By Kate Holton
LONDON (Reuters) - Tesco (L:TSCO) could see its debt downgraded to "junk" status unless it outlines plans to cut borrowing and improve trading, rating agency Moody's said, raising the prospect of higher financing costs for Britain's biggest grocer.
Tesco, already facing a severe slowdown in sales in its stores, said last month it had uncovered what has become a 263 million pound ($420 million) accounting hole, resulting in the suspension of eight senior members of staff and a Serious Fraud Office investigation.
Moody's has already cut the supermarket group to one notch above junk, Baa3, and last week also put it on review for a further downgrade after first-half results showed the pension deficit and net debt growing, while trading profits slumped.
The agency urged the group to lay out its plans or face further cuts -- a warning to newly appointed Tesco Chief Executive Dave Lewis who said last week investors should not expect a big strategy announcement.
"We expect to have a much better idea of the management's strategy within three months," Sven Reinke, the agency's lead analyst on Tesco, told Reuters.
"There are a few big decisions to make -- their strategy to turn around operations, what happens to the final dividend, the speculation about possible disposals and capital measures. Those things can't just happen without anyone noticing so we would expect a material announcement at some stage."
The prospect of a downgrade to non-investment grade, or junk, would mark a fall from grace for Britain's biggest private employer, a staple of British pension funds which was rated A1 by Moody's in 2008.
It could also prompt many investors to sell, as some funds cannot hold debt rated below investment grade.
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Tesco does not face any short-term liquidity issues, and analysts point to significant spare cash and undrawn bank facilities at its disposal. But in the first half, interest costs amounted to almost 80 percent of its operating profit.
Its net debt stands at 7.5 billion pounds ($12 billion), with long-term liabilities of 16.5 billion pounds. It faces peak repayments in 2016 and 2017, when around a fifth of its debt matures.
In order for Tesco to keep its investment grade rating Moody's wants to see a plan that would bring the group's adjusted gross debt to core earnings down towards 4.5 times over the next 12 to 24 months.
On Moody's calculations the ratio currently stands at 5.4. Thomson Reuters calculates the industry average for net debt to core earnings is close to 3.7, compared to 5.7 for Tesco.
With trading at its home market deteriorating at an alarming rate, the group has said it is reviewing all options to raise cash and would rather cut costs and sell assets before considering asking shareholders for a rights issue.
It has already cut the interim dividend by 75 percent and is expected to take a similar approach to the final payout.
Tesco Finance Director Alan Stewart, in the job for just over a month, told analysts last week he understood the need to stay on an investment grade rating but said his priority was to find the right strategy and shape of the group.
"In terms of commitment (to investment grade), you're asking me slightly early in the process for me to give that," he said. "I do understand the importance of a BBB or an investment grade rating. We... will continue to engage with the rating agencies."
Sector bankers warned that Tesco would be loathe to be downgraded, but said it would take at least six months for it to begin selling off unwanted assets -- such as the international operations or its data analytics firm Dunnhumby.
"While it might be unrealistic to expect Tesco to execute any disposals within the next three months, we do expect a credible strategy to emerge, and we will assess its likelihood of success," Reinke said.
Both Fitch and Standard & Poor's have also downgraded Tesco to one notch above junk.
(Additional reporting by Anjuli Davies and Neil Maidment; editing by Clara Ferreira Marques)