Fitch Rates Michael Kors' Term Loans 'BBB-'; Outlook Stable.
Pro-forma for the acquisition, leverage is expected to be 3.6x compared with 2.4x at the end of 2017 (fiscal year ended March 2018). Given the company's publicly stated debt paydown plans as well as its track record with the recent Jimmy Choo acquisition, Fitch expects Michael Kors to direct FCF toward debt reduction, which, in conjunction with EBITDA growth, should result in leverage declining to under 3x within two years post acquisition close.
Michael Kors' ratings reflect the company's long-term growth trajectory, its strong positioning in the U.S. handbag and small leather goods market, and its financial policy of targeting a 2.00x-2.25x leverage range (Fitch-adjusted equivalent is 2.50x to 2.75x). Fitch's rating on Michael Kors assumes the company may execute leveraging tuck-in M&A transactions, which could keep leverage elevated on a temporary basis but be managed under 3x over the medium term, by using FCF
to reduce debt (as it has done post the November 2017 Jimmy Choo acquisition). The rating also considers the fashion risk inherent in the accessory and apparel space, illustrated by Michael Kors' recent topline weakness.
The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
KEY RATING DRIVERS
Proposed Versace Acquisition: Michael Kors's proposed acquisition of Versace, an independently operated luxury goods company, provides some diversification opportunities across product categories, geographies and segments. Versace had $775 million in sales and 220 stores in 2017 and is expected to have $850 million in revenue in 2018 (on an expected store base of 190 stores).
Versace is more heavily skewed toward apparel, Asia and men's products, all areas in which Michael Kors is underpenetrated. Michael Kors intends to grow Versace's revenues to USD1.2 billion by 2021 with a long-term target of USD2 billion in revenues by focusing on Versace's first line, building out the brand's retail footprint, increasing e-commerce capabilities and expanding men's and women's accessories and footwear penetration to 60% of revenues from 35% currently.
While Versace's historical financial information is private, commentary in the news has cited operating challenges at the brand over the last few years. Fitch believes that the integration risk around this acquisition is higher given that it could be a turnaround situation that would require more management attention versus the Jimmy Choo acquisition, which has been on a strong trajectory. While Versace is expected to make a small contribution to Michael Kors' EBITDA -- with EBITDA of around $40 million to $50 million in 2017 based on a mid-single digit EBITDA margin and anticipated to grow to around $180 million in 2021 on management's projected mid-teens margins -- any execution issues could affect operating performance of the consolidated company. This risk is somewhat mitigated by the strong FCF generation at underlying Michael Kors.
Blackstone currently owns a 20% stake in Versace (acquired in 2014), while the remaining 80% is split between several Versace family members. The Versace family will receive EUR150 million in equity in Michael Kors (to be renamed Capri Holdings) as part of the transaction. Donatella Versace heads the company's design team and will stay on after the acquisition.
Promotional Activity Drove Challenges: Michael Kors is a fashion & accessories wholesaler and retailer, primarily operating in the Americas (63% of revenue) and Europe (24%). While the company's heritage is women's apparel, today 67% of company revenue is accessories (chiefly handbags) with the remainder divided between apparel and footwear. Approximately 60% of the company's revenue and 50% of EBITDA is generated at Michael Kors-operated retail locations, with the remainder generated through wholesale sales (primarily to department stores) and licensing relationships.
The company built an impressive track record of growth through 2015 (fiscal year ended March 2016), with revenue growing to a peak of USD4.7 billion from USD400 million in 2008. The company benefited from growth in the accessories market, successful marketing and product innovation. Arguably, the company also benefited during the 2014-2015 period from weakness at competitor Tapestry, Inc., as the latter company saw sales declines stemming from fashion misses and a subsequent reduction to promotional activity.
Fitch believes the company's operating challenges that started in 2016 have been somewhat macro-driven, as Michael Kors has been affected 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 Tapestry. 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.
Standalone Operating Trends Improving: Michael Kors' underlying revenue growth, excluding Jimmy Choo, improved to flat in 2017 from negative 5% in 2016 as promotional activity resets and wholesale pullback in North America have produced positive results. Consolidated EBITDA (including Jimmy Choo) in 2017 was essentially flat to 2016 at around USD1.2 billion, compared with a peak of USD1.4 billion in 2015.
To generate growth, the company has an ongoing 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 in digital capabilities to support an omnichannel presence across stores and ecommerce, in line with changes to customer shopping patterns. Michael Kors also plans to close 100 to 125 full-price retail locations over the next few years.
Fitch expects comps to be in the negative low single digits and for top-line to be flat to up modestly for 2018. Fitch's expectation assumes that reset of promotional activity and pullback of wholesale sell-in in Europe will continue to negatively affect results in 2018. Fitch projects that sales for the Michael Kors brand could grow in the low single digits beginning 2019, assuming completion of the Europe reset, low-single-digit comps and modest store openings.
Jimmy Choo Acquisition: Michael Kors acquired Jimmy Choo in November 2017 for USD1.35 billion, representing a 16.5x EV/EBITDA multiple (based on Fitch-defined EBITDA) on trailing 12 month (TTM) June 30, 2017 results and was nearly double the company's pre-acquisition market capitalization.
Jimmy Choo, which currently operates 191 stores and a wholesale business focusing on high-end department stores and retailers, reported a 12% revenue compound annual growth rate (CAGR) over the five years prior to the acquisition on increased brand acceptance in the luxury shoe and related accessories space. The company generated about USD460 million in revenues prior to acquisition (and the company expects $585 million in revenue in 2018) and added about 10% to Michael Kors' EBITDA. EBITDA grew somewhat less on increased growth investments, and was USD81 million (at 2017 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 did 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 low-to-mid single digit 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 (added approximately 12% to Michael Kors' last 12 month [LTM] revenue at the time of acquisition).
Michael Kors financed the purchase with USD1 billion of unsecured term loans and USD450 million in unsecured notes. The company has since paid down a substantial portion of the term loans with FCF, with only about USD110 million outstanding as of June 30, 2018.
Modest EBITDA Growth Expected: Fitch expects Michael Kors' EBITDA (excluding Versace) to grow 2%-3% annually, with EBITDA in 2018 expected to be approximately USD1.2 billion and trending toward USD1.3 billion over the next two to three years. This assumes modest expansion in gross margin on improved promotional cadence and SG&A growth in line with projected top-line expansion in the low single digits. Pro-forma for the Versace acquisition (assumed to close in April 2019, the beginning of Michael Kors' fiscal year for modeling purposes), EBITDA is expected to be about USD1.3 billion in 2019 and trend toward USD1.4 billion by 2021.
Financial Policy and Leverage Expectations: Prior to the 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 an average of USD900 million in FCF annually over the past three years.
In conjunction with the Jimmy Choo acquisition, the company announced a financial policy that includes the expectation of operating within an adjusted leverage range of 2.00x-2.25x, capitalizing leases at 6x. This range equates to 2.50x-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 Tapestry. Fitch's rating on Michael Kors assumes the company may execute leveraging tuck-in M&A transactions that could keep leverage elevated on a temporary basis, but be managed under 3x over the medium term by using FCF to reduce debt (as it has done post the November 2017 Jimmy Choo acquisition and as Fitch expects post the Versace acquisition).
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 financial policy of targeting a 2.00x-2.25x leverage range (Fitch-adjusted equivalent is 2.50x-2.75x). Fitch's rating on Michael Kors assumes the company may execute leveraging tuck-in M&A transactions that could keep leverage elevated on a temporary basis but be managed under 3x over the medium term by using FCF to reduce debt (as it has done post the November 2017 Jimmy Choo acquisition and as Fitch expects post the Versace acquisition). The rating also considers the fashion risk inherent in the accessory and apparel space, illustrated by Michael Kors' recent topline weakness.
Fitch views Tapestry, Inc. (BBB-/Stable) to be Michael Kors' closest peer given similar product mix, revenue base and margin profile. Similar to Michael Kors, Tapestry acquired Kate Spade & Company in 2017, a specialty brand intended to supplement its existing offering and diversify its portfolio. Tapestry'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 its Kate Spade acquisition.
Tiffany & Co. (BBB+/Stable) is of similar size and profitability to Michael Kors, though has better credit metrics (Fitch-defined leverage: 2.5x) and competes in a space (jewelry) that is less susceptible to fashion risk, is more competitively fragmented and more insulated from alternate channel incursion (such as value and online channels).
Industry leaders in other retail segments, 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%).
Fitch's Key Assumptions Within the Rating Case for the Issuer:
2018 (fiscal year ended March 2019)
--Standalone Michael Kors revenue is expected to be flattish to up modestly at around USD4.5 billion, on negative low-single-digit comps;
--Jimmy Choo revenue is expected to grow in the low-to-mid single digits annually from around USD500 million in 2017;
--EBITDA is projected to grow in the low-single digits on improved sales trends from approximately USD1.2 billion in 2018;
--FCF is expected to be (before any impact from the proposed Versace acquisition) around USD650 million.
2019 and Beyond (Pro Forma for Versace)
--Pro-forma for Versace, 2019 consolidated revenue is expected to increase to USD6.0 billion, reflecting stabilization in the Michael Kors brand via low-single-digit positive comps (offset by store closures), and low-to-mid single digit growth at Jimmy Choo;
--Pro-forma consolidated EBITDA is expected to approximate USD1.3 billion with the addition of Versace as well as Michael Kors (including Jimmy Choo) realizing low-to-mid single digit EBITDA growth from improved top-line. Fitch expects EBITDA to trend toward USD1.4 billion over the next two years on positive operating trends;
--Annual FCF is expected to be about USD650 million in 2019 and potentially increase to USD900 million in 2021 on EBITDA growth and capex moderation;
--Fitch expects Michael Kors to direct FCF toward debt reduction over the next two years such that the company's leverage trends from pro forma levels of around 3.6x to under 3.0x. 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.
Developments That May, Individually or Collectively, Lead to Positive Rating Action
--A positive rating action could result from sales stabilization that leads to sustained EBITDA growth and a public commitment to maintain Fitch-adjusted leverage below 2.5x.
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.
The company reported USD155 million in cash and cash equivalents as of Sep. 29, 2018 and had USD729 million available on its USD1 billion revolver, yielding total liquidity of almost USD885 million. The company has no near-term debt maturities.
FULL LIST OF RATING ACTIONS
Fitch currently rates Michael Kors as follows:
Michael Kors Holdings Ltd
--Long-Term IDR 'BBB-';
--Senior Unsecured Credit Facility (as co-borrower) 'BBB-'.
Michael Kors (USA), Inc.
--Long-Term IDR 'BBB-';
--Senior Unsecured Credit Facility (as co-borrower) 'BBB-';
--Senior Unsecured Notes 'BBB-'.
The Rating Outlook is Stable.
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|Publication:||Daily the Pak Banker (Lahore, Pakistan)|
|Date:||Jan 21, 2019|
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