June 6, 2017 / 1:21 PM / 2 months ago

Fitch Rates Coach's Credit Facility and Unsecured Notes 'BBB'

(The following statement was released by the rating agency) NEW YORK, June 06 (Fitch) Fitch Ratings has rated Coach Inc.'s new unsecured credit facility and $1,000 million of unsecured notes 'BBB'. The credit facility includes a $900 million revolving loan facility, an $800 million six-month term loan credit facility and a $300 million three-year term loan facility. The revolving loan facility, which expires May 30, 2022, will replace the company's existing $700 million revolving loan facility. Proceeds from the term loans and notes, along with excess cash, will be used to fund Coach's proposed $2.4 billion acquisition of Kate Spade & Company. Coach expects to use excess cash to repay the $800 million six-month term loan upon maturity. The proposed acquisition, which represents an EBITDA multiple of 9x on an LTM basis, is expected to close in Coach's first fiscal quarter of 2018, assuming regulatory approval. Coach's ratings are currently on Rating Watch Negative, and Fitch anticipates a one-notch downgrade of Coach's IDR to 'BBB-' upon completion of the transaction as proposed. The acquisition would cause Coach's leverage to increase from the current 2.6x level to 3.7x on a pro forma basis at closing and decline to around 3.3x at the end of FY 2018 upon the repayment of the $800 million six-month term loan. Leverage is expected to trend to under 3.0x over the following two years on EBITDA growth. The anticipated rating also reflects integration risk from potential changes to Kate Spade's growth strategies, and the addition of a young, rapidly grown brand to Coach's portfolio. A full list of ratings follows at the end of this release. KEY RATING DRIVERS Proposed Kate Spade Purchase Acquisition Kate Spade is a global specialty soft goods retailer that designs and markets women's, men's and children's accessories and apparel under the kate spade new york and Jack Spade brands. Kate Spade generated $1.4 billion in sales and $264 million in EBITDA, for a 19.2% margin, in the LTM ended April 1, 2017. While handbags and small leather goods drive approximately 70% of the company's sales, the company has recently sought to diversify its mix through product introductions in other accessories, apparel and home categories. Products are sold through wholly owned specialty retail and outlet stores and wholesale distribution at select specialty retail and upscale department stores, such as Nordstrom, Saks Fifth Avenue, Neiman Marcus and Bloomingdales. Approximately 75% of Kate Spade's revenue is generated in the direct-to-consumer segment, while the remaining 25% comes from the wholesale and licensing channels. Additionally, approximately 20% of revenues are generated online. Kate Spade grew brand revenues at a compound annual rate of nearly 40% from 2010 to 2015. Growth was predicated on square footage growth in the U.S., international expansion, and double-digit annual comps between 2010 and 2015. Comps slowed meaningfully to the mid-single digits in 2016 and turned negative 2.4% in first quarter of 2017 due to reduced promotions, weak tourist traffic caused by the stronger U.S. dollar and a general slowdown in luxury spend. Pro forma for the acquisition, Coach will generate almost $6 billion in sales and $1.4 billion in EBITDA. From a qualitative standpoint, Fitch views the addition of Kate Spade to Coach's portfolio as neutral to modestly negative given the rapid rise of the young brand that creates a higher risk of the brand falling out of favor and the targeted changes to the company's operating strategy through pullback of online flash sales. Coach expects to realize approximately $50 million of run-rate cost synergies within three years of acquisition close, which will be evenly split between cost of goods sold and SG&A. Fitch views these synergies as modest but reasonable relative to the combined EBITDA base (at around 4% of total EBITDA). Standalone Coach Coach's current ratings reflect the company'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 approximately 60% of total sales and EBITDA. Reported international sales growth has averaged approximately 4% 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 approximately 40% decline in consolidated EBITDA to $1.1 billion in FY 2015 and FY 2016 from $1.9 billion in FY 2013, coupled with the company's issuance of $900 million in senior unsecured debt 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. Coach's North American Sales Improving NA revenue, which has declined since FY 2013, appears to be stabilizing, with comps improving from -9.5% in 1Q 2016 to 3% in 3Q 2017. Comps are expected to be modestly positive in 4Q 2016 (around 2.5% for the full year) and positive low-single digits beginning FY 2018. NA EBITDA after corporate overhead has declined from $1.1 billion in FY 2013 (32% of sales) to $412 million in FY 2016 (17% of sales), and is expected to be in this range in FY 2017. 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 September 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 2017 and the company plans to end the year with over 700 remodeled locations (or about 70% of the total store base) globally versus 450 locations last year. 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 and FY 2017, 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. Comps and EBITDA in recent quarters have stabilized despite continued challenges for many mid-tier mall-based apparel and accessories retailers. 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 9% in FY 2016 (constant currency basis). Despite increasing economic headwinds, China has continued its growth trajectory, becoming Coach's largest international market in FY 2016 at $652 million, while Europe has had the highest growth rate, albeit from a small base. Japan, Coach's second largest international market at approximately $560 million in FY 2016 revenue, has seen positive mid-single digit constant currency growth in FY 2016 after experiencing a modest constant currency decline in FY 2015. Fitch expects annual sales growth beginning FY 2017 to trend in the mid-to-high single digits, predicated on mid-single-digit growth in China and significant square footage expansion in Europe. Stable Credit Metrics Despite a 42% decline in EBITDA from peak fiscal 2013 levels to FY 2016 levels, credit metrics remain reasonable with LTM adjusted debt/EBITDAR leverage of 2.6x. Fitch expects standalone leverage to remain in the 2.6x to 2.7x range over the next 24 to 26 months, with EBITDA growth in FY 2017 and onwards and the $293 million term loan repayment being somewhat offset by increased capitalized rent from the headquarters sale-leaseback and expansion in China and Europe. Assuming the Kate Spade acquisition closes, leverage is expected to be 3.7x at close on a pro forma basis and decline to 3.3x at end of FY 2018 following pay down of the expected $800 million six-month term loan. Leverage is expected to trend to under 3.0x two years post acquisition close on EBITDA growth. Standalone Coach FCF is expected to be about $120 million in FY 2017 and increase to $350 million to $400 million annually over the next two to three years as remodelling activity moderates and capex declines to about $200 million. FCF assuming the transaction closes in FY 2018 is expected to be around $200 million in FY 2018 and increase to around $400 million annually thereafter driven by EBITDA growth. KEY ASSUMPTIONS --Fitch expects reported sales growth to be flattish in FY 2017 for standalone Coach. NA Coach brand sales are expected to be up modestly and international sales down modestly. NA comps are expected to be around 2.5% in FY 2017 and positive low-single digits thereafter, with continued expansion in Europe driving low- to mid-single digit company-wide annual revenue growth. Assuming the acquisition closes in the beginning of FY 2018, revenues are expected to grow almost 40% to reflect the inclusion of Kate Spade. --FY 2017 standalone EBITDA is expected to up low-single digits at $1.1 billion, driven by improvement in NA comp stores sales and improve to $1.2 billion by FY 2019/FY 2020. Including Kate Spade, EBITDA is expected to be $1.4 billion in FY 2018 and improve to $1.6 billion thereafter, including the around $50 million of expected run-rate synergies. --Standalone FCF is expected to be about $120 million in FY 2017 and increase to $350 million to $400 million annually over the next two to three years on moderating capex. FCF including Kate Spade is expected to be around $200 million in FY 2018 and increase to around $400 million annually thereafter driven by EBITDA growth. --Adjusted leverage on a standalone basis is expected to remain in the 2.6x to 2.7x range over the next 24 to 26 months driven by EBITDA growth and $293 million term loan repayment being somewhat offset by increased capitalized rent from the headquarters sale-leaseback and expansion in China and Europe. Adjusted leverage including Kate Spade is expected to be 3.7x at close on a pro forma basis and decline to 3.3x at end of FY 2018 following pay down of the expected $800 million six-month term loan. Leverage is expected to trend to under 3.0x two years post acquisition close on EBITDA growth. 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 April 1, 2017, Coach had $1.9 billion in cash and short-term investments, of which approximately 70% was overseas. Coach has a $900 million unsecured domestic facility with a maturity date of May 30, 2022. 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 $390 million and $365 million FY 2014 and FY 2015, respectively, on significant EBITDA declines and spending on the new headquarters. FCF was negative $12 million in FY 2016 driven by $146 million capex spend on the new headquarters and higher interest costs. Coach sold its interest in its headquarters in August 2016 and subsequently paid down its $293 million senior unsecured term loan. FULL LIST OF RATING ACTIONS Fitch currently rates Coach, Inc. as follows: --Long-Term IDR 'BBB'; --Senior unsecured bank credit facility 'BBB'; --Senior unsecured notes 'BBB'. The Rating Watch is Negative. Contact: Primary Analyst David Silverman, CFA Senior Director +1-212-908-0840 Fitch Ratings, Inc. 33 Whitehall St. New York, NY 10004 Secondary Analyst JJ Boparai Associate Director +1-212-908-0543 Committee Chairperson Michael Weaver Managing Director +1-212-368-3156 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Date of Relevant Rating Committee: May 8, 2017 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to add back non-cash stock based compensation and exclude restructuring charges. 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