TEXT-S&P affirms Jo-Ann Stores ratings, outlook now stable
Overview -- U.S. fabrics and crafts retailer Jo-Ann Stores Inc.'s indirect parent, Jo-Ann Stores Holdings Inc. (Holdings) is issuing $325 million of senior unsecured PIK notes to finance a dividend to equity holder Leonard Green & Partners. -- We are assigning a 'B' corporate credit rating to Holdings and a 'CCC+' issue-level rating to the proposed notes. -- We are affirming our ratings on Jo-Ann Stores, including the 'B' corporate credit rating, and revising the outlook to stable from positive. -- The stable outlook reflects our view that the proposed debt issuance will cause financial ratios to improve, but to remain within levels indicative of a "highly leveraged" financial risk profile. Rating Action On Oct. 9, 2012, Standard & Poor's Ratings Services affirmed its 'B' corporate credit rating on Hudson, Ohio-based Jo-Ann Stores Inc. and revised the outlook to stable from positive. In addition, we are assigning a 'B' corporate credit rating to Jo-Ann Stores Holdings Inc. (Holdings). We assigned a 'CCC+' (two notches below the corporate credit rating) issue-level rating to the company's proposed $325 million senior unsecured paid-in-kind (PIK) notes due 2019. The recovery rating is '6', indicating our expectation of negligible (0% to 10%) recovery for noteholders in the event of a payment default. At the same time, we affirmed the 'B+' (one notch above the corporate credit rating) issue-level rating on the company's $650 million senior secured term loan B facility due 2018. The recovery rating is '2', indicating our expectation of substantial (70% to 90%) recovery for lenders in the event of a payment default. We also affirmed the 'CCC+' (two notches below the corporate credit rating) issue-level rating on the company's $450 million senior unsecured notes due 2019. The recovery rating is '6', indicating our expectation of negligible (0% to 10%) recovery for noteholders in the event of a payment default. Rationale The rating action reflects our view that the company's financial ratios will weaken following the proposed debt issuance, but will return to near current levels over the next 12 months, including adjusted total debt to EBITDA approaching 7x after the debt issuance that improves to near 6x. We no longer forecast an improvement in the company's financial ratios to levels indicative of an "aggressive" financial risk profile under our criteria, which was the primary basis for our previous positive outlook. Profit growth remains the primary driver of ratio improvement in our view. Our ratings on Jo-Ann Stores reflect its "weak" business risk profile and "highly leveraged" financial risk profile under our criteria. Our business risk assessment reflects our analysis that the company needs to make continued capital investment in store enhancements to maintain its competitive position. It also reflects Jo-Ann's participation in the competitive and highly fragmented craft and hobby retail industry, as well as the seasonal nature of its earnings. Our financial risk assessment reflects our expectation for financial policies to remain very aggressive under financial sponsor ownership, as confirmed by the proposed debt-financed dividend. Given this proposed issuance, we now forecast that financial ratios will improve but remain within levels indicative of a highly leveraged financial risk profile. Below is our revised financial ratio forecast for fiscal year-end January 2013 and for fiscal year-end January 2014, respectively: -- Lease-adjusted total debt to EBITDA increases to nearly 7x from nearly 6x, and recedes to 6.3x by fiscal year-end January 2013 and to 6.0x by fiscal year-end January 2014. Our prior forecast was for leverage to decrease to 5.6x and then to 5.2x, respectively. -- Funds from operations (FFO) to total debt falls to 12.0% from 14.2%, and increases to 12.3% by fiscal year-end January 2013 and then to 12.6% by fiscal year-end January 2014. Our prior forecast was for FFO to total debt to increase to about 15% and then to nearly 16%, respectively. -- EBITDA coverage of interest falls to 2.0x (pro forma to reflect the full interest expense impact of the proposed issuance) from 2.3x, and increases to 2.4x by fiscal year-end January 2013 and then falls to 2.3x by fiscal year-end January 2014 as the full interest expense impact is reached. Our prior forecast was for EBITDA coverage of interest to increase to 2.5x and then to 2.7x, respectively. Financial ratios indicative of a highly leveraged financial risk profile include total debt to EBITDA above 5x and FFO to total debt below 12%. Financial ratios indicative of an aggressive financial risk profile include total debt to EBITDA between 4x and 5x and FFO to total debt between 12% and 20%. Standard & Poor's economists believe the risk of another U.S. recession during the next 12 months is between 20% and 25%. We expect GDP growth of just 2.2% this year and only 1.8% in 2013, consumer spending growth of between 2.0% and 2.3% per year through 2013, the unemployment rate remaining at or above 8% through late 2013, and crude oil (WTI) finishing 2012 at $93.75 per barrel and finishing 2013 at $89.68 per barrel. (See "U.S. Economic Forecast: He's Buying A Stairway To Heaven," published Sept. 21, 2012.) Considering these economic forecast items, our base-case forecast for the company's operating performance over the next two years is as follows: -- Revenue growth in the mid-to-high-single-digit percent area. Fiscal 2013 growth is boosted by an extra week; the company's plan to continue adding new stores and remodeling existing ones also provides a boost in both years. -- Gross margin is slightly higher, as elevated input costs continue to partly offset modest gains from private-label and direct-sourcing initiatives. -- Operating expenses grow at a slower rate than revenue, with growth principally from store development initiatives. -- Debt repayment is limited to contractual debt amortization. We view the company's financial policies to be very aggressive, primarily because of the majority equity ownership by the financial sponsor, Leonard Green & Partners L.P. This view incorporates our expectation for Jo-Ann to prioritize capital investments and dividends over accelerated debt repayment, a strategy that is evident in the proposed debt-financed dividend. Leonard Green took Jo-Ann Stores private through a leveraged buyout in March 2011. The business risk assessment incorporates our opinion that the industry will remain competitive and highly fragmented. We believe the top three companies control about one-third of industry share, with Jo-Ann Stores trailing Michaels Stores and Hobby Lobby. We believe these three companies will continue to invest in store expansion to gain industry share and to contribute to growth. Jo-Ann is highly dependent on discretionary consumer spending, and we believe the company relies on a loyal, yet narrow base of repeat customers for growth. For same-store sales growth to consistently exceed GDP growth, the company will need to expand its customer base and broaden its customer profile, likely through targeted marketing campaigns via multiple channels. We believe such initiatives are under way, but it is still too early to gauge the potential benefits. There is significant seasonality in the company's business. The majority of sales take place in the third and, to a greater extent, fourth quarter. Heightening this risk is the long ordering lead times the company's suppliers require. For example, holiday season merchandise is typically ordered in February or March. As such, misjudging consumer preference or demand could have a material adverse impact on financial results. We believe the company will be able to continue to benefit from operating expense leverage, though not to the extent achieved in recent years. An enhanced store base and increased direct sourcing of products has helped profitability. We calculate gross margin has improved by about 350 basis points since fiscal 2007, and we believe increased direct product sourcing contributed meaningfully to this improvement. The company has also efficiently managed its operating expenses. Since fiscal year 2007, operating expenses have increased at a compound annual growth rate (CAGR) of less than 1.5% while revenue has increased at a CAGR of about 3.5%. Liquidity We believe Jo-Ann Stores has adequate liquidity, with cash sources expected to exceed cash uses over the next 24 months. Cash sources primarily include surplus cash, funds from operations, and revolver availability. Cash uses primarily include working capital, capital expenditures, and debt amortization. Our liquidity assessment includes the following factors, expectations, and assumptions: -- We forecast cash sources to exceed cash uses by more than 1.2x over the next 12 months and to remain positive over the next 24 months. -- We forecast net sources would remain positive even if EBITDA were to decline 15%. -- We believe the company will maintain excess availability under its revolving credit facility so that no material financial ratio maintenance covenants would apply. -- Contractual debt amortization is low at $6.5 million per year. -- Debt maturities are favorable, with the revolving credit facility due in 2016, term loan due in 2018, the senior notes due in 2019, and the proposed senior unsecured PIK notes due 2019. As of July 28, 2012, we calculate total liquidity of nearly $320 million, with revolver availability of nearly $300 million. Revolver availability is an average of $285 million over the past four quarters, and total liquidity has been above $300 million over the past three quarters. Liquidity will fall in the third quarter as the company prepares for its busy holiday season. We forecast the company can generate positive free cash flow, even after accounting for its store expansion and remodel plan. However, after accounting for the proposed dividend, discretionary cash flow, on a cumulative basis, is forecast to remain negative for at least the next three years. This also assumes no additional dividends are paid over the next three years. Recovery analysis For the complete recovery analysis, please see the recovery report on Jo-Ann Stores, to be published on RatingsDirect following this report. Outlook The outlook is stable, reflecting our forecast that the proposed debt issuance will lead to some improvement in financial ratios, but they will remain within levels indicative of a highly leveraged financial risk profile. We could lower our ratings if positive operating performance stalls or worsens, causing financial ratios to remain near pro forma levels, including adjusted leverage in the high-6x area. We could raise our ratings if operating performance exceeds our current expectations or, though we consider this less likely, if a change in financial policies allows financial ratios to reach levels indicative of an aggressive financial risk profile, including adjusted leverage of 5x. Based on second-quarter fiscal 2013 results and pro forma for the proposed debt issuance, EBITDA growth of about 37% or debt reduction of nearly $600 million is necessary for adjusted leverage to reach 5x. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors for Global Corporate Issuers, Sept. 28, 2011 -- "here 4765458&rev_id=11&sid=805195&sind=A&", April 15, 2008 Ratings List Ratings Affirmed; Outlook Action To From Jo-Ann Stores Inc. Corporate Credit Rating B/Stable/-- B/Positive/-- Ratings Affirmed Jo-Ann Stores Inc. Senior Secured B+ Recovery Rating 2 Senior Unsecured CCC+ Recovery Rating 6 New Rating Jo-Ann Stores Holdings Inc. Corporate Credit Rating B/Stable/-- Sr unsecured $325 mil 8.75% due 2019 CCC+ Recovery Rating 6 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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