Fitch Ratings retains a cautious credit outlook for the UK retail sector despite the actions many companies are taking to preserve the strength of their balance sheets. These actions, which include asset sales and dividend reductions, will help to moderate, though not eliminate, the credit downside for the sector over the next 12 months.

Fitch expects weak retail sales in the UK will persist into 2009. The British Retail Consortium reported in September 2008 that like-for-like (LFL) sales were negative for five of the previous six months. This trend will continue and will be paired with a more promotional posture and growing cost pressures, implying additional stress on margins. Cost pressures for UK retailers will be exacerbated over the next year by higher inflation in developing economies and the depreciating sterling (if not hedged), raising the cost of importing merchandise. Moreover, most UK retailers are not as geographically diversified as their peers in continental Europe, leaving them highly dependent on the challenging UK market.

Fitch believes consumers will continue to shift away from sellers of discretionary items and toward discounters. Among non-food retailers, year-to-date LFL sales within the UK were down 4.8% at home improvement retailer Kingfisher, down 7-12% at consumer electronics chain DSG International, and down 7.3% at apparel retailer Next (UK and Ireland). At the same time, recent statistics from TNS Worldpanel released in September 2008 confirm that food sales volumes are static and that shoppers are trading down to discounters. This has benefited Asda, Aldi, Iceland and Morrisons, while Tesco, Sainsbury's and Waitrose have seen limited market share contraction.

"Despite these trends, the credit outlook for the sector is not uniformly negative," says Philip Zahn, Senior Director in Fitch's European retail and consumer products group.

The outlook for food retailers is stable, demonstrated by stable rating outlooks on Tesco and Sainsbury. Conversely, the outlook for non-food retailers is generally negative. Fitch has a stable rating outlook on Next as the rating still has headroom, but has negative outlooks on Kingfisher, DSG International, and food/apparel chain Marks & Spencer. And among the highly leveraged retailers, while trading performance varies by segment, the specialty apparel retailers face the ongoing risk of unanticipated changes in customer preferences.

Appropriately, many retailers are taking a more conservative approach to managing their balance sheets in an effort to reduce their financial risk at a time of heightened operating risks. These efforts include asset sales as well as reductions in capital expenditures, share repurchases and dividends. Notably, Kingfisher announced the sale of its Italian operation for EUR560m, with the proceeds to be used for net debt reduction. Kingfisher has also cut its capital expenditures and, together with DSG, cut its dividend payout. Other retailers, including Next, have reduced or suspended their share repurchase activity.

Fitch believes these efforts will help to underpin the sector's credit profile, suggesting only moderate rating downside over the next 12 months. This downside may be more pronounced for lower-rated credits which face the additional challenge of tight credit market conditions and higher borrowing costs, to the extent they have near-term maturities. Future rating activity will be driven both by the extent of the current consumer and credit downturns and the degree to which managements continue to take mitigating actions to strengthen their balance sheets and cash flow. A deeper downturn, or one that stretches further into 2009, could lead to more negative actions.