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Fitch: Viability of Target's Canadian Business Uncertain

NEW YORK--(BUSINESS WIRE)--Significant operating shortfalls in Target's Canadian business in its first year of operation are raising questions about the viability of the business. Sales volumes in Canada of $1.6 billion LTM through May 2, 2014 are tracking around 50% below Fitch Rating's initial expectations.

Target is in the process of addressing its supply chain issues, initiating a new price-match policy, and adding new merchandise to the Canadian stores. Nonetheless, Fitch believes that getting to a breakeven EBITDA in Canada will be a significant challenge and will take a number of years.

Sales volumes together with the costs associated with clearing excess inventory due to poor sales performance were a major drag on Canada's earnings in fourth quarter 2013 (4Q'13) and into 1Q'14. EBITDA came in at negative $714 million in 2013 (versus Fitch's expectation of a loss of less than $200 million), and Fitch expects EBITDA will remain materially negative at around negative $450 million-$500 million in 2014.

The shortfall can be attributed to significant problems with the supply chain, which has made difficult to track inventory levels in distribution centers and stores, and keep store shelves stocked. In addition, the merchandise assortment differs from what is typically available in U.S. stores, and prices are higher than in U.S. stores where Canadian consumers also shop.

Assuming Canadian SG&A (excluding depreciation and amortization) of $1 billion to $1.1 billion and a 30% gross margin rate (to align it with the domestic business), sales in Canada would have to reach $3.3 billion to $3.7 billion, versus estimated full-year 2014 sales of $2 billion, to reach a breakeven EBITDA level. This would imply average sales/store of $25 million-$30 million versus around $15 million currently in Canada and $40 million in the U.S.

Fitch sees significant hurdles to achieving these levels and believes it is possible that Target's management could evaluate strategic alternatives for the business including a divestiture if it is unable to materially turn the business around over the next 12-24 months.

Should management decide to restructure or divest the business, the implications could be positive insofar as it would remove a significant drag on earnings. However, this would likely result in significant write-offs and/or wind-down costs. Target purchased the Zeller store leases in 2011 for C$1.825 billion and has invested $2.5 billion in capital expenditures to date.

Updated Consolidated 2014 Outlook

In the U.S. business, Fitch expects the challenging environment will likely continue to dampen sales growth in the near term, with U.S. comp sales flat to up 1% for full-year 2014, leading to modestly lower domestic EBITDA.

Target announced in August 2014 that it expects gross expenses related to the data breach of $148 million, partially offset by an insurance receivable of $38 million. These costs, which relate to fraud reimbursement, card reissuance costs and litigation should be manageable in the context of the company's healthy ongoing cash flow.

Free cash flow (FCF) post-dividends is projected at around $800 million to $900 million in 2014, supported by a reduction in capex to around $2.4 billion in 2014 from $3.5 billion in 2013 due to the completion of the Canadian store build-out. Target is expected to size its share repurchases based on its operating performance and the data breach costs, and that debt levels will be flat for the year.

Adjusted leverage was 2.55x at May 2014 compared with 2.4x at end-2013 (Feb. 1, 2014). Leverage is expected to remain flat at around 2.4x at end-2014 on flat debt levels and slightly improved EBITDA of around $6.3 billion, up from $6.2 billion in 2013, assuming the Canadian business is less of a drag. Assuming the U.S. business turns around and comps are in the low single digits beginning 2015 and the Canadian business is less of a drain on profitability, leverage is expected to drift down to the 2.1x - 2.2x range over the next few years.

The significant losses in the Canadian business and the soft domestic performance are expected to constrain any ratings upside over the medium term. Should management effectively resolve the issues facing the Canadian business, the domestic business improves, and lease-adjusted leverage is maintained below 2.0 times, there could be ratings upside potential. A negative rating action could be triggered by operating shortfalls and/or more aggressive share repurchase activity that drove leverage to over 2.5x for an extended period.

Fitch rates Target as follows:

--Long-term IDR 'A-';

--Senior unsecured debt 'A-';

--Bank credit facility 'A-';

--Short-term IDR 'F2';

--Commercial paper 'F2'.

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'.

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Contacts

Fitch Ratings
Primary Analyst
Philip M. Zahn, CFA, +1-312-606-2336
Senior Director
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Monica Aggarwal, CFA, +1-212-908-0282
Senior Director
or
Committee Chairperson
Eric Ause, +1-312-606-2302
Senior Director
or
Media Relations
Brian Bertsch, +1-212-908-0549 (New York)
brian.bertsch@fitchratings.com