July 11, 2017 / 8:54 PM / 2 years ago

Fitch Downgrades Coach, Inc.'s IDR to 'BBB-'; Outlook Stable

(The following statement was released by the rating agency) NEW YORK, July 11 (Fitch) Fitch Ratings has downgraded the Long-Term Issuer Default Rating (IDR) for Coach, Inc. to 'BBB-' from 'BBB' following the closing of the previously announced Kate Spade & Company acquisition. Coach has been removed from Negative Watch and the ratings have been assigned a Stable Outlook. A full list of ratings follows at the end of this release. At closing, the Kate Spade acquisition has caused Coach's adjusted leverage to increase from the previous 2.6x level to 3.7x on a pro forma basis. To fund the $2.4 billion acquisition, which represents a 9x EBITDA multiple on Kate Spade's TTM results, Coach has issued $2.1 billion of debt, including $1 billion of unsecured notes, an $800 million six-month term loan credit facility and a $300 million three-year term loan facility. Leverage is expected to decline to around 3.3x at the end of FY 2018 upon repayment of the $800 million six-month term loan. Leverage is expected to trend to under 3.0x in fiscal 2020 on EBITDA growth. The ratings also reflect Coach's strong position in the premium bag and small leather goods market, albeit a market which is somewhat exposed to fashion and brand risk. Finally, the ratings reflect integration risk from potential changes to Kate Spade's growth strategies, and the addition of a young, rapidly grown brand to Coach's portfolio. KEY RATING DRIVERS Kate Spade 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 generates 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 closed on its acquisition of Kate Spade in 1Q of fiscal 2018. The acquisition price of $2.4 billion represents a 9x EBITDA multiple on an LTM basis. Coach expects to realize approximately $50 million of run-rate cost synergies within three years of acquisition close, which would 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, but 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. Following the closing of the Kate Spade acquisition, pro forma leverage is 3.7x but is expected to decline to 3.3x at the end of FY 2018 following pay down of the company's $800 million six-month term loan. Leverage is expected to trend to under 3.0x two years post acquisition close based 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 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. DERIVATION SUMMARY Coach's 'BBB-' rating reflects its strong brand positioning and leading market share within the U.S handbag market. The rating is constrained relative to department stores with similar leverage metrics like Macy's Inc. ('BBB'/Outlook Negative) and Kohl's Corporation ('BBB'/Outlook Negative) due to the diversified brand and category profile of these leading department stores. The rating is lower than leading global jeweler Tiffany & Co ('BBB+'/Outlook Negative) due to both higher leverage and higher fashion-related sales volatility in handbags vis a vis jewelry. Finally, Coach is rated higher than The Gap Inc. ('BB+'/Outlook Stable), primarily due to Coach's lower leverage profile. KEY ASSUMPTIONS Fitch's key assumptions within its rating case for the issuer include: --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. Reported FY 2018 revenue growth is expected to be 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 including Kate Spade, which is 3.7x at close on a pro forma basis, is expected to decline to 3.3x at the end of FY 2018 following pay down of the $800 million six-month term loan. Leverage is expected to trend to under 3.0x two years post close on EBITDA growth. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action A positive rating action would result from Coach's core NA comparable store sales growing mid-single digits and a successful Kate Spade integration, yielding at least $1.8 billion in EBITDA by year three post acquisition. These assumptions, plus expected debt paydown, would drive leverage to the mid 2x range. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action 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; mis-execution of Kate Spade integration strategies; and/or loss in confidence of the company's ability to reduce leverage to the high-2.0x 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 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 has downgraded Coach, Inc. as follows: --Long-term IDR to 'BBB-' from 'BBB'; --Senior unsecured bank credit facility to 'BBB-' from 'BBB'; --Senior unsecured term loans to 'BBB-' from 'BBB'; --Senior unsecured notes 'BBB-' from 'BBB'. The Rating Outlook is Stable. 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 Shalini Mahajan, CFA Managing Director +1-212-908-0351 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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