Sainsbury’s slides closer to junk

Standard & Poor’s has downgraded Sainsbury’s £1.98 billion of bond debt to the brink of junk after the supermarket chain announced the worst results in its 135-year history. While the downgrade to BBB- was expected, S&P surprised the market by leaving the name on negative outlook.

Fitch affirmed Sainsbury’s BBB rating, saying that bondholders should be reassured that the dividend has been cut by 50%. Fitch notes that the company expects to be broadly cashflow neutral in 2006, and cashflow positive thereafter.

But some analysts feel that Sainsbury’s recovery plans are optimistic. Rob Orman, consumer analyst at Royal Bank of Scotland, says that the business has yet to bottom out. “It will be a long time before things get better, and there is further trouble to come. The firm says that its distribution problems alone will take 18 months to fix,” he says. Orman believes there is a 70% chance the name will fall to junk before next May.

The best outcome for bondholders would be a takeover. Sainsbury’s unsecured bonds contain a change-of-control covenant which would see all bonds repaid at par if the firm were sold.

But the very fact that the change-of-control covenant exists makes a takeover less likely. Any prospective buyer would have to add an extra £2 billion onto the price of the deal – on top of around £5 billion for the equity alone – in order to cover the cost of repaying bonds. This would be the largest LBO deal in European history by some margin. Add to this concerns over the large pension deficit and competitive landscape, and Sainsbury’s looks like an unattractive buy.

Unfortunately for unsecured bondholders, secured lending is the most likely option for any future refinancing. Sainsbury’s is not heavily leveraged, but has plenty of security in the form of its stores, which can be pledged for bank finance.

This is more likely than a sale and leaseback of stores, as investors might be reluctant to rely on Sainsbury’s for tenant income. Sainsbury’s would also be unable to sell stores outright to Tesco or Wal-Mart, owing to competition law, and would take a large haircut – up to 30% – if it sold stores to a non-supermarket chain. But Sainsbury’s does not face any acute liquidity pressures, so the form of any future refinancing may be a moot point.