Fitch Affirms Coach's IDR at 'BBB'; Outlook Stable
OREANDA-NEWS. Fitch Ratings has affirmed the 'BBB' long-term Issuer Default Rating (IDR) for Coach, Inc. (Coach). The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
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 FY 2013 (ended June 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 2% 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, 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 $1.3 billion and adjusted debt to be modestly higher (due to rent expense associated with international expansion). Risks to the ratings include the inability for domestic comps to stabilize by mid-2016 and grow in the low single digits thereafter or a material deceleration in its international business.
North American Sales Decline
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 comparable store sales (comps) and net store closures. Comps at Kate Spade and Michael Kors, on the other hand, trended in the double digits during 2013-2014, yielding NA sales increases of $2 billion for the two companies over that period (note: includes apparel).
Coach's revenue trajectory caused NA EBITDA declines of around 19% to $1.27 billion in FY 2014 and around 27% to $930 million in FY 2015. 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).
FY 2016 as Inflection Point
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 will continue 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, and should cycle through these reductions in 2016. 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.
As a result of the above, FY 2016 is expected to represent an inflection point for Coach, as it anniversaries the significant reduction in promotional events while reaping the benefits of its other investments. Fitch anticipates a 4% NA comps decline (of 22% in FY 2015), somewhat worse than management guidance of a low single-digit decline, and flattish NA EBITDA (before corporate expense) at the low $900 million level. Comp store sales are expected to improve sequentially from -9.5% in in first quarter 2015 (1Q15) to flattish by 4Q15, vs. the company's guidance of positive 4Q comps.
On an annualized basis beginning FY 2017, Fitch expects positive low single-digit comps and continued reduction of square footage to yield modestly positive NA sales growth. Fitch assumes modest EBITDA margin expansion from trough FY 2015 levels; however, the fashion nature of Coach's assortment, coupled with its recent volatile history, could lead 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 (constant currency basis). In FY2015, despite increasing economic headwinds and a sales decline in 4Q, China continued its growth trajectory, becoming Coach's largest international market at $636 million, while Europe had the highest growth rate, albeit from a small base. Japan, Coach's second largest market at approximately $550 million in revenue, experienced a modest constant currency decline, due largely to a consumption tax increase in April 2014. Fitch expects low single-digit constant currency growth in FY 2016 international revenue as China and Europe continue to expand, but notes the company's reported results will be negatively impacted by the strong U.S. dollar. 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 projected 45%-50% decline in EBITDA from peak fiscal 2013 levels to fiscal 2016, credit metrics remain reasonable with LTM adjusted debt/EBITDAR leverage of 2.7x. Fitch expects leverage to remain in the mid-2x range over the next 24-26 months, with EBITDA growth in FY 2016 onwards being somewhat offset by increased capitalized rent from 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 to $400 million of FCF in each of the subsequent years based on annual capital spending of approximately $250 million.
--For FY 2016, Fitch expects flattish company revenues, before the full-year inclusion of the recently closed 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 after 2016, with continued expansion in Europe driving low single-digit company-wide annual revenue growth. International sales are expected to represent around 45% of Coach branded sales in FY 2019 vs. 40% in FY 2015.
--FY 2016 EBITDA is expected be flat at $1.08 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) and therefore low probability of the company finding incremental, material cost saves in the short term. Based on improving sales trends, EBITDA is expected to improve to $1.3 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.
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 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.
As of the end of FY 2015, Coach had $1.3 billion in cash and $234 million in short-term investments, of which nearly 60% is overseas. Coach has a $700 million unsecured domestic facility with a maturity date of March 18, 2020. As of June 27, 2015, 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.
The company also incurred $91 million in cash charges related to its expense management initiatives in fiscal 2015 and is expected to incur $26 million in after-tax cash charges in FY 2016. Note that the 2016 FCF estimate excludes an expected $125 million inflow from the sale of the company's existing headquarters.
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 term loan and notes at 'BBB'.
The Rating Outlook is Stable.