August 31, 2017 / 1:57 PM / 22 days ago

Fitch Downgrades New Look to 'CCC'

(The following statement was released by the rating agency) LONDON, August 31 (Fitch) Fitch Ratings has resolved and removed the Rating Watch Negative (RWN) and downgraded New Look Retail Group Ltd's (New Look) Long-Term Issuer Default Rating to 'CCC' from 'B-'. The agency has also downgraded New Look's Secured Issuer plc's 2022 senior secured notes to 'CCC'/'RR4' from 'B'/'RR3' and New Look Senior Issuer plc's 2023 senior notes to 'CC'/'RR6' from 'CCC'/'RR6'. The downgrades reflect New Look's deteriorating operating performance in both FY17 (ending 25 March 2017) and in Q1FY18. The competitive threat from pure online retailers, falling UK consumer confidence, some loss of fashion trendsetter status, rising input prices following the fall in sterling and Brexit uncertainty has placed the business model under pressure. We do not foresee a tangible improvement in profitability or operating margins in FY18, despite measures to reduce price promotions and efforts to reduce the group's costs. This combined with rising leverage and declining liquidity due to negative cash-flow generation which is projected to continue in FY18, leads to a credit profile consistent with a 'CCC' rating. We nevertheless believe that the group has sufficient cash and committed debt resources to meet its commitments during FY18. KEY RATING DRIVERS UK Retail More Competitive: There is intense competition in the UK fast fashion sector, particularly from pure online players such as ASOS, Shop Direct and Boohoo which benefit from their asset-light operating structures. Retailers also now need to respond virtually instantaneously to new fashion trends, and products need to be available for sale in very short timescales. This puts pressure on the responsiveness of New Look's supply chain, something that management is currently working on to improve across all product ranges. The appointment of a new chief creative officer with extensive fast fashion experience should allow the group to produce a more trend setting product range but likely not fully reflected before FY19. Negative Cash Flows Affect Liquidity: Free cash flow (FCF) fell by over GBP40 million in FY17 and is now negative and not expected to recover to previous levels in the near term. This has reduced liquidity, although this remains reasonable. We expect FCF margin to be negative in FY18 by around -3.0% reflecting negative FCF of around GBP43 million, which needs to be covered by an RCF drawdown as the available cash and bank overdraft would not be enough. This will nevertheless put pressure on the group's net debt to EBITDA covenant of a maximum of 8.7x at end-March 2018, if the GBP100 million RCF is drawn by more than 25%. Weakening Leverage Metrics: FFO adjusted leverage has increased to a high of 8.4x at FYE17, and in the absence of a significant improvement in operating performance, we expect a slight increase in leverage to 8.7x by end-March 2018. Financial flexibility has also weakened slightly with FFO fixed charge cover falling to 1.2x at FYE17, and is not expected to significantly recover in the next few years, thus making the capital structure unsustainable in the absence of meaningful profit recovery or equity injection. Business Model Under Threat: Further to both a challenging FY17 and a poor Q1FY18 trading environment, we have revised downwards our view on the business model to 'Intact' from 'Sustainable' given the structural changes in the UK fast fashion sector. We expect margins to remain under pressure due to rising input costs, and despite the anticipated reduction in promotions and discount sales. Falling UK Consumer Spending: According to Visa Consumer Spending Index, UK consumer spending has fallen in H117 as a result of Brexit uncertainty, increased inflation and stagnant wage growth. Fitch does not expect a recovery in UK spending in H217, particularly in clothing. Profit Margins Erosion: We are reducing our forecasts for EBITDA margin, assuming the competitive environment will endure in 2017 limiting price increases, although the anticipated reduction in discount offers should assist New Look's operating margins later in 2017. Gross margins will also be affected by sterling's depreciation against the US dollar, which is impacting pricing and competitiveness when New Look's legacy foreign currency hedges roll off during 2017. Good Multi-Channel Sales Platform: New Look retains a flexible multi-channel sales platform, although we project group revenue to fall by 2.3% in FY18. This will be driven by a like-for-like (lfl) sales decline in the UK core retail business, partially offset by a reasonably stable performance in the group's e-commerce, international and franchise divisions. We view the multi-channel sales platform as supporting the recovery of the business. However, this is only one of the elements required for the business turnaround. Strategic Focus on China: Fitch expects New Look's international segment to break even after FY18, as higher penetration of the Chinese retail market begins to contribute to profitability alongside a positive contribution from the majority of its other international stores. New Look's value fashion and Western styling proposition remains resilient in China, supported by a growing network of stores and third-party e-commerce retailers as well as a favourable operating environment. However, this segment is yet to be a significant profit contributor to the overall group. Lower Recovery Expectations: We have downgraded the recovery rating for the senior secured notes to 'CCC'/'RR4'/44%, due to lower profitability translating into a lower going-concern valuation. The Recovery Rating for the senior notes has been downgraded to 'CC'/'RR6'/0% in line with the IDR downgrade and weaker recovery expectations upon default. Fitch has applied a discount of 0% to LTM EBITDA at end-Q1FY18 and a distressed multiple of 5.0x (previously 5.5x). DERIVATION SUMMARY New Look is a fast-fashion multichannel retailer operating in the value segment of the UK clothing and footwear market for women, men and teenage girls. The group also generates around 20% of revenue internationally. The e-commerce platform is a key differentiating factor relative to other sector peers such as Financiere IKKS S.A.S (CCC) and continues to develop internationally, which partially helps to offset weaknesses in the domestic UK retail market where it is heavily exposed. Key credit metrics are now in the 'CCC'-rated category. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - group revenue to decline by 2.3% in FY18 driven by a challenging operating environment and reductions in price promotions in the UK with lfl sales declines, partially offset by growth in other channels such as E-Commerce, International and Franchise; - margin pressure leading to moderate group EBITDA margin of 9.4% in FY18, which should rise to 10.3% in FY19 as full pricing begins to take effect; - capex to remain stable overall in FY18, while expansionary spending for e-commerce and store openings will increase; - capex to sales will be of the order of 4.9% of sales in FY18 and 2.5% thereafter; - no dividend payments or extraordinary non-recurring cash outflows. KEY RECOVERY ASSUMPTIONS - The recovery analysis assumes that New Look would be considered a going concern in bankruptcy and that the company would be reorganised rather than liquidated. We have assumed a 10% administrative claim in the recovery analysis. - New Look's recovery analysis assumes 0% discount to the LTM EBITDA at end-Q1FY18 resulting in post-reorganisation EBITDA of GBP133.4 million. At this level of EBITDA and after taking corrective measures into account, we would expect New Look to generate a broadly neutral cash flow with no deleveraging capacity. - It also assumes a distressed multiple EV of 5.0x which is in line with clothing retail peers such as Financiere IKKS S.A.S. ('CCC'). - Fitch assumes a fully drawn RCF and bank overdraft in its recovery analysis since these credit facilities are usually tapped when companies are under distress. Therefore Fitch assumes New Look's GBP100 million RCF will be fully drawn and the bank overdraft will reach the limit of GBP15 million. In addition, Fitch has also added the utilised amount of operating facilities of GBP27.8 million onto the fully drawn RCF and bank overdraft. The facilities rank in priority to the notes in the debt waterfall. - These assumptions result in a downgrade of New Look's Secured Issuer plc's 2022 senior secured notes to 'CCC'/'RR4' with no notching above New Look's IDR as recoveries fall in the 31%-50% range. Following the payment waterfall, New Look Senior Issuer plc's 2023 senior notes' recovery rating is downgraded to 'CC'/'RR6' indicating recoveries in the 0%-10% range. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -Improvement in the business model through increasing diversification and scale, resilient pricing structure, and a proven track record of strategy implementation over the medium term, including successful expansion in China, leading to EBITDA margin at or above 12.5% (10.4% at FY17 (ending at March 2017)) -FFO adjusted leverage consistently below 7.0x (FY17: 8.4x) due to operational improvements and/or a capital injection -FFO fixed charge cover trending towards 1.5x (FY17: 1.2x) Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - Negative FCF generation along with breach in maintenance springing covenant on RCF resulting in liquidity erosion - Failure to overcome profit margin pressure, FX impact, loss of market share and weaker consumer confidence in the UK leading to EBITDA margin below 8% -FFO adjusted leverage consistently above 9.0x LIQUIDITY Reasonable Although Declining Liquidity: At the end of July 2017 there was GBP65 million of cash together with access to a GBP100 million undrawn RCF and a bilateral GBP15 million overdraft. Fitch adjusts cash as restricted for GBP1.7 million held as guarantees over leases, GBP12.1 million held for employee share options and GBP50 million for working-capital seasonality requirements. Fitch expects liquidity to come under some pressure from FY18, as we forecast the cash outflow to reach GBP43 million by FY18 and this would have to be covered by drawdowns on its overdraft and RCF. This could constrain future drawdowns under the RCF facility as there is a springing covenant under the RCF when more than 25% drawn, requiring leverage (net debt/EBITDA) to be below 8.7x (against our estimate of 9.4x in FY18). FULL LIST OF RATING ACTIONS New Look Retail Group Limited --Long-term IDR downgraded to 'CCC' from 'B-' New Look Secured Issuer plc --Senior Secured Notes downgraded to 'CCC/RR4' from 'B/RR3' New Look Senior Issuer plc --Senior Notes downgraded to 'CC/RR6' from 'CCC/RR6' Contact: Principal Analyst Louise Liu Analyst +44 20 3530 1660 Supervisory Analyst Jean-Pierre Husband Director +44 20 3530 1155 Fitch Ratings Ltd 30 North Colonnade London E14 5GN Committee Chairperson Pablo Mazzini Senior Director +44 20 3530 1021 Summary of Financial Statement Adjustments - Fitch has adjusted the debt by adding 8x of annual operating lease expense related to long-term assets in the UK (around GBP173 million for FY18) and 7x related to a small portion of group operating leases in Poland. Fitch also sets aside an amount of GBP50 million as restricted cash related to working capital requirements during the year. 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