Fitch Affirms Coach's IDR at 'BBB'; Outlook Stable
Coach's operating results have improved as anticipated in fiscal 2016 (ends July 2), with North American comparable store sales (comps) trending from -9.5% in 1Q to flat in 3Q and Fitch anticipates modestly positive comps beginning 4Q 2016. EBITDA, which Fitch forecasts will trough at $1.1 billion in 2016, is expected to improve to $1.2 billion over the next 24-36 months. The sale of Coach's interest in its headquarters is a leverage-neutral event as the term loan pay down is mitigated by $360 million in additional Fitch-defined debt due to capitalization of incremental rent from the sale-leaseback of the headquarters ($45 million in annual rent for the first five years capitalized at 8x). After the term loan pay down, the sale provides the company with approximately $400 million additional liquidity which could be used to fund current operations, M&A, or share buybacks.
KEY RATING DRIVERS
The ratings reflect Coach's strong position in the premium bag and small leather goods market as well as reasonable credit metrics despite recent EBITDA headwinds. Since fiscal year (FY) 2013, the company has seen significant sales declines in its North American (NA) business, now representing 60% of total sales and EBITDA. Reported international sales growth has averaged approximately 2.5% since FY 2013, as growth in China and Coach's entry in Europe has been mitigated by a decline in Japan and currency headwinds.
The 30% decline in consolidated EBITDA to $1.1 billion in FY 2015 and FY 2016 (expected) from $1.9 billion in FY 2013, coupled with the company's issuance of $600 million of senior unsecured notes and $300 million term loan in March 2015 to support the purchase and construction of its new headquarters, has resulted in adjusted leverage increasing to 2.6x from 1.4x at the end of FY 2014, in line with Fitch's expectations. Leverage is expected to remain reasonable in the 2.5x-2.7x range over the next three years, as Fitch expects consolidated EBITDA to be $1.1 billion to $1.2 billion and adjusted debt to rise modestly on increased international and headquarters rent, mitigated by the pay down of the company's term loan. Risks to the ratings include the inability for domestic comps to grow in the low single digits beginning FY 2017 or a material deceleration in its international business.
North American Sales Declines Moderating
NA revenue, which has declined since FY 2013, appears to be stabilizing, with comps improving from -9.5% in 1Q 2016 to flat in 3Q 2016. Comps are expected to be modestly positive in 4Q 2016 (around -3% for the full year) and positive low-single digits beginning FY 2017.
Beginning FY 2014, NA revenue declines have stemmed from weak new-product acceptance coupled with a reduction in promotional events as the company aims to elevate price/quality perception and improve full-priced selling. Competition in the entry-level luxury handbag/accessories sector, meanwhile, has increased. Coach revenue fell approximately 10% to $3.1 billion in FY 2014 and 20% to $2.5 billion in FY 2015, on both negative comps and net store closures.
Coach's revenue trajectory caused NA EBITDA declines of around 19% and 27% to $1.27 billion and $930 million in FY 2014 and 2015, respectively, with a modest decline to the $900 million level expected in FY 2016. During this time, EBITDA margin contracted approximately 800 basis points (bps) to around 37% before unallocated corporate expense due to gross margin declines and fixed-cost deleverage on flattish SG&A expense. NA EBITDA after corporate overhead has declined from $1.1 billion in FY 2013 (32% of sales) to $430 million in FY 2015 (18% of sales), and is expected to be in this range in FY 2016.
Coach has undertaken a number of actions to reposition the brand further upscale, with the intention to increase the penetration of full-price sales and higher price point purchases. First, Stuart Vevers, the company's creative director who joined in June 2013, has evolved the product mix with a view toward an innovative, design-led and editorial offering. Second, Coach has invested in remodels of owned stores and department store presentations, yielding positive sales results. The remodels have continued in FY 2016, and the company plans to end the year with around 40% of the store base in the updated layout. Third, Coach has restructured its promotional cadence by reducing the amount of periodic sale events. Finally, Coach has refocused its marketing efforts away from price point and event messaging to a product-focused platform across e-mail, social media, and fashion industry activity.
The combination of the above have yielded stabilization in Coach's operating performance in FY 2016, improving Fitch's confidence in its projections of positive annual comps beginning 2017. Coupled with modest declines in square footage, Fitch expects modestly positive NA sales growth annually. Fitch assumes slight EBITDA margin expansion from trough FY 2015-FY 2016 levels; however, the fashion nature of Coach's assortment, coupled with its recent volatile history, could lead to either to material downside or upside risk to our expectations.
International Sales Stability
International sales, which represent approximately 40% of revenue, have been less volatile, with a 4% increase in FY 2015 and around 7% expected in FY 2016 (constant currency basis). Despite increasing economic headwinds, China has continued its growth trajectory, becoming Coach's largest international market in FY 2015 at $636 million, while Europe has had the highest growth rate, albeit from a small base. Japan, Coach's second largest international market at approximately $550 million in FY 2015 revenue, has seen positive mid-single digit constant currency growth in FY 2016 after experiencing a modest constant currency decline in FY 2015. Annual sales growth beginning FY 2017 is expected to trend in the mid-to-high single digits, predicated on mid-single-digit growth in China and significant square footage expansion in Europe.
Reasonable Credit Metrics
Despite a 40%-45% decline in EBITDA from peak fiscal 2013 levels to projected fiscal 2016 levels, credit metrics remain reasonable with latest 12 months (LTM) adjusted debt/EBITDAR leverage of 2.7x. Fitch expects leverage to remain in the 2.5x-2.7x range over the next 24-26 months, with EBITDA growth in FY 2017 onwards and the term loan repayment being somewhat offset by increased capitalized rent from the headquarters sale-leaseback and expansion in China and Europe.
While free cash flow (FCF; after dividends) is expected to be an outflow of approximately $300 million in FY 2016 due to headquarters and store remodel spending, the company should generate $300 million to $400 million of FCF in each of the subsequent years based on annual capital spending of approximately $250 million.
KEY ASSUMPTIONS
--For FY 2016, Fitch expects flattish constant currency company revenues (modestly negative on a reported basis), before the full-year inclusion of the Stuart Weitzman acquisition, which should add approximately $330 million or 7% to sales. NA Coach brand sales are expected to be slightly down with international sales up modestly on continued growth in China and Europe. NA comps are expected to be up low single digits beginning FY 2017, with continued expansion in Europe driving low - to mid-single digit company-wide annual revenue growth. International sales are expected to represent around 45% of Coach branded sales in FY 2019 versus 40% in FY 2016.
--FY 2016 EBITDA is expected to be flat versus FY 2015 at $1.06 billion from continued negative NA comp store sales, offset by approximately $35 million from Stuart Weitzman. Fitch expects the company to show its fourth year of flattish SG&A spending (before the impact of the Stuart Weitzman acquisition) on cost reduction efforts but expects SG&A to increase in line with revenue growth beginning 2016, before the impact of additional headquarters rent. Based on improving sales trends but mitigated by $45 million in incremental annual rent beginning 2017, EBITDA is expected to improve to $1.2 billion over FY 2017-2019.
--FCF is expected to be an outflow of $300 million after common dividends of $375 million in FY 2016, due to increased spending on the company's new headquarters and store remodels. FCF is expected to turn positive $300 million in fiscal 2017 and trend to the $400 million level by 2019 due to improved EBITDA and lower capex spend.
--Adjusted leverage is expected to remain in the mid-2x range.
RATING SENSITIVITIES
A positive rating action would result from Coach's core NA comparable store sales growing in line with or better than the low - to mid-single digit growth which Fitch expects for the domestic luxury space, and total EBITDA improving to the $1.5 billion to $1.6 billion range, driving leverage to the low 2x range.
A negative rating action could result from worse than expected top-line, profitability and cash flow trends driven by the inability to stabilize its market share in the low - to mid-tier luxury market; a slowdown in the momentum of Coach's international business; and/or a sustained increase in leverage above the mid-2x range.
LIQUIDITY
As of March 26, 2016, Coach had $1.3 billion in cash and short-term investments, of which approximately 70% was overseas. Coach has a $700 million unsecured domestic facility with a maturity date of March 18, 2020. As of March 26, 2016, Coach had no borrowings under this facility.
Historically, Coach has generated strong FCF (after dividends) of $700 million to $800 million between FY 2011 through FY 2013. However, FCF dropped to approximately $300 million in FY 2014 given a $350 million decline in EBITDA and $90 million related to Coach's new headquarters. FCF in fiscal 2015 was about $230 million on a $470 million further EBITDA decline mitigated by lower cash taxes and working capital reduction, and $145 total million spending on the new headquarters.
As a result of continued EBITDA headwinds and a final year of headquarters investment, FCF is expected to decline to negative $300 million in FY 2016 but return to positive $300 million in FY 2017 as EBITDA stabilizes and capex moderates.
The total cost of headquarters construction is expected to total $750 million through FY 2017, of which $380 million of the remaining $395 million will be incurred in 2016. In addition, capex (excluding headquarters) is expected to accelerate to approximately $300 million in FY 2016 from an average of $200 million annually the prior four years due to store remodels, moderating to the $250 million level annually thereafter.
FULL LIST OF RATING ACTIONS
Fitch affirms Coach's ratings as follows:
--Long-Term IDR at 'BBB';
--Senior unsecured bank credit facility at 'BBB';
--Senior unsecured notes at 'BBB'.
In addition, Fitch has withdrawn the rating on the company's senior unsecured term loan.
The Rating Outlook is Stable.
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