NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned an Issuer Default Rating (IDR) of 'BBB' to Coach, Inc. (Coach). Fitch has also assigned a 'BBB' rating to the entity's shelf registration of senior unsecured debt securities. The Rating Outlook is Stable.
As Coach indicated at its June investor meeting, the company anticipated a debt issuance in fiscal 2015 for its new headquarters. The total cost of land/construction for the headquarters is expected to be $750 million, of which the remaining $550 million will be incurred in fiscal 2015 and fiscal 2016. Coach currently does not have any long-term debt in its capital structure.
KEY RATING DRIVERS
The ratings reflect Coach's strong positioning in the premium bags and small leather good market with a #1 share of the domestic market and #2 globally, high EBITDA margins, and reasonable credit metrics. However, the company's North American business, which accounts for two-thirds of total revenue and EBITDA before allocating corporate expenses, is experiencing significant pressure on top-line growth and profitability due to lack of newness in product introduction and brand messaging. There has also been an influx of participants that have aggressively built share in the entry level luxury price points that Coach competes in.
As a result, Fitch expects North American EBITDA to decline by more than 50% in fiscal 2015 from a peak level of $1.6 billion in fiscal 2013. The ratings are therefore contingent on Coach's ability to maintain strong momentum in its international business as it grows its presence in China and enters Europe to offset some of the North American decline. However, Japan (14% of total revenue), which is currently its second largest market is expected to remain under some pressure.
Fitch expects overall top line to contract by 10% over the next two years to $4.3 billion and EBITDA to decline to $1.1 billion from $1.5 billion in fiscal 2014, with the growth in the international segment somewhat offsetting the sharp decline in the North American business. Fitch expects the EBITDA margin to decline to the mid-20% range from 36%-37% in fiscal 2011-2013. Fitch expects leverage (lease-adjusted debt/EBITDAR) to increase 1.5x to the mid-2x range by the end of fiscal 2015 (ended June 2015), assuming debt issuance of $750 million sized to total cost of the headquarters. Fitch expects leverage to remain in the mid-2x over the next 36 months.
Significant Contraction in Domestic Business
Coach has approximately $4.8 billion in sales and directly operates over 1,000 stores, including full-price retail and outlet concepts and has over 1,200 wholesale doors globally. Coach's top line has grown at a CAGR of 8.3% over the last five years supported by the strong recovery in the demand for luxury goods in North America over this timeframe and Coach's expansion into new markets, in particular China.
However, the North American segment, which generated $3.1 billion (including approximately $1320 million of Canadian sales) or 65% of total revenue in fiscal 2014 has come under significant pressure over the past few quarters. The weakness is attributed to the lack of product newness and underinvestment in its store base and marketing in an increasing competitive space with companies such as Michael Kors - now #2 after Coach - Kate Spade and Tory Burch, significantly gaining share in the entry level luxury price points that Coach competes in. As a result, Coach's women's handbag business (55% of total fiscal 2014 revenue) is down 8.5% over the last two years while its accessories business (22% of revenue) is down 10.6%.
Coach expects to invest heavily in remodeling its stores over the next few years to create a new store environment - particularly its flagship stores, close 70 underperforming North America retail stores in fiscal 2015, introduce new product lines, and increase its marketing spend by $50 million over fiscal 2015 and fiscal 2016.
Fitch expects North American comparable store sales (comps) to decline in the mid-20% range, with 10 points of the comp decline attributable to promotional cutback in its Electronic Outlet Store (eOS). Coach generated $500 million in e-commerce sales in fiscal 2014, mostly via its outlet flash sales held three times a week in fiscal 2014 and the company expects this business alone will shrink by $300 million in fiscal 2015. Coach will reduce the number of eOS events from three times per week to one time per week (started in 1Q'15) and eventually move to one to two events per month.
Overall, the North American business is expected to contract by over 20% over the next two years to $2.5 billion from $3.1 billion in FY2014 (ended June) and a peak level of $3.5 billion in FY2013. Fitch expects the North American EBITDA (before allocating corporate expenses) to decline to around $750 million in fiscal 2015 from $1.4 billion in fiscal 2014 and $1.6 billion in fiscal 2013. It could decline to below the $700 million level in fiscal 2016 before stabilizing or growing modestly thereafter assuming comp store sales turn positive.
International Operations a Bright Spot
Coach's international operations, which generated $1.6 billion or 34% of total revenue in fiscal 2014, has experienced compound revenue growth of 12.5% over the past five years and Fitch expects similar growth rates for the next three to five years. China accounted for two-thirds of the growth with sales growing from $55 million in fiscal 2009 to $545 million in fiscal 2014.
Japan is currently Coach's largest international market with fiscal 2014 sales of $655 million, but sales in China are likely to surpass Japan's by the end of 2015. China's sales are expected to grow up to $800 or $900 million by 2019, assuming low double digit growth. Sales in Japan have been weak in contrast, and Fitch expects sales to decline from a peak of $845 million in fiscal 2012 to the $600 million level going forward as the overall market is expected to be relatively flat. Coach recently entered the European market, generating $60 million in revenue in F2014 and is expected to increase it to $100 million in F2015. The growth trajectory in Europe could potentially take longer than China, in Fitch's view, as it is a more mature market.
As of Sept. 27, 2014, Coach had $661 million in cash mostly held overseas and $247 million in short-term investments. Coach has a $700 million unsecured domestic bank facility with a maturity date of Sept. 9, 2019. As of Sept. 27, 2014 and June 28, 2014, there was $170 million and $140 million outstanding on the facility.
Material Increases in Capex Contribute to FCF Declines
Coach generated strong free cash flow (after dividends) of $700 million to $800 million between F2011 through F2013. However, FCF dropped to approximately $280 million in fiscal 2014 given a $350 million decline in EBITDA and $120 million of spending on Coach's new headquarters.
The total cost of land/construction for the headquarters is expected to be $750 million, of which the remaining $550 million will be incurred in fiscal 2015 and fiscal 2016. In addition, non-headquarters capex is expected to accelerate to $350 million in fiscal 2015 from the $220 million annual level in fiscal 2012/2013 as Coach spends heavily on its remodeling activity and international expansion.
Of the $250-$300 million in transformation charges, Coach took $132 million in 4Q'14 and $37 million in 1Q'15, leaving $80-$130 million over the balance of fiscal 2015. 40% or $100 million to $120 million of these charges will be cash charges.
As a result of this and further deterioration in EBITDA to the $1.1 billion level, Fitch expects FCF to decline around $400 million annually over F2015 and F2016.
RATING SENSITIVITIES
A positive rating action would be driven by the improvement in Coach's core North American business with comparable store sales growing in line with or better than the mid-single digit growth Fitch expects for the domestic luxury space and total EBITDA improving to the $1.5 billion to $1.6 billion range that would drive leverage to the low 2x range and enable Coach to be FCF positive.
A negative rating action could result in the event of worse than expected top-line, profitability and cash flow trends driven due to a deterioration in its brand or market positioning in the low-to-mid tier luxury market; a slowdown in the momentum of Coach's international business; and/or a sustained increase in leverage above the mid-2x range.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (May 28, 2014).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=938235
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