Spain-Based Diversified Retailer El Corte Ingles Rated ‘BB’; Outlook Stable; Proposed Notes Rated ‘BB+’

          MADRID (S&P Global Ratings) Sept. 21, 2018--S&P Global Ratings today assigned its 'BB' long-term issuer credit rating to Spain-based diversified retailer El Corte Ingles, S.A. (ECI). The outlook is stable.
          At the same time, we assigned our 'BB+' to ECI's proposed EUR600 million senior unsecured notes. The recovery rating of '2' reflects our expectation of substantial recovery (70%-90%; rounded estimate: 85%) in the event of a default. 
          Our rating reflects ECI's large and diverse operations, complementary businesses, superior brand awareness both nationally and internationally, and an unparalleled network of large stores in affluent parts of major Spanish cities and tourist destinations, underlined by strong after-sale services and financing to customers. Moreover, ECI benefits from substantial operational and financial flexibility, thanks to its ownership of a large real estate portfolio. However, ECI's retail segment is sensitive to changing consumer preferences, rising competition from pure online players, and large specialized food and non-food retailers. In addition, ECI displays lower profitability than peers', although it is improving; high seasonality of earnings; geographic and store concentration in Spain; and a moderately aggressive capital structure. 
          We believe ECI benefits from solid market positions in the Spanish food and non-food retail, travel, IT, and financial services industries and from superior brand recognition in Spain and abroad, with over 700 million visits per year. Its diversification into five distinct businesses allows it to leverage on operational, customer, and know-how synergies while reducing the sensitivity of the group's performance to temporary setbacks in any one segment.
          However, ECI's limited geographic diversity outside Spain curtails its international reach and resilience to economic cycles. Like most retailers, ECI is exposed to volatility stemming from seasonality (a material portion of EBITDA is generated in the fourth quarter), some concentration risks, since the top 10 stores represent about 40% of the group's EBITDA; fashion risks; and dependence on discretionary consumer spending. Furthermore, the highly competitive retail market is undergoing a deep transformation with the advent of online, fast fashion, value retailers, and changing customer-shopping habits. ECI's main competitors include pure online players, such as Amazon and Zalando, and large specialized retailers, such as Inditex and Decathlon in apparel, Mercadona in food, IKEA in home furniture, and Media Markt in consumer electronic goods. We believe that ECI's own branded products, commoditized furniture, and consumer goods are the most exposed to competition. 
          ECI manages these competitive threats through a number of distinct competitive advantages. In its department stores business, which accounts for 55% of revenues, ECI owns the only omnichannel third-party brand platform in Spain, with a large selection of exclusive brands, representing about 25% of the group's retail sales. Given its extensive store network, high store traffic, and competitive edge in the department store format, ECI acts as an important gateway for international brands keen on entering the Spanish retail market. In addition, ECI's broad product offering, varying from mass market to premium brands, including an assortment of own-brand products, differentiate it from competitors, supported by an omnichannel proposition, including in-store, catalogue, click and collect, and online platforms. Similarly, ECI's solid supply chain infrastructure and nationwide logistics network give it a competitive edge, particularly against pure online players such as Amazon or Zalando. 
          Yet ECI's retail margins are lower than that of other rated department stores and fashion retailers, and this weighs on the group's consolidated margins. This is primarily due to ECI's legacy cost structure, further burdened by the last financial crisis, and ongoing investments in omnichannel. Improving the operating efficiency of the department stores is a primary focus of the group's near-term transformation program.
          Competition in the food segment, where ECI generated 18% of its consolidated revenue in fiscal year ended Feb. 28, 2018 (fiscal 2017), has intensified, with value players like Mercadona continuing to gain market share (now close to 30%). Nonetheless, ECI's reported food EBITDA margin rose by 80 basis points (bps) in fiscal 2017 to 7.6%. This compares favorably with S&P Global Ratings-adjusted margins of France-based competitors Auchan (5.1%) and Carrefour (5.3%) for 2017, as well as that of U.K.-based Tesco 6.5% for the year to Feb. 28, 2018. This is due to different local dynamics and ECI's strong position in the high-margin premium segment and efficient cost management, including via a reduction in personnel and other operating expenses. In food, ECI stands out from its rivals due to its premium quality offerings, such as its 68 gourmet food stores. Nonetheless, we believe margins in the food segment have peaked and, in our view, current profitability levels would be difficult to surpass. 
          Another strength of ECI's business model relative to other retailers lies in its branded credit card program available to customers via a joint venture FECI ("Financiera El Corte Ingles") with Banco Santander. This proposition--and the accompanying loyalty program that offers additional benefits--attracts a large number of customers and enhances the frequency of purchases. ECI owns 49% of FECI and does not consolidate it in its accounts. 
          ECI's other business segments include travel agency, IT consulting, insurance brokerage, and proprietary life insurance (about 63% of premiums) and non-life insurance (about 37% of premiums) platform. ECI's travel business is the country's largest and its performance is solid, although this industry is intrinsically more cyclical. Dividend income from FECI and interest income received from the insurance business further support ECI's operating profitability. 
          ECI owns the majority of its store locations. It therefore displays better operational and financial flexibility than comparable peers, due to lower rent payments. ECI's real estate portfolio is independently appraised at EUR17 billion (although the book value is about EUR9.3 billion), and includes prime locations in major metropolitan and tourist areas across Spain. We note as positive that, over the past 18 months, ECI has divested more than EUR500 million of noncore buildings at a premium to the appraisal values and used the proceeds to partly fund its turnaround measures and reduce leverage. 
          ECI's large legacy debt resulted from the impact of the recessions in 2008-2013 after a significant capital-intensive expansion. The group has consequently executed an extensive cost-cutting and deleveraging plan, with the net reported leverage ratio dropping to 3.3x for fiscal 2017 from the 6.9x peak in 2012. 
          Nevertheless, we view the capital structure as aggressive for the industry, although we forecast deleveraging over the next three years, with the S&P Global Ratings-adjusted debt to EBITDA ratio dropping below 4.0x over that period from 4.5x in fiscal 2017. This would be supported by modest EBITDA growth and discretionary cash flow (DCF) generation, consistent with ECI's target to reduce net reported leverage (as defined by ECI) in the medium to long term.
          Overall, near-term costs and cash outflows, execution risks related to the extensive transformation program, and a limited track record of profitability growth constrain the ratings. In addition, the recent shareholder dispute, with the public ousting of the former CEO could result in changes in strategy. Although the day-to-day operations appear so far unaffected by the dispute, we cannot rule out potential effects in the future.
          The stable outlook reflects our view that ECI will continue to execute its transformation program, expanding organically, while maintaining an adjusted EBITDA margin of at least the current 7%. This should result in gradual deleveraging over the next 12-24 months. Specifically, we forecast adjusted debt to EBITDA at 4.0x-4.5x, FFO to debt at 18%-20%, and positive reported DCF that will go toward debt repayment over that period. 
          We could lower the ratings in the next 12-24 months if ECI's operational performance were to fall short of our base case, weakening its financial metrics. This could stem from softer economic conditions leading to a decline in consumer spending on discretionary goods, intense online and offline competition affecting ECI's top-line growth, or from setbacks or cost overruns related to the group's transformation plan. 
          We could also take a negative rating action if ECI's adjusted debt to EBITDA increases toward 5.0x and FFO to debt approached 12%, with no near-term improvement prospects, or if reported DCF approached zero. 
          We could consider a positive rating action in the next 12-24 months if ECI continued to demonstrate positive trends in like-for-like sales, advancement in e-commerce capabilities, and sustained improvement in profitability and cash generation. We consider a strong commitment to debt reduction, backed by financial policy consistent with a leverage reduction target, as a prerequisite for a higher rating. Specifically, we would expect debt to EBITDA to stay well below 4.0x, FFO to debt comfortably above 20%, and DCF to increase substantially and on a sustainable basis.