S&P: Netherlands-Based Consumer Plastics Producer Keter Group B. V. Assigned 'B' Rating On Acquisition
At the same time, we assigned a 'B' issue rating to the proposed €690 million term loan B due 2023, with a recovery rating of '3', reflecting our expectation of meaningful (50%-70%) recovery in the event of a payment default.
Keter enjoys market-leading positions in its niche segment of resin-based consumer products for household, hardware, outdoor, and leisure use and recorded revenues of €777.3 million (pro forma the combination of the Israeli operations with outside operations) and reported earnings of €132.7 million in 2015. The consumer plastics industry is largely fragmented--most players have a concentrated geographic presence, narrow product offering, and relatively small revenue base. We consider that this supports Keter's ability to defend its market position in the medium term. The group is present in over 100 markets worldwide and generates most of its revenue in North America, and Western and Eastern Europe. We see the group's presence in the European and North American markets as positive because of their relatively large populations and because GDP per capita there is higher than that seen in emerging markets. That said, growth prospects will be determined by the company's ability to produce competitively priced products that appeal to consumer tastes and preferences in the relevant regions.
The group's product offering includes storage boxes, garbage bins, dining sets, and outdoor sheds and are marketed in major do-it-yourself and mass retailers, as well as online. Most of these products are traditionally prepared from other materials such as wood, melamine, and metal, but the group's strategy is to drive sales volumes by developing alternative products which are reasonably priced and of comparable quality.
Keter enjoys strong relationships with major retailers in its core markets and collaborates with them on new product designs and prototypes. This helps to optimally position its products and fuels future earnings stability and growth. The group has established a reputation for leading innovation across various product categories and possesses the required manufacturing capacity to meet any potential future increase in demand. Although we generally consider purchases of home furnishing-related products as largely discretionary in nature, we also see that the varied price points of Keter's products may help mitigate volatility in demand across economic cycles as resin-based products present an attractive alternative to more-expensive traditional materials.
Keter derives most of its revenues from its branded portfolio, which includes Jardin, Keter, Curver, US Leisure, and Allibert. We view this positively in our analysis as we consider that its established brand awareness among both retailers and consumers enables the group to differentiate its products in the retail space. These proprietary brands also provide a platform for marketing its products and support further innovation initiatives--consumers are more likely to try new products if they have had a positive experience with a similarly branded product in another category.
Keter's ability to maintain a steady pipeline of new products is also seen as crucial to the operating performance of the group. The group has over 15 manufacturing sites in nine countries and has a track record of converting new product launches into sustainable sales volumes in recent years. Investment in research and development is integral and as such management has allocated the required resources to capital expenditure and recruitment of top engineering talent to support product development.
Keter possesses a strong portfolio of intellectual property (IP), which includes plastic injection molds, as well as domain names, registered patents, designs, and trademarks. We view these as a key barrier to entry for new players. In our opinion, Keter's ability to successfully defend any infringements on the group's IP is vital in maintaining its market position.
We expect the group to incrementally enhance its operating performance as it looks to streamline its production facilities and rationalize the product offering under the guidance of its new owners. Reported profitability has exhibited some resilience historically and we posit that, given management's proposals for overhead cost management, more modern efficient machinery, and improved procurement processes, the group should be able to maintain reported EBITDA margins above 15% over the next three years. We view the exposure to volatile raw material prices, in particular polypropylene, as a significant risk as it has influenced gross margins over the past two years. Continued product innovation, supported by the brand portfolio, enables Keter to pass on some of these price movements to consumers.
We consider that the group's strategy of continuing to offer inexpensive resin-based alternatives to consumers should support sales volume growth. That said, consumer tastes and preferences are not homogenous across different regions, in our view. In the key North American growth market, we also note that Keter is smaller than regional peers in most product categories. This is most pronounced in the indoor storage and houseware segments, where Keter's current market share is less than 5%.
Despite Keter's strong market presence and breadth in product offering, our assessment of its business risk as fair is ultimately constrained by our view that the group's operations are focused on a somewhat niche industry and are considerably exposed to exogenous factors such as consumer tastes, disposable income growth, and the relative price of substitutes across product categories.
Following the acquisition, private equity firm BC Partners and Canadian pension manager PSP Investments will own a majority of Keter and the previous owners, the Sagol family, will maintain a minority interest. We consider the new owners to be financial sponsors; as such, we assess financial policy as FS-6 and the financial risk profile as highly leveraged. This is supported by our S&P Global Ratings-adjusted debt-to-EBITDA of 5.0x-6.0x and EBITDA interest coverage at the upper end of the 2.5x-3.0x range over the next 12-18 months. Our estimate of debt includes the proposed €690 million term loan B, €150 million of payment-in-kind (PIK) toggle notes, and operating lease and pension adjustments of over €25 million in our calculations. Given the financial sponsor ownership, we do not net-off any cash balances that are held by the group. In our base-case projections, we assume the term loan B is priced at around EURIBOR plus 4.25% with a floor of 1.0% and matures in seven years. We understand that the PIK toggle notes will be issued outside the restricted group and downstreamed as equity, but it is captured in our calculations as we view the operating activities of Keter and its subsidiaries as the main source of cash flow generation to service the debt obligations. We understand that these notes will accrue interest at a rate of 11.5% until the reported net senior secured leverage falls below 3.5x, at which point it will pay cash with a 11.0% coupon provided there is no event of default.
We expect revenue growth to be fueled by increased sales in core markets including North America, Eastern Europe, and France. Increased sales volumes is likely to be recorded across all product categories, but houseware, indoor storage, and outdoor furniture are expected to account for the highest proportion of recorded value as new innovative products are brought to market. We anticipate that Keter will renew its focus on cost management, efficiency improvement, and further investment in modernizing the manufacturing equipment across the group's operations. This focus will help the group to improve its profitability metrics and we forecast adjusted EBITDA to be approximately €155 million-€165 million in 2016, rising to €175 million-€185 million in 2017.
In our base case, we assume: Revenue growth of 5%-10% per year over the next two years, reflecting robust volume growth in North America and the U. K. and a rebound in the difficult DACH region (Germany, Austria, and Switzerland). This is supported by management's recent organizational restructuring, which demonstrated a strong focus on driving sales across all product categories and markets, supported by its strong IP portfolio and continued product innovation. We expect reported EBITDA margins to improve slightly more, based on enhanced gross profit margins as polypropylene prices fall further in 2016. We expect a slight reduction and stabilization of reported margins to 17%-20% thereafter, based on a recovery in polypropylene prices and mitigated by management's enhanced procurement practices and raw materials mix. We also expect management to continue its cost reduction initiatives which may include optimizing the number of manufacturing sites and further streamlining the logistics activity. Modest increase in working capital requirements driven by sales growth and offset by careful management of the cash conversion cycle. We expect capital expenditure of 4%-8% of sales over our forecast period and that maintenance capex will account for approximately 40%-50% of the total. We are assuming bolt-on acquisitions of approximately €10 million-€25 million a year, and that these will help to stimulate earnings growth. We assume that there will be no dividend distribution. Based on these assumptions, we arrive at the following credit measures: Revenues of €825 million-€850 million in 2016 rising to €870 million-€900 million in 2017.Stable operating performance, resulting in adjusted EBITDA margins of 18%-21% in 2016 and 2017.Adjusted debt to EBITDA of 5.0x-6.0x in 2016 and 2017.Forecast adjusted EBITDA interest coverage of 2.5x-3.0x. The stable outlook reflects our views that Keter is likely to enjoy healthy growth rates in its revenue base, supported by its strong brand portfolio and continued market penetration as it introduces innovative products. We forecast that the group will maintain adjusted EBITDA margins of 18%-21% over the next three years, supported by management's ongoing operational efficiency projects and improved procurement processes to mitigate any volatility in raw material prices, as well as labor and energy costs. As a result, we expect Keter to enjoy EBITDA interest coverage of above 2.5x and generate healthy free operating cash flows due to the prudent management of working capital seasonality, even if core leverage metrics were to remain above 5.0x over the next three years.
We could lower the ratings if Keter fails to generate positive free operating cash flow, which would constrain the group's liquidity and increase the risk of future refinancing. We will also closely monitor the EBITDA interest coverage--if this metric weakens to 2.0x or below, we could also lower the rating. In our view, the most likely causes of such failures would be a significant reduction in sales volumes as a result of a major operational disruption or a substantial reduction in consumer demand due to changing tastes and preferences.
We would only raise the rating if we saw stronger leverage and interest coverage metrics on a sustainable basis, given the financial sponsor ownership after the transaction. Additional debt-financed acquisitions are highly likely, given that the owners will continue to seek to create value and consolidate in the industry, in order to solidify its leading market position. That said, we could raise our rating should adjusted debt/EBITDA remain below 5.0x while EBITDA interest coverage rises comfortably above 3.0x over the next three years, supported by positive free operating cash flow.