DEBT RATINGS FOR BIG THREE ONE STEP CLOSER TO 'JUNK'

Jon Springer

NEW YORK -- Saying that competitive pressures from nontraditional food retailers have fundamentally changed the supermarket business, Standard & Poor's here last week lowered its bond ratings on Kroger, Albertsons and Safeway.

Ratings for the three retailers, which fell to BBB- from BBB, are still considered investment grade but are one notch above "junk" level. Analysts told SN the change could impact the cost of borrowing money, but that the real risk would be any further downgrades. S&P said further downgrades are unlikely at this time.

Also last week, Fitch Ratings, New York, maintained its BBB ratings on Kroger, Albertsons and Safeway but changed its outlook on Kroger and Albertsons to negative, as it already had with Safeway. A similar pronouncement this spring by S&P preceded its rating action last week. Moody's Investors Service, New York, did not take any rating action last week.

"The downgrades are based on increased business risk, reflected in the difficult operating environment, and our view that progress in restoring credit-protection measures, which suffered during the lengthy labor dispute in Southern California, is insufficient to offset this risk," said Mary Lou Burde, credit analyst for S&P, in a conference call discussing the rating action last week.

Officials from Kroger, Cincinnati, and Safeway, Pleasanton, Calif., told SN they were "disappointed" by S&P's decision -- particularly coming on the heels of relatively strong quarterly performances -- and said they intend to regain BBB status. Albertsons officials were not available for comment.

"Kroger's debt rating is very important to us. We believe that a BBB rating likely provides us with the cheapest cost of debt, so we were disappointed by S&P's announcement," Gary Rhodes, a spokesman for Kroger, told SN.

"We like being a BBB credit: It gives us a lot of flexibility," Melissa Plaisance, a spokeswoman for Safeway, told SN. "We'll take the actions we believe will earn us that once again."

S&P indicated that regaining that status, however, would require operating at a level that exceeds industry performance before the three companies endured the labor dispute in Southern California, which lasted more than four months and ended in February 2004.

This reflects what one analyst called "secular change" in the competitive landscape, with supermarkets facing market share, price and margin pressures from alternative formats led by Wal-Mart Stores.

"We believe credit measures need to be stronger than they were in the past, when we had a somewhat more positive view of the industry," Burde explained.

Ratios of debt to earnings for all three retailers have increased over the last three years, with Kroger currently at 3.5 times, Albertsons 3.7 times and Safeway 3.8 times. All were at or close to three times earnings in 2002. "By the end of 2005 I expect they could be back down in the low 3s, which is fine, but not enough to get them back to BBB," Burde said. Asked if 2.5 times would be enough, she said, "I don't want to put a number on it."

Sheila McNeely, lead analyst for Fitch, sounded a similar note. "We will need to see improvement in balance-sheet metrics as well as ongoing momentum in store sales and cash flow," she said. "Given the higher risk profile of the industry, we believe [supermarkets] need to maintain lower leverage ratios than they have historically."

Analysts told SN the S&P downgrade itself is not expected to have a significant impact on operating strategies, but instead raises the stakes for their success. A downgrade to "junk" status -- which Burde said would come only as a result of "some unexpected, huge decline in profitability and cash flow," and which she stressed was unlikely -- would prohibit some funds from investing with the companies and make borrowing money much more expensive.

"This is not an event like a car crash, but more like another drop on the forehead in a water torture," Matt Richards, president of Richards Asset Management, a Parkton, Md.-based investment firm, told SN.

"Operations are key because these companies have a lot of debt outstanding. It will be important for them to maintain investment-grade if they want to compete on price," one debt analyst, who asked not to be identified, told SN.

Analysts had differing opinions on whether the downgrade would change financial strategies for retailers. Kroger, which stated its intention was to spend two-thirds of cash flow on stock buybacks and one-third on debt reduction, in recent quarters spent more on debt reduction than stock, analysts noted. "It's possible retailers said, 'Let's bring our debt levels closer to where they were in 2003 and save our rating,' " one analyst said. "Now maybe they're less inclined. I don't think you'll see another $1 billion debt-reduction year like Safeway just had."

David Shapiro, credit analyst for Fischer, Francis, Trees & Watts, New York, told SN he expected that companies would continue efforts to reduce debt through the end of the year. "But I don't think they'd do that just to get back to BBB. Once S&P made the decision, it could be some years before these companies get back there."

S&P's reduction of the retailers to an A3 commercial paper rating could make short-term borrowings more expensive. "It would be a modest increase in cost -- basis points, not percentage points," one analyst said.

Retailers and observers were puzzled at the timing of the S&P announcement -- saying the acknowledgement that the environment was changing was evident years ago -- and that the operating strategies retailers put in place to compete in that environment has only begun to produce its desired results. "S&P was late to the punch," one analyst said.

"We're obviously disappointed this happened at a time when the strategy we put in place three years ago is starting to bear fruit," Plaisance of Safeway said. "We feel that the momentum is improving."

Others said they were surprised that all three companies were downgraded at once. "Kroger got the short end of the stick," one debt analyst said. "They have more flexibility than the other two companies and a longer track record."

Burde noted Kroger "is modestly better than its peers," but, she said, "we do not feel the differences were sufficient to merit a different rating."