Fitch Ratings has assigned Pepco Group N.V. a first-time Long-Term Issuer Default Rating (IDR) of 'BB' with a Stable Outlook.
We have also assigned the existing senior secured debt issued by PEU (Fin) Limited and PEU (Tre) Limited a senior secured rating of 'BB+' with a Recovery Rating of 'RR2' and the planned EUR300 million senior secured notes to be issued by PEU (Fin) Limited an expected senior secured rating of 'BB+(EXP)'/'RR2'.
The 'BB' IDR reflects Pepco's scale, leading market positions in central and Eastern Europe (CEE), value positioning, improving diversification and record of revenue and profit growth along with adequate leverage for the rating. This is balanced by execution risk from accelerated expansion in Western Europe leading to negative free cash flow (FCF) over the next two years and neutral thereafter, some near-term margin pressure and weak coverage metrics.
The Stable Outlook is driven by an adequate liquidity position to support accelerated capex plans over the next two years, a sizeable part of which is discretionary, combined with EBITDAR leverage stabilising at around 4.0x.
Assignment of a final rating is contingent on completing the transaction in line with terms already presented and using the proceeds to repay existing term debt as planned.
Key Rating Drivers
Strong Growth for Discounter: Our forecast incorporates continued double-digit revenue growth over FY23-FY26 (financial year ending September) due to Pepco's value appeal to consumers and accelerated new store openings. We assume more normalised like-for-like (LFL) sales growth as the increased cost of living affects discretionary demand in 2H23.
This follows 11% LFL sales growth in 1H23, and the company's guidance about weaker consumer sentiment around discretionary spend in response to high inflation in April and May, leading to mixed performance in clothing and general merchandise categories. We expect LFL sales growth to align with historical performance from FY24, at around 5%-6% for the Pepco segment.
Execution Risk from Expansion: We see execution risk from Pepco's ambitious plans to add around 550 stores per year over the next four years, with the majority in Western Europe. In our view, there is a risk of overexpansion, intensifying competitive pressures in some markets, as well as potential for less stickiness to the discounter model upon economic recovery in Western markets, where the share of discretionary disposable income is above that of CEE.
However, we regard Pepco's approach to entering new Western markets, such as Germany, as prudent, and consider that the current cost of living pressures continue to provide discounters with the opportunity to gain market share.
Profit Growth: We expect EBITDAR to trend to EUR1 billion by FY25 from around EUR700 million forecast in FY23. However, we project the EBITDAR margin will remain below pre-pandemic levels at 15% vs 18% in FY19 due to accelerated expansion into Western markets with a higher cost base and the need to build brand and scale, unlike CEE countries, where Pepco has an established market position and scale. Furthermore, its strategy to increase the fast-moving consumer goods (FMCG) share in Pepco stores will weigh on the margin.
Near-term Margin Pressure: Fitch's forecast incorporates continued margin pressure and projects an EBITDAR profitability decline in FY23 to 13% from around 15% in FY22. This will mainly be due to a lower gross profit margin under Pepco brand (around 70% of FY22 reported underlying EBITDA), and operating cost inflation. From FY24, we estimate a gradual recovery in profit margins as cost-inflationary pressures ease, some with a lag due to the long buying cycle, and as efficiency programmes show results, leading to EBITDAR margins expanding towards 15%.
Weak Coverage Metrics: We project weak coverage metrics for the rating, with EBITDAR fixed charge coverage of around 2.0x, mapping to the 'b' mid-point. This is mostly due to the high share of leases and a fast-growing store network, affected by new stores ramp up. A tightening coverage ratio would signal declining capital returns due to weak execution of the business strategy, and could put the ratings under pressure.
Cash-generative Operations, Capex-driven FCF: Pepco generates adequate operating cash flow with the funds from operations (FFO) margin projected to trend to 7% by FY26. However, due to higher discretionary capex on expansion and store refurbishments, we anticipate negative FCF over the next two years, before it turns mildly positive (above 1%).
Based on our assessment of the sector and Pepco's corporate strategy, we believe all operating cash will likely be reinvested into new stores, resulting in a mostly negative FCF profile, albeit also bringing additional earnings. Accumulated cash could be used for shareholder distributions if approved by the board, and subject to financing documentation restrictions.
Adequate Leverage: We view Pepco's leverage metrics as adequate, with EBITDAR gross leverage estimated at around 4.5x over the next two years, potentially improving towards 4.0x from FY25 due to mild profitability expansion. We forecast an additional EUR1.6 billion lease debt by FY26, as we capitalise lease expenses, in line with our methodology, using a weighted average 7.6x multiple based on the country mix of Pepco's operations. We estimate Pepco's guided net debt/ EBITDA (pre-IFRS16) of 1.5x to be comfortably achieved, although this does not provide material protection as an increase in lease debt is not captured within this guidance.
Resilient Business Profile: In our view, Pepco has a resilient business profile benefiting from scale, leading market positions in its core CEE markets with well-known brands, and a value offering that should help protect LFL growth, even if some product categories are affected by the decline in discretionary demand, and limited fashion risk within adult-wear (around 15% of sales). It has reasonably good and improving geographic diversification across 20 markets. The UK and Poland remain key markets (60% of FY22 sales).
We believe Pepco balances the more discretionary but higher gross margin and value offering within clothing & home under Pepco brand with the less discretionary and lower margin FMCG offering under the Poundland and Dealz brands. The lack of an online sales channel may lead to the loss of some consumers that value convenience above value, although this approach is not dissimilar to other discounters.
Derivation Summary
Fitch rates Pepco using its Non-Food Retail Navigator. Pepco's business is broadly comparable with that of other Fitch-rated peers in the food and non-food retail sectors.
Pepco has meaningful size but it is smaller (by revenue) than our non-food retail rated peers, including Ceconomy AG (BB/Stable), the largest electronics retailer in Europe, Marks and Spencer Group plc (M&S, WD, BB+/Stable until November 2022) and Kingfisher plc (BBB/Stable), the largest DIY group in the UK and Poland. Pepco demonstrates stronger growth and higher profit margins, in particular against Ceconomy, which benefits from being market leader with a large share of revenues online, but suffers from low margin amid price transparency in a broadly flat market.
Pepco has a smaller scale than European discounter Action (unrated), similar to B&M European Value Retail S.A. (B&M, unrated) and larger than Dutch Hema (unrated). Discounters are growing strongly and demonstrate good profit margins.
Pepco has higher EBITDAR leverage (around 4.5x) than Kingfisher plc (around 2x) and M&S (around 3x). Leverage is expected to be similar to Ceconomy over the rating horizon.
Compared with its Fitch-rated food retail peers, including Bellis Finco plc (ASDA, B+/Stable), WD FF Limited (Iceland, B/Negative) and Market Holdco 3 Limited (Morrisons, B+/Stable), Pepco is materially smaller in terms of scale (except Iceland), better geographically diversified, with higher exposure to discretionary spending than grocers. Pepco's profitability is higher than that of food grocers who operate on thinner margins. Pepco is less levered than these grocers, but has weaker coverage metrics than ASDA and Morrisons due to a large part of their stores being freeholds.
Generic Approach to Instrument Ratings: We have applied generic approach to senior secured debt instrument ratings and this results in a one-notch uplift from IDR at 'BB+'/RR2, in line with our Corporates Recovery Ratings and Instrument Ratings Criteria.
Ring-fencing from Steinhoff: We rate Pepco on a standalone basis amid insulated legal ring-fencing and porous to insulated access and control, in line with our criteria. The Pepco group does not guarantee or provide security to creditors lending above Pepco and there is no cross default between the groups. There is an established governance framework to regulate the relationship between Pepco and the entities above, and to keep transactions in the best interests of Pepco group and at arm's length. Dividend distributions are not explicitly forbidden according to documentation, but would require board approval and be limited under debt covenants.
Key Assumptions
Fitch's Key Assumptions Within Our Rating Case for the Issuer:
500 new store openings per year for Pepco and 50 for Poundland/Dealz, in line with management's business plan, which will drive solid top line growth of 14% in FY23, followed by around 10-13% over the rating horizon
EBITDAR margin to decline to around 13% in FY23, then recover to around 15% by FY26
EBITDA margin around 7% in FY23-24, recovering towards 8.6% by FY26
Small working capital outflows over the rating horizon from some planned improvements in working capital management. Increased use of supply chain finance facility with half of it treated as debt (which is increasing from EUR100 million in FY22 to around EUR210 million in FY26), assuming that this is used to extend payables days.
Average annual capex of around at EUR370 million per year between FY23 and FY26, with material portion of it discretionary and relating to new store expansion and store refits
No M&A and no dividends in the next four years
RATING SENSITIVITIES
Factors That Could, Individually Or Collectively, Lead To Positive Rating Action/Upgrade
Continued LFL sales growth along with successful expansion and ability to manage cost inflation while protecting profitability, leading to growth in EBITDAR towards EUR 1.25 billion
FFO margin trending towards 10% and positive FCF post growth capex and dividends (if re-instated)
EBITDAR gross leverage below 3.8x on a sustained basis combined with maintained prudent financial policy
EBITDAR fixed charge cover trending towards 2.5x on a sustained basis
Factors That Could, Individually Or Collectively, Lead To Negative Rating Action/Downgrade
LFL sales decline, loss of market share, unsuccessful expansion or inability to manage cost inflation leading to weaker profitability, and reduced deleveraging capacity with
EBITDAR gross leverage above 4.5x on a sustained basis
EBITDAR fixed charge cover below 2.0x on a sustained basis
Persistently negative or low visibility of FCF due to underperformance, continued accelerated expansion not yielding returns, or large shareholder distributions leading to weakened liquidity headroom.
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
Adequate Liquidity: As of 30 March 2023, Pepco had adequate available liquidity, comprising reported cash of EUR260 million, with a EUR102 million undrawn revolving credit facility (RCF) of a total committed EUR190 million. Of the reported cash, we restrict EUR125 million as cash required for operations in our calculations. As part of the transaction, Pepco will upsize its RCF to EUR390 million, which further supports liquidity.
On completion of the refinancing, Pepco will benefit from improved debt maturities with a term loan due in 2026 and the new senior secured notes, which refinance the existing term loan A maturing in 2024, due in 2028.
Issuer Profile
Pepco Group is a large-scale variety discounter operating across Europe from around 4,000 stores in 20 countries in Europe, with its two largest markets the UK and Poland.
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.
PEPCO GROUP N.V. 
