Woolworths Limited (ASX: WOW) has been handed another credit outlook downgrade from one of the world's leading ratings agencies.
Following a less-than-ideal first quarter trading update and a shock half-year profit guidance reduction, Woolworths' shareholders (myself included) have already suffered through numerous analyst price target downgrades and a falling share price. The average price target of the five prominent investment banks on Woolies dropped this week and is now $24.07.
However, leading global credit rating agencies have also moved to lower their all-important ratings on the supermarket giant. Last week, Standard & Poor's said Woolworths' outlook was now "negative" — down from "stable". The company did, however, affirm its 'BBB+/A-2' rating.
The 'BBB+' component is the long-term creditworthiness rating and is S&P's fourth highest. The 'A-2' is the short-term creditworthiness rating and is the second-highest rating. It suggests the company rated could be, "more susceptible to the adverse effects of changes in circumstances and economic conditions," according to S&P's website.
Last week, S&P credit analyst, Paul Draffin, said, "The outlook revision reflects our view that Woolworths' forecast profit decline, due to accelerated price and service investment in the core supermarket operations, and challenging operating conditions in the group's nonfood businesses, could pressure the group's financial risk profile beyond tolerances for the 'BBB+' rating in the next 1-2 years."
Yesterday evening Moody's followed suit. It affirmed Woolworths' credit rating but downgraded its outlook to "negative" citing weak first quarter sales, a lack of leadership and the shock half-year profit reduction as catalysts.
On 29 October, Woolworths forecast its half-year profit to fall between 28% and 35% as it ramps up investment to improve operations in its Food and Home Improvement businesses. CEO Grant O'Brien has resigned and a new CEO has yet to be appointed.
Buy, Hold or Sell
Woolworths is under pressure from Wesfarmers Ltd's (ASX: WES) Coles and Aldi to lower its prices within the Food, Liquor and Petrol business – which accounts for 88% of group EBIT (earnings before interest and tax).
When interpreting credit ratings (as opposed to stock analyst price targets), it's important to remember that in the event of liquidation, Woolworths' debt investors (creditors) rank above stockholders to recoup losses (like a bank would if you defaulted on a mortgage). Credit agencies may require Woolworths' board to cut its dividend or sell assets to uphold particular ratings.
Moreover, credit ratings are important because they'll influence the future price of debt on Woolworths' balance sheet.
Therefore, as we alluded to here while Woolies looks cheap using conventional valuation metrics, it's important to be cognisant of the downside risks before buying shares for your portfolio.
