December 22, 2017 / 6:38 PM / 3 months ago

Fitch Downgrades GNC to 'C' on Distressed Debt Exchange Announcement

(The following statement was released by the rating agency) NEW YORK, December 22 (Fitch) Fitch Ratings has downgraded GNC Holdings, Inc.'s Issuer Default Rating (IDR) to 'C' from 'B-' following the company's announcement that it will be exchanging approximately $99 million of its $288 million of convertible notes due August 2020 for approximately 14.6 million shares (approximately 17% of pro forma share count or around $55 million in value), given Fitch's view that this represents a distressed debt exchange (DDE). Per Fitch's criteria, we would downgrade the IDR to Restricted Default (RD) upon the completion of the exchange. The IDR may subsequently be upgraded reflecting the post-DDE credit profile. The existing senior secured credit facility is not affected by the exchange; however, Fitch's 'B+/RR2' rating on the facility has been placed on Negative Rating Watch given the possibility that following the DDE, GNC's IDR may be upgraded to a level below the prior 'B-'. A full list of rating actions follows at the end of this release. While GNC's announced exchange would modestly reduce the company's total debt burden, it also highlights GNC's challenges in addressing upcoming maturities after recent operating declines and the December 2017 withdrawal of its proposed credit facility refinancing. Fitch remains concerned about the company's ability to address upcoming maturities ($300 million revolver due September 2018 and $1.1 billion term loan maturity in March 2019). The inability of GNC to successfully address its upcoming maturities in a timely fashion would be a rating concern. The ratings continue to reflect GNC's leading position in the growing health and wellness products market. The ratings consider recent market share declines, driven by encroaching competition and executional missteps, which in concert with recent financial policy decisions, have weakened the company's leverage profile. However, the ratings also reflect steps the company has taken to reverse operational declines and reduce leverage, through diverting FCF to debt paydown and suspending dividends and share buybacks. Fitch expects total revenue to remain fairly stable at around $2.5 billion between 2016 and 2020 and EBITDA is expected to trough in the mid-$200 million range in 2017, versus $350 million in 2016 and the average $500 million between 2012 and 2015. EBITDA is expected to improve to the $300 million-$325 million range by 2019/2020 on modest top-line growth and gross margin expansion as a result of store closings leading to reduced occupancy costs and merchandise margin stabilization. KEY RATING DRIVERS Unsuccessful Refinancing: Upon the withdrawal of its proposed credit facility refinancing on Dec. 4, 2017, the company announced that it had engaged Goldman Sachs and Co. LLC to explore strategic alternatives and optimize its capital structure, inclusive of a $300 million revolver due September 2018, $1.1 billion term loan maturing March 2019 and $288 million of convertible notes due August 2020. On Dec. 21, the company announced an exchange of approximately $99 million in convertible notes for 14.6 million shares of common equity. Fitch views this as a DDE, as the common equity is valued at approximately $55 million based on GNC's Dec. 21 closing price. Fitch viewed the withdrawal of the proposed credit facility refinancing as a rating concern given heightened urgency in addressing upcoming maturities. While the company could generate some liquidity through asset sales (such as distribution centers) or increased refranchising activity, Fitch projects the company will need to refinance a significant portion of upcoming maturities; as such, its inability to successfully complete its proposed refinancing suggests the possibility the company may need to perform further distressed debt exchanges or a restructuring. Good Position in a Growing Category: GNC is a leading U.S. retailer and manufacturer (with around 6% share) of health and wellness products, including vitamins, minerals and herbal supplements (VMHS), and sports nutrition and diet products. Historically, the company has benefited from stable growth in the VMHS industry, brand leadership, and its broad store footprint and brand presence in the U.S. and internationally. The company has 9,083 stores globally as of September 2017 and manufactures products sold at retailers across the food, drug, and discount category. The company has outsized presence at Rite Aid Corporation stores through a partnership and a storefront on Overall online sales penetration is around 10%, in line with industry averages. GNC's brand leadership is evident with nearly half of consolidated revenue derived from owned-brand product. The approximately $40 billion VMHS industry has proven to be recession resistant by growing at a mid-single-digit rate through economic cycles. The consumable nature of the products and high frequency of usage as part of regular dietary regimens drive the stability and defensibility of the business. Given an aging U.S. population and increased consumer focus on personal health and wellness, Fitch expects the VMHS industry to continue mid-single-digit growth over the next several years, making it one of the faster-growing segments within retail. Historically, the standalone vitamin retail business has been resilient to channel disruption from discount and online players for several reasons. First, inventory breadth in the category is significant, which is an unappealing characteristic for discount players that prefer a focused, high-turning inventory mix. Second, the nature of the industry's product requires an elevated service component. GNC, whose service model provides product and regimen guidance to less knowledgeable customers, has benefited from this information asymmetry. Finally, loyalty programs have proven effective for standalone players to maintain share in the space, with GNC's (now-replaced) Gold Card discount program generating nearly 80% of company sales. Recent Weakness: Despite good historical fundamentals, GNC's operating trajectory turned in 2014, with sales declining from a peak of $2.6 billion in 2013 to an expected $2.5 billion in 2017, while EBITDA has been halved from around $530 million in 2013 to an expected $260 million in 2017. While the category has continued its growth trajectory, the alternate channels appear to be taking share from standalone players such as GNC. The proliferation of vitamin-related information online coupled with an increased vitamin focus by a number of competitors in the discount, grocery, drug retail and online spaces have limited GNC's competitive advantage in recent years. Fitch believes GNC also took some operational missteps in recent years. The company's marketing and merchandising efforts have historically appealed to sports-related products such as muscle-gain proteins, while industry growth has focused more on natural/organic supplements, particularly for the aging baby boomer population. In addition, while the company's Gold Card loyalty program was a historical advantage, the loyalty scheme recently created price confusion among consumers who increasingly value price transparency. The pricing structure was also misaligned in the company's stores relative to its online channel, where products were heavily discounted. EBITDA declines in recent years have outpaced revenue moderation due to the deleveraging impact on fixed expenses such as rent and store payroll as well as the company's decisions to maintain investments in marketing and product innovation. More recently, margins have declined due to the company's concerted efforts to reduce prices in an increasingly competitive environment and to align pricing across its channels and simplify its pricing model for loyalty card customers. EBITDA erosion has weakened the company's leverage profile, with adjusted debt/EBITDAR forecast to rise from the mid-4.0x range in 2013 to around 7.0x in 2017. This increase was exacerbated by the company's decision to execute debt-financed share buybacks in 2015 and first half of 2016 (1H16). Outstanding debt balances increased by around $300 million from the beginning of 2015 until the company ceased share buybacks in mid-2016. EBITDA Expected to Trough in 2017: Over the past 18 months, GNC has implemented a number of strategic changes that could stabilize results while improving leverage. The company has reduced prices to be more competitive and aligned price points across channels to reduce customer confusion. GNC replaced its existing loyalty program, wherein a paid membership provided ongoing product discounts. The new loyalty program includes both a free tier where customers can earn rewards based on spending, and a paid tier with additional benefits. The goal of the new free tier is to grow enrollment in the overall program while improving ongoing product margins. Research and development investments have been geared toward enhanced product innovation to drive customer excitement and brand differentiation. Sales staff re-training is designed to fortify the company's ability to effectively counsel and advise customers. GNC's efforts have led to some signs of improvement, with average transactions improving from negative in 2015-2016 to up over 10% through the first three quarters of 2017, and positive enrollment trends for the company's new loyalty program (nine million members in the free tier and 600,000 members in the paid tier as of October 2017). Comparable store sales (comps) were 1.3% in 3Q17, the company's first positive comp since 4Q15, and are expected to be positive in 4Q17 and annually beginning in 2018. While sales have shown some evidence of stabilization, GNC's initiatives have had a negative impact on EBITDA. Price reductions have reduced gross margin by over 200bps to 33% through 3Q17, while the elimination of the paid loyalty program has caused significant declines in high-margin membership fee revenue. EBITDA, which was $350 million in 2016, could decline to around $260 million in 2017, with quarterly declines YTD through 3Q17 but flattish EBITDA in 4Q17. Despite recent trends and increased competition from alternate channels, Fitch believes there is long-term viability in the standalone vitamin retail space and that GNC's size, positive FCF generation, brand recognition and vertical manufacturing capabilities are assets that would allow it to defend share longer-term should its recently enacted strategies be unsuccessful. As the company laps significant changes made in 2017, the continuation of modestly positive comps could yield EBITDA trending above $300 million over the next three years. New Financial Policy and FCF Supports Deleveraging: As GNC undertakes these initiatives; the company has also made significant changes to its cash deployment strategies. Over the past 18 months, the company has eliminated both its dividend and share buyback program, and redirected its FCF to debt paydown, repaying nearly $200 million of debt from 2Q16 through 3Q17. The company's net leverage target of 3x, capitalizing leases at 5x, equates to 4x Fitch-defined leverage (capitalizing leases at 8x) assuming minimal cash balances for both calculations. Assuming the company successfully completes the refinancing of its upcoming maturities and continues to direct FCF toward debt paydown along with its stated financial policy, leverage could approach mid-5.0x in 2020 based on around $200 million of FCF in 2017 and $100 million annually beginning in 2018. RECOVERY CONSIDERATIONS Fitch's recovery analysis is based on a going-concern value of $1.25 billion, versus approximately $630 million from an orderly liquidation of assets composed primarily of inventory, receivables and owned property and equipment. Post-default EBITDA was estimated at $250 million, similar to the company's TTM EBITDA. Fitch believes current operating results represent a potential post-bankruptcy scenario following an approximately 50% decline in EBITDA over the past three years. The analysis uses a 5.0x enterprise value/EBITDA multiple, consistent with the 5.4x median multiple for retail going-concern reorganization but at the low end of the 12-year retail market multiples of 5x-11x, and below 7x-12x for retail transaction multiples. The multiple considers GNC's historically strong position in a good category, recent competitive encroachment by alternate channels and operational missteps. After deducting 10% for administrative claims, the remaining $1.125 billion would lead to superior recovery prospects (71%-90%) for the company's credit facility, which is therefore rated 'B+'/'RR2'. DERIVATION SUMMARY GNC's previous IDR of 'B-' reflected increased refinancing risk following the company's withdrawal of its proposed term loan refinancing. The ratings continue to reflect GNC's leading position in the growing health and wellness products market. The rating considers recent market share declines, driven by encroaching competition and executional missteps, which in concert with recent financial policy decisions, have weakened the company's leverage profile. However, the rating also reflects steps the company has taken to reverse operational declines and reduce leverage, through diverting FCF toward debt paydown and suspending dividends and share buybacks. Other retailers within the 'B' category include SUPERVALU Inc. (B/Stable) and Rite Aid Corporation (B/Stable). SUPERVALU is a secularly challenged grocery retailer and wholesale grocery operator, with leverage around 4.0x. Rite Aid is a drug retailer whose recent market share losses raise questions around EBITDA stabilization prospects. Its pro forma leverage following the sale of assets to Walgreens Boots Alliance, Inc. is projected to trend around 7.0x. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --Fitch expects total revenue to remain fairly stable in the $2.5 billion range in 2016-2020. Revenue is expected to decline 3% in 2017 and 1% in 2018 due to store closings before turning modestly positive in the low-single-digits. Same store sales are expected to be flat in 2017 given second-half improvement, and grow in the low single digits in 2018-2020. --EBITDA is expected to trough in the mid-$200 million range in 2017, versus $350 million in 2016 and the average $500 million range in 2012-2015. EBITDA is expected to improve to $300 million-$325 million by 2019/2020 on modest top-line growth and gross margin expansion as a result of store closings leading to reduced occupancy costs and merchandise margin stabilization. --FCF is expected to be $200 million in 2017, partly driven by working capital improvement of $75 million, and $100 million annually thereafter, assuming interest expense could increase from a refinancing of the company's term loan. GNC has suspended both its dividends and share buybacks. Fitch would expect the company to use FCF for debt paydown, in line with its public guidance. --Adjusted leverage (capitalizing rent expense at 8x) is projected at 7x for 2017, versus the 4.5x-5x range in 2013-2015, but is expected to trend toward mid-5x by 2020 based on EBITDA growth and debt reduction. This assumes the successful refinancing of its entire capital structure. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -- Per Fitch's criteria, we would downgrade the IDR to Restricted Default (RD) upon the completion of the exchange. The IDR would subsequently be upgraded reflecting the post-DDE credit profile. GNC's IDR may be upgraded to a level below the prior 'B-'; therefore, ratings on GNC's senior secured credit facility and term loan have been placed on Negative Watch. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action --Following the completion of its DDE, a downgrade would occur if the company is unable to successfully address upcoming debt maturities in a timely fashion. LIQUIDITY GNC's total liquidity as of Sept. 30, 2017 was $286 million, which includes $40 million in cash and $246 in availability on the company's $300 million revolver. Revolver availability was reduced by $48 million in borrowings and $5.9 million in letters of credit. FULL LIST OF RATING ACTIONS Fitch has downgraded GNC as follows: GNC Holdings, Inc. --Long-Term IDR to 'C' from 'B-'. General Nutrition Centers, Inc. --Long-Term IDR to 'C' from 'B-'. Fitch has placed the following rating on Negative Watch: General Nutrition Centers, Inc. --Senior secured credit facility at 'B+'/'RR2'. Contact: Primary Analyst David Silverman, CFA Senior Director +1-212-908-0840 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst Hoai Ngo Senior Director +1-646-582-4603 Committee Chairperson Monica Aggarwal, CFA Managing Director +1-212-908-0282 Summary of Financial Statement Adjustments: Fitch has added back $7.7 million in stock-based compensation to SG&A in the LTM ended Sept. 30, 2017. Fitch has also added back $3.4 million in non-recurring, non-operational costs to SG&A over the same period. 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