S&P affirms Bi-Lo's corporate credit rating following its purchase of Winn-Dixie, removes all ratings from CreditWatch with negative implications, says combined company's sales, earnings should grow moderately

Cindy Allen

NEW YORK , March 15, 2012 (press release) – Overview
-- Shareholders of Winn-Dixie Stores Inc. approved BI-LO LLC's offer to purchase the company and the transaction has subsequently closed. The purchase was partly funded with borrowings drawn from a new $700 million asset-based (ABL) revolving credit facility.
-- We are affirming the 'B' corporate credit rating on the U.S. supermarket chain and removing all ratings from CreditWatch with negative implications.
-- At the same time, we are revising the recovery rating on the company's $285 million senior secured second-lien notes to '5' from '4' and thereby lowering the issue-level rating to 'B-' from 'B'.
-- The stable outlook incorporates our expectation that the change in operating strategies at Winn-Dixie will not materially weaken operating performance in 2012 and the combined company will moderately grow sales and profits and enhance credit ratios accordingly.

Rating Action
On March 14, 2012, Standard & Poor's Ratings Services affirmed the 'B' corporate credit rating on the Greenville, S.C.-based BI-LO, LLC (BI-LO) and removed the ratings from CreditWatch with negative implications.

At the same time, we revised the recovery rating on the company's $285 million senior secured second- lien notes to '5' from '4' and consequently lowered the issue-level rating on the notes to 'B-' from 'B'. The '5' recovery rating indicates our expectation of modest (10% to 30%) recovery of principal in the event of default, and the notes are now rated one notch below the corporate credit rating. This action comes after the company closed on its purchase of the Jacksonville, Fla.-based Winn-Dixie Stores Inc. (Winn-Dixie).

Rationale
The recovery rating on the company's notes reflects our expectation of weaker recovery prospects in the event of a payment default for second-lien note holders, which is a result of the increased priority debt. The combined company now has the ability to borrow up to $700 million on its ABL revolving credit facility, which was previously $100 million. We increased our estimate of the company's enterprise value upon emergence of a default pursuant to the Winn-Dixie acquisition. The increase, however, did not completely compensate for the larger-sized revolving credit facility and therefore worsened the recovery prospects for second- lien note holders, in our view.

The rating reflects our view that the company's financial risk is "highly leveraged" under our criteria, and we anticipate moderate sales and profit gains leading to credit ratio enhancement. However, we do not expect to change our view of the company's financial risk profile over the next year. We also assess the company's business risk profile as "vulnerable," which incorporates the highly competitive nature of the industry, the likelihood of sustained elevated unemployment in the U.S., and the relatively weak operating metrics of the combined company compared with industry peers.

We anticipate that management will use similar operating strategies at Winn-Dixie that BI-LO has used over the past few years, which will entail managing in-store costs more acutely and then employing more competitive pricing strategies. We also expect remodeling activity will be considerably lower at Winn-Dixie. Althugh BI-LO's recent sales and performance trends have
been relatively strong compared with much of the industry, we do not assume that these strategies will have a meaningful effect in 2012. Nonetheless,Winn-Dixie's sales and operating trends have improved over the past three quarters, and we expect Winn-Dixie to maintain a similar sales trajectory over the next year. Our 2012 performance expectations of the combined company include:
-- Low-single-digit comparable-store sales at Winn-Dixie stores--near 2%.
-- Mid-single-digit comparable-store sales growth at BI-LO grocery stores.
-- No meaningful change in stores or square footage; thus, companywide revenue growth will be slightly higher than that of Winn-Dixie.
-- Relatively stable operating margins at BI-LO and slight expansion of margins at Winn-Dixie and at the company overall. We include in this forecast the switch to the first-in, first-out (FIFO) accounting method for cost of goods sold at Winn-Dixie.
-- If inventory accounting methods remained the same, there would be a slight operating margin contraction at Winn-Dixie and at the company overall.
-- Cost-cutting and management efforts would partly offset gross margin investments at Winn-Dixie.
-- We also anticipate some benefits from the reduction of duplicative functions, as a result of combining the two companies.
-- Thus, overall EBITDA growth will mostly be in line with revenue growth.
-- We also expect the company to reduce ABL borrowings with free cash flow.

With the increased debt to fund the transaction, our performance expectations for pro forma and expected credit ratios at the end of 2012 are outlined below:
-- We expect pro forma operating lease-adjusted leverage of 5.7x to improve to 5.3x at the end of 2012.
-- Pro forma adjusted EBITDA coverage of interest to be 2.2x, increasing to 2.5x for the year.
-- Funds from operations (FFO) to debt to improve from 14.5% to 15.9% over that period.

The pro forma leverage and coverage ratios are in line with indicative ratios of highly leveraged financial risk profiles, while the FFO to debt levels are commensurate with indicative ratios of "aggressive" financial risk profiles. However, we also view the company's financial policies as "very aggressive," which is an important factor in assessing the company financial risk profile.

BI-LO has grown sales better than most industry competitors over the past few years, which we believe is a result of pricing initiatives, the roll-out of its fuelperks! program, and relatively good market presence. More recently, Winn-Dixie has rolled out its fuelperks! program and has made technological investments that should help its inventory management, aiding its sales and operating performance in our view. This should continue in the near term. Moreover, better pricing strategies could lead to further sales gains. Therefore, we believe the combined company may have the opportunity to exceed our performance expectations with greater-than-anticipated sales growth. Conversely, the biggest threat to our performance expectations is that price competition may intensify in the industry as a result of sustained high unemployment and rising gasoline prices. Therefore, both BI-LO and Winn-Dixie will then not be able to pass along higher food costs to consumers, and there will be greater margin contraction than we expected, leading to lower profits.

Liquidity
We view BI-LO's liquidity as "adequate," and we expect its sources of liquidity to exceed uses over the next 12 to 24 months by a ratio of at least 1.2x. After the close of the transaction, we expect sources of liquidity to include some excess cash, expected available revolver borrowings of over $300 million, and funds from operations. Liquidity uses include capital spending and working capital needs. We also forecast the company will generate meaningful free cash flow, and, given expected capital spending levels, we believe that beginning in 2013, the company can convert between 25% and 35% of EBITDA to free cash flow

Relevant aspects of BI-LO's liquidity include:
-- We forecast cash sources to exceed cash uses by more than 1.2x over the next 12 months, and to remain above 1.0x over the next 24 months.
-- We forecast net sources to remain positive over the next 12 months, even if EBITDA declines 15%.
-- The company has no meaningful maintenance financial covenants.
-- Sound relationships with the banks in our view.

Recovery analysis
For a complete analysis, please see our recovery report, to be published as soon as possible following this report, on RatingsDirect.

Outlook
The outlook is stable. This incorporates our expectation that the company will improve credit metrics with moderate profit growth and debt reduction from free cash flow. We would consider a higher rating if management successfully implements its strategic operational initiatives at Winn-Dixie, BI-LO continues with is positive operating trends, and the combined company improves debt leverage to the mid-4x area and FFO to debt to approximately 18%. We forecast this would occur with about 15% EBITDA growth and debt reduction of $125 million. We believe such a scenario could occur in about two years. However, we would want to be sure that the company's financial policies and its private equity sponsor would be such that the company would maintain credit ratios appropriate for a higher rating.

Conversely, we would consider a lower rating if debt leverage was in the mid-6x area, which could occur with a 15% decline in EBITDA. This could in turn occur with only 1% sales growth and about 50 basis points of EBITDA margin contraction at the combined company.

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