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Fitch Assigns First-Time IDR of 'BBB-' to Michael Kors Holdings Limited; Outlook Stable
September 29, 2017 / 3:05 PM / 19 days ago

Fitch Assigns First-Time IDR of 'BBB-' to Michael Kors Holdings Limited; Outlook Stable

(The following statement was released by the rating agency) NEW YORK, September 29 (Fitch) Fitch Ratings has assigned a Long-Term Issuer Default Rating (IDR) of 'BBB-' to Michael Kors Holdings. Fitch has also assigned a 'BBB-' rating to the company's $1 billion revolving credit facility and $1 billion new senior unsecured term loans. Michael Kors, which previously operated without permanent debt on its balance sheet, has issued two senior unsecured term loans to partially fund its $1.35 billion acquisition of Jimmy Choo PLC, with the remainder expected to be financed with unsecured notes. The acquisition was announced on July 25, 2017 and is expected to close by calendar year end. The Outlook is Stable. The rating reflects the company's long-term growth trajectory, its strong positioning in the U.S. handbag and small leather goods market, and its conservative financial policy of targeting a 2.0x-2.25x leverage range (Fitch-adjusted equivalent is 2.5x to 2.75x). The rating also considers the fashion risk inherent in the accessory and apparel space, illustrated by Michael Kors' recent topline weakness. KEY RATING DRIVERS Track Record of Growth: Michael Kors is a large fashion wholesaler and retailer, primarily operating in the Americas (70% of revenue) and Europe (21%). While the company's heritage lies in women's apparel, approximately 70% of company revenue is accessories (chiefly handbags) with the remainder divided between apparel and footwear. Approximately 40% and 50% of the company's revenue and EBITDA, respectively, is generated at company-operated retail locations, with the remainder generated through wholesale (primarily to department stores) and licensing relationships. Prior to fiscal 2017 (ended April 2017), the company built an impressive track record of growth, with revenue expanding tenfold from $400 million in fiscal 2009 to $4.7 billion in fiscal 2016. Growth resulted from store expansion globally (838 stores currently, of which around half are in the U.S.), positive comparable store sales (comps) and increased and strengthened wholesale relationships (currently present in around 2,500 department stores and 1,100 specialty stores globally). EBITDA margins, which were 25% in fiscal 2016 and similar to recent results from leading accessories retailer Coach Inc., are amongst the highest in retail, and compare well with trailing margins at competitor Kate Spade (19%). The company's operating success has allowed it to produce ample cash flow with annual FCF of $850 million the past two years (the company does not pay a dividend). The company recently began a share buyback program, repurchasing $2.1 billion in stock over the past two fiscal years. The company has benefited from growth in the accessories market, successful marketing and product innovation. Arguably, the company also benefited during the 2014-2016 period from weakness at competitor Coach, as the latter company saw sales declines stemming from fashion misses and a subsequent reduction to promotional activity. Recent EBITDA Dislocation: Revenue growth moderated from 32% in fiscal 2015 to 8% in fiscal 2016 and turned negative at -5% in fiscal 2017. EBITDA, which had doubled from fiscal 2013 to a peak of $1.4 billion in fiscal 2015, declined to $1.1 billion in fiscal 2016 on lower sales and margins. EBITDA margin, which peaked at 34% in fiscal 2014, fell to 25% in fiscal 2016 primarily on fixed-cost deleveraging exacerbated by increased costs from recent store openings. Fitch believes the company's operating trajectory is somewhat macro-driven, as Michael Kors has been impacted by the challenges facing many mall-based fashion-oriented retailers. These headwinds include reduced interest in fashion, which has led to divergence of discretionary spend to experiences like travel and entertainment, and increased industry markdown levels needed to prompt consumer action and clear inventory. Beyond industry pressures, there exist striking similarities between the current operating trajectory at Michael Kors and recent results at Coach. Fitch believes both companies historically drove revenue, in part, from increased promotional activity across various channels. This activity trained existing customers to expect further markdowns and also exposed both companies to new, more value-driven customers that incorporate promotional "calls to action" in their purchasing decisions. The promotional activity also exposed Michael Kors to a new tier of competitors, prompting the company to engage in competitive activity that somewhat disrupted its ability to maintain a planned promotional cadence. Post the significant hit to sales in 2013-2015 from reduction in promotional activity, Coach has been able to stabilize results through a renewed focus on product design, store remodels, store closures, and a pullback in department store exposure. Similarly, Michael Kors has planned for a 40% reduction to promotional activity in fiscal 2018 and the closure of 100 to 125 full-price retail locations over the next few years. The company is also reducing its sell-in to department stores and reducing participation in department store-wide promotional events. To generate growth, the company has begun a remodel program across stores to drive excitement, and is increasing both square footage allocation and wholesale focus toward less-penetrated categories like women's footwear and ready-to-wear, along with men's apparel and accessories. The company is also increasing investment on digital capabilities to support an omnichannel presence across stores and ecommerce, in line with changes to customer shopping patterns. As with Coach, Michael Kors' strategy is likely to yield further near-term declines in operating results before sales stabilize. Michael Kors reported a 6% decline in comparable store sales and a 3.6% revenue decline in the first quarter of fiscal 2018 (ended July 2, 2017), and Fitch expects this trend to continue through the balance of the year. Fitch's fiscal 2018 projection includes a mid-single-digit revenue decline (from $4.5 billion in fiscal 2017) and high-single-digit comp decline. These top-line pressures, coupled with higher expected SG&A spending from recently opened stores, are expected to drive EBITDA toward $950 million, 18% lower than fiscal 2017. Gross margin is projected to grow modestly by 10 to 20bps from 59.4% in fiscal 2017 as first-quarter margin improvement demonstrates progress in the company's promotional pullbacks. Assuming Michael Kors is successful in implementing its strategy, sales could grow modestly beginning fiscal 2019, with low-single-digit increases in annual sales and EBITDA. Jimmy Choo Acquisition: On July 25, 2017, the company proposed the acquisition of Jimmy Choo, which is currently a publicly traded entity but majority owned by JAB Holding Co. In April 2017, JAB indicated it was exploring strategic alternatives for its Jimmy Choo stake given a desire to focus on its coffee-related brands. The purchase price of $1.35 billion represents a 16.5x EV/EBITDA multiple (based on Fitch-defined EBITDA) on TTM June 30, 2017 results and is nearly double the company's pre-acquisition market capitalization. Jimmy Choo, which operates 150 stores and a wholesale business focusing on high-end department stores and retailers, has reported a 12% revenue CAGR over the past five years on increased brand acceptance in the luxury shoe and related accessories space. EBITDA has grown somewhat less on increased growth investments, and was $81 million (at current exchange rates) in 2016. Jimmy Choo's business mix is primarily shoes (75%), with the remainder accessories and apparel. The brand mostly sells products for women, with a very limited men's assortment. Michael Kors does not expect material procurement or synergy opportunities with the acquisition, though Jimmy Choo provides Michael Kors some brand and product diversification. Fitch expects Jimmy Choo to produce modest sales and EBITDA growth on an annual basis, though EBITDA growth outside Fitch's expectations would have a limited impact on Michael Kors' EBITDA and credit profile given its relatively small size (adds approximately 12% to Michael Kors LTM revenue). Michael Kors plans to finance the purchase with $1 billion of unsecured term loans and $450 million in unsecured notes. Pro forma Fitch-defined adjusted leverage would be approximately 3.0x and Fitch projects that it will trend toward the mid-2x over the next 24-36 months on EBITDA growth, some debt paydown and a benefit from reduced rent following the closure of 100 Michael Kors stores. Financial Policy and Leverage Expectations: Prior to the proposed Jimmy Choo acquisition, Michael Kors operated with no permanent debt on its balance sheet. Management has historically funded operations with internally generated cash. Cash flow has been ample, with the company generating $850 million in FCF annually over the past two years. In conjunction with the Jimmy Choo acquisition announcement, the company announced a financial policy which includes the expectation of operating within an adjusted leverage range of 2.0x-2.25x, capitalizing leases at 6x. This range equates to 2.5x-2.75x of Fitch-defined leverage, which capitalizes leases at 8x. Fitch views this range as representative of a low investment-grade rating that considers the company's scale as well as the risk associated with being a fashion-focused retailer, similar to Fitch's view of Coach Inc. Given the company's debt paydown plans, Fitch believes the company could operate within this leverage range even if its operating turnaround takes 12 or so months longer to execute. DERIVATION SUMMARY The rating reflects the company's long-term growth trajectory, its strong positioning in the U.S. handbag and small leather goods market, and its conservative financial policy of targeting a 2.0x-2.25x leverage range (Fitch-adjusted equivalent is 2.5x-2.75x). Michael Kors' recent topline weakness illustrates the fashion risk inherent in the accessory and apparel space, and similarly sluggish results at fashion-oriented peers such as Coach (BBB-/Stable) and Tiffany (BBB+/Negative) corroborate this risk. Fitch views Coach to be Michael Kors' closest peer given similar product mix, revenue base and margin profile. Similar to Michael Kors, Coach just acquired Kate Spade & Company, a specialty brand intended to supplement its current offering and diversify its portfolio. Coach's leverage profile is similar to that of Michael Kors, with leverage expected to trend to below 3.0x following paydown of debt associated with the Kate Spade acquisition. Tiffany is of similar size and profitability to Michael Kors, though has slightly improved credit metrics (Fitch-defined leverage: 2.5x) and competes in a space that is less susceptible to fashion risk, is more competitively fragmented and more insulated from alternate channel incursion (such as value and online channels). However, Tiffany has also experienced recent EBITDA declines via comp weakness - evidence that sluggish global luxury trends are impacting the broader space beyond just handbags and accessories. Industry leaders in other spaces, such as AutoZone, Inc. (BBB/Stable) and Best Buy Co., Inc. (BBB-/Stable), have similar leverage profiles, though compete within very different competitive environments. AutoZone operates in an industry that has fairly benign competitive characteristics and favorable long-term secular growth with limited economic cyclicality. Best Buy is the leading national consumer electronics retailer, though industry trends remain highly competitive and secularly challenged, reflected in its much lower EBITDA margins (6%) versus Michael Kors (25%). KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: FY 2018 -In fiscal 2018 (ends April 2018), standalone Michael Kors revenue is expected to decline by mid-single digits to $4.2 billion from $4.5 billion the prior year, on negative mid- to high-single-digit comps. -EBITDA is projected to decline around 20% to $900 million on fixed-cost deleverage. FCF is projected around $600 million (before any impact from the Jimmy Choo acquisition), below the $850 million average of the prior two years due to the EBITDA decline. Pro Forma -Pro forma for Jimmy Choo, fiscal 2019 revenue is expected to increase to $4.8 billion, reflecting stabilization in the Michael Kors brand via modestly positive comps (offset by store closures), and continued double-digit growth at Jimmy Choo. -Pro forma EBITDA is expected to approximate $1 billion as Michael Kors realizes reduced rent from store closures, margin upside from less promotional activity and approximately $100 million of EBITDA from Jimmy Choo. Fitch expects EBITDA to trend toward $1.1 billion over the following 24 months on modest annual sales and EBITDA growth for the combined entity. -Annual FCF is expected to trend in the $500 million to $600 million range as higher EBITDA is expected to be offset by higher interest expense and capex. -Fitch expects Michael Kors to partially direct FCF toward debt reduction over the next two to three years such that the company's leverage trends from pro forma levels of approximately 3.0x to 2.5x-2.75x, the company's leverage target (Fitch-defined). Excess FCF could also be used to resume the company's share repurchase program or for M&A, within the context of Michael Kors' publicly stated financial policy. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action A positive rating action could result from sales stabilization which leads to sustained EBITDA growth, paydown of the company's term loan and a public commitment to maintain Fitch-adjusted leverage below 2.5x. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action A negative rating action could result from continued weak sales trends, causing sustained EBITDA declines. Sustained Fitch-adjusted leverage over 3.0x could also lead to a negative rating action. LIQUIDITY The company reported $274 million in cash and cash equivalents as of July 1, 2017 and had $839 million available on its $1 billion revolver, yielding total liquidity of $1.1 billion. Subsequent to July 1, 2017, Michael Kors amended its credit facility to extend the revolver from 2020 to 2022 and issue the above mentioned term loans. FULL LIST OF RATING ACTIONS Fitch has assigned ratings for Michael Kors as follows: Michael Kors Holdings Limited -- Long-Term Issuer Default Rating (IDR) at 'BBB-'; -- Senior unsecured revolving credit facility at 'BBB-'; -- Senior unsecured term loans at 'BBB-'. The Rating Outlook is Stable. Contact: Primary Analyst David Silverman, CFA Senior Director +1 212 908-0840 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst JJ Boparai Associate Director +1 212 908-0543 Committee Chairperson Monica Aggarwal, CFA Managing Director +1 212 908-0282 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 any one-time charges. In fiscal 2017 (ended April 1, 2017), Fitch added back $34 million in non-cash stock-based compensation to its EBITDA calculation. -- Fitch has adjusted the historical and projected debt by adding 8x yearly operating lease expense. . Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Additional information is available on www.fitchratings.com Applicable Criteria Corporate Rating Criteria (pub. 07 Aug 2017) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here#solicitation Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. 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