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Wal-Mart

NEW YORK CITY—The pace of negative ratings activity for retailers has slowed as 2009 has progressed, Fitch Ratings notes in a special report: The Retail Register, released last week. Among the retailers whose debt is rated by Fitch, there were no ratings changes during the second quarter; three outlooks were changed in a negative direction and two were changed in a positive direction. During the first quarter, Fitch downgraded two retailers, changed the outlook for one to negative and had no positive actions.

“Despite the challenging sales environment, many companies across Fitch’s US retail coverage have been managing inventory positions well. Gross margins have rebounded for those companies in the discretionary categories that were hit particularly hard during the 2008 holiday period,” according to Fitch’s report. “This, combined with strong cash flow management and the resolution of liquidity issues for several companies, has resulted in an improved overall credit outlook as evidenced by the lower level of negative rating movement in recent months.”

For the discount retailers such as Wal-Mart, Costco and Target, food “continues to be a major driver of store traffic,” Fitch notes, and these retailers “are expected to continue to focus on capturing market share through broader food offerings, an attractive value message and further store base expansion, albeit at a slower rate than historically.”

“Liquidity is strong for the discounters as a result of solid cash flow generation,” Fitch reports. “Lower capital expenditures are expected to help generate additional cash in excess of $1 billion each for Wal-Mart and Target. Adding to their financial flexibility, the discounters have a high percentage of real estate ownership.”

Supermarkets will continue to be pressured by a number of factors, according to Fitch, including the trade down to discount formats and reduced discretionary purchases. They find themselves in a “highly competitive operating environment as many non-traditional grocery retailers, such as discounters, warehouse clubs, drugstores and dollar stores…continue to grow their stores bases [and] have increased their food offerings to drive shopping frequency.”

Still, “cash flow generation and a demonstrated ability to access the capital markets have resulted in strong liquidity for the three large US supermarket companies rated by Fitch,” namely Kroger, Safeway and Supervalu. “Cash flow generation is anticipated to continue to be strong for the supermarket operators and increase for some large operators that are cutting capital expenditures.”

The drugstore chains, meanwhile, “are expected to benefit from their mainly nondiscretionary merchandise offering despite the challenging environment,” Fitch notes. Of the three largest—CVS Caremark, Rite Aid and Walgreen—Rite Aid “has been particularly challenged in improving its pharmacy comparable store sales and its share of the prescription market as it remains capital-constrained. As a result, its operating metrics significantly lag those of CVS Caremark and Walgreen, and Fitch views pharmacy same-store sales improvements as a key factor in strengthening Rite Aid’s Ebitda margin.”

Same-store sales for department stores are expected “to be considerably weak through 2009 and credit metrics to weaken from 2008 levels,” says Fitch. It warns that while there have already been a number of bankruptcies among department store operators, “the pace could accelerate in a prolonged downturn.” Fitch also notes that “department store square footage is expected to contract as retailers close underperforming stores.”

And among specialty retailers—which includes electronics, home improvement, office supplies and automotive parts retailers, among others—is mixed. On the one hand, demand for consumer electronics “is expected to remain weak as much of the new product adoption has already taken place and incremental price declines will not be adequate to stimulate demand,” says Fitch. On the other hand, in the auto parts subsector, “AutoZone is benefiting from the auto maintenance aspect of its business combined with the current economic climate, which has motivated consumers to fix their vehicles.”

While the retail industry is hardly out of the woods, if the trend Fitch cites continues, it could be early signs of some good news for investors. In the meantime, the less discretionary a retailers’ wares, the better. Although retail assets represent roughly half the net lease property market—and certainly there are net lease retail assets trading—one net lease industry veteran recently observed that on the debt side, “it’s still tough to get a deal done when the tenant depends on cash registers.”