.
EBITDA margin to contract by 100bp, given energy cost and wage inflation, partially offset by cost-savings initiatives. Improvement by 70bp in FY24 and further 50bp in FY25 as energy hedging impact feeds through, EBITDA margin reaching 3.6% by FY25.
Working capital slight outflow of GBP8 million in FY23 (movement of inventory, payables, and receivables only) and slight inflow thereafter.
Capex of GBP50 million in FY23 and reduced to GBP25 million in FY24 in line with management guidance, and reversal to GBP50 million thereafter.
No dividends or other distributions (to the restaurants business, for example) over the rating horizon.
Restaurant business has been deconsolidated.
Fitch's Key Recovery Rating Assumptions:
Fitch's recovery analysis assumes that Iceland would be reorganised as a going-concern in bankruptcy scenario rather than liquidated.
We have assumed a 10% administrative claim.
Iceland's going-concern EBITDA assumption reflects our expectation of recovery in earnings amid visibility on energy cost and cost savings initiatives. We have excluded the restaurant business from our going-concern EBITDA calculation.
The going-concern EBITDA estimate of GBP110 million (unchanged) reflects our view of a sustainable, post-reorganisation EBITDA, upon which we base the enterprise valuation (EV). The assumption also reflects corrective measures taken in the reorganisation to offset the adverse conditions that trigger its default, such as cost-cutting efforts or a material business repositioning.
We apply an EV multiple of 4.5x to the going-concern EBITDA to calculate a post-reorganisation EV.
Iceland's revolving credit facility (RCF) is assumed to be fully drawn upon default. The RCF is super-senior to the company's senior notes in the debt waterfall.
The allocation of value in the debt waterfall results in recovery expectations corresponding to a 'RR3' Recovery Rating for the rated notes totalling GBP800 million, with a recovery percentage of 53% (unchanged).
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to an upgrade (to B+):
We view an upgrade of the IDR as unlikely over the next two years, unless Iceland demonstrates material improvements in operating performance and adopts more conservative capital allocation.
Evidence of positive and profitable like-for-like sales growth and the maintenance of stable market shares, leading to resilient profitability with EBITDA margins increasing towards 5%, could lead to positive rating action.
Total EBITDAR leverage below 5.5x and FFO adjusted gross leverage below 6.0x, both on a sustained basis.
EBITDAR fixed-charge coverage above 2.0x on a sustained basis.
Factors that could, individually or collectively, lead to Outlook revision to Stable (at B):
Evidence of stable market share, demonstrated ability to pass on or mitigate cost inflation, including progress on energy hedging, leading to stabilised EBITDA margin towards 3.5% and positive FCF.
Maintenance of comfortable liquidity position while making voluntary debt prepayments, combined with less adverse market conditions or EBITDAR leverage trending to 6.5x or below and FFO adjusted gross leverage trending to 7.0x or below.
EBITDAR fixed-charge coverage at or above 1.5x.
Factors that could, individually or collectively, lead to negative rating action/downgrade (to B-):
Evidence of negative like-for-like sales growth, with loss of market shares due to a competitive environment or to permanently lower capex, or inability to pass on or to mitigate cost inflation, including lack of progress on energy hedging, leading to a prolonged and accelerating EBITDA margin erosion or neutral FCF.
Tightening of liquidity amid unexpected cash outflows, combined with adverse market conditions suggesting high refinancing risk.
EBITDAR leverage above 6.5x and FFO adjusted gross leverage above 7.0x, both on a sustained basis.
EBITDAR fixed-charge coverage below 1.5x on a sustained basis.
Best/Worst Case Rating Scenario
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
Liquidity and Debt Structure
Comfortable Liquidity: Fitch views Iceland's liquidity as comfortable, given a cash balance of GBP116 million at September 2022, which excludes restricted GBP20 million for working-capital purposes (Fitch's adjustment), along with an undrawn GBP20 million RCF. Fitch expects Iceland's liquidity to remain comfortable over the rating horizon, despite weaker earnings as we expect Iceland to flex its capex accordingly. Around 25% of the GBP60 million capex in FY22 was for maintenance.
Refinancing risk on the upcoming GBP550 million senior secured notes maturities in March 2025 has increased and depend on execution of profits recovery and visibility on deleveraging before refinancing, while healthy liquidity provides some buffers to implement cost-saving measures. We do not assume any voluntary debt prepayments before maturities.
Iceland is currently exposed to limited interest rate risks as all debt is fixed, reflected in FFO fixed charge cover of around 1.5x, in line with the rating.
Issuer Profile
Iceland is a British food retailer specialising in frozen and chilled food products at a low price point. It operates around 1,000 stores in the UK.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG Considerations
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.
TESCO PLC 
