Fitch Downgrades Staples to 'BB+' on Rating Watch Negative

NEW YORK--()--Fitch Ratings has downgraded the Long-term Issuer Default Rating (IDR) for Staples, Inc. (Staples) to 'BB+' from 'BBB-' and the Short-term IDR to 'B' from 'F3'. The ratings remain on Rating Watch Negative pending outcome of the Office Depot acquisition process. Should the acquisition close, Fitch would expect to rate Staples within the mid to high 'BB' category.

A full list of ratings follows at the end of this release.

KEY RATING DRIVERS

Standalone Business Expected to Be Flat at Best

The downgrade reflects continued secular headwinds and competitive challenges in the office products category, which have pressured EBITDA since 2012. On a standalone basis, Fitch views Staples as having limited ability to reverse declines in sales and EBITDA over the forecast horizon, especially given the heightened threat from new entrants in the contract stationer business.

Staples has fought a number of challenges in recent years, including both secular headwinds and strengthened competition. The ongoing digitalization of the workplace has negatively impacted sales of core office supplies, ink/toner and paper, which represent around half of Staples volume. Sales of technology products (approximately 20% of sales) have been weak due to a slowing replacement cycle and saturation of key products such as laptops and tablets. Fitch expects both of these headwinds to continue over the forecast horizon.

As sales shift online across many retail categories, new competitors have emerged in the office products category, pressuring in-store sales across the industry. Since 2012, Staples' North American retail sales are down approximately 25% (recently exacerbated by the weak Canadian dollar) and margins of the combined retail/Staples.com business have contracted from 8.3% to 4.5%. As a result, EBITDA contribution has declined nearly 50% from $1.2 billion (57% of total) in 2012 to $650 million (45% of total) in 2015.

Amazon has begun a significant push into office products sales to contract customers, which will limit market share opportunities for existing players. Sales and EBITDA to contract customers have been fairly stable for the last few years underpinning the 'BBB-', rating but Fitch expects Staples' competitive positioning on a standalone basis could weaken over time.

In addition to the proposed acquisition of Office Depot, Staples has undertaken a number of initiatives to combat these challenges. First, the company has significantly reduced its North American store base by around 300 units to an expected 1,560 by the end of 2016. Second, the company has refocused selling efforts around categories including breakroom and janitorial supplies, which are seeing less secular pressure. Finally, the company has managed its cost structure through the removal of over $750 million in expenses over the last three years.

While these efforts have mitigated secular pressures, Staples' sales and EBITDA have declined each year from their respective peaks in 2011 of $25 billion and $2.3 billion, respectively. In 2015, sales of $21 billion and EBITDA of $1.4 billion were both 6% below 2014 levels, with EBITDA margin falling to 6.7% from the 2011 peak of 9%. Fitch believes medium-term EBITDA will remain flat at best, likely within the $1.2-$1.4 billion range, as industry challenges persist.

Given the above EBITDA expectations, adjusted leverage is expected to trend in the 3.2 - 3.4x range over the forecast horizon, which Fitch views as representative of a 'BB+' rating for a secularly challenged retailer.

Combined Business Would be Stronger but Highly Levered

The Rating Watch Negative on Staples reflects the uncertain outcome of the acquisition process of Office Depot, which would increase pro forma leverage to near 5.0x upon consummation given $4.25 billion of incremental debt issued for Office Depot shares. The incremental debt will include a $2.5 billion term loan and $1.75 billion drawn on the company's new $3 billion revolver. This is a slight change in mix from prior expectations of a $2.75 billion term loan and $1.5 billion drawn on the revolver.

Should the acquisition close, Fitch would expect to rate Staples within the mid to high 'BB' category, depending on asset dispositions and updated views on timing of synergies and debt reduction. Staples ability to maintain the current 'BB+' rating would require Fitch to be comfortable with the company's ability to reduce leverage below 3.5x within 36 months following the close of the acquisition.

Pro forma for the Office Depot acquisition, Staples had EBITDA of approximately $2.2 billion in 2015, unadjusted for any disposals required to consummate the transaction. Assuming Staples realizes 50%-70% of the planned $1 billion in net synergies within three years of the transaction close, EBITDA is expected to be in the range of $2.6 - $2.8 billion vs. $2.2 billion pro forma 2015 EBITDA. Adjusted leverage could decline from close to 5.0x pro forma toward the mid-to-high 3.0x range within 36 months from transaction close, assuming FCF is used towards debt reduction.

The 'BBB-' ratings of the bank facilities reflects their senior secured position in the capital structure. The ABL revolver is secured by a first lien on receivables and inventories and a second lien on the term loan priority collateral. The term loan is secured by property and equipment, intellectual property, and equity interests in restricted subsidiaries, and a second lien on the ABL priority collateral. Both facilities would be expected to receive a full recovery, resulting in an 'RR1' Recovery Rating with the ratings capped at 'BBB-' in accordance with Fitch's criteria given the expectation that Staples' IDR would be 'BB' or 'BB+'.

KEY ASSUMPTIONS

Standalone Staples:

--Fitch expects flattish annual sales around $20 billion over the forecast horizon, with EBITDA ranging between $1.2 - $1.4 billion on modest margin declines.

--Projected free cash flow after dividends (FCF) of $300 million in 2016 will be used for merger-related debt issuance expenses of $100 - $150 million and merger breakup fees of $250 million. FCF is expected to remain in the $300 million range annually and could be used to restart the company's share buyback program.

--Adjusted leverage is expected to remain in the 3.2x-3.4x range.

Combined Staples/Office Depot Entity:

--Sales are expected to be close to pro forma levels of around $35 billion over the forecast horizon, assuming no further divestitures are required.

--Assuming Staples realizes 50%-70% of the planned $1 billion in net synergies within three years of the transaction close, EBITDA is expected to be in the range of $2.6 - $2.8 billion vs. $2.2 billion pro forma EBITDA in 2015.

--FCF is expected to grow from $700 million in 2017 to $1 billion by 2019, depending on timing of restructuring charges. Fitch expects Staples to use FCF for debt reduction. As a result, adjusted leverage could decline from close to 5.0x pro forma toward the mid-to-high 3.0x range within 36 months from transaction close.

RATING SENSITIVITIES

Fitch would expect to rate Staples' IDR in the mid to high 'BB' category assuming the merger closes. Staples ability to maintain the current 'BB+' rating would require Fitch to be comfortable with the company's ability to reduce leverage below 3.5x within 36 months following the close of the acquisition.

If the merger is terminated, future developments that may, individually or collectively, lead to a negative rating action include continued negative sales and margin trends and declines in EBITDA that drive adjusted leverage above the mid-3x range.

Future developments that may, individually or collectively, lead to a positive rating action include a stabilization of top-line trends, the resumption of positive EBITDA momentum, and maintenance of adjusted debt/EBITDAR at or under 3x.

LIQUIDITY

The company had adequate liquidity at Jan. 30, 2015, comprised of $825 million in cash and full availability on its $1 billion revolving credit facility.

FULL LIST OF RATING ACTIONS

Fitch has downgraded the following ratings:

Staples, Inc.

--Long-term IDR to 'BB+' from 'BBB-';

--$1 billion unsecured revolving credit facility to 'BB+/RR4' from 'BBB-';

--Senior unsecured notes to 'BB+/RR4' from 'BBB-';

--Short-term IDR to 'B' from 'F3';

--Commercial paper to 'B' from 'F3'.

The ratings remain Rating Watch Negative. Given the Watch is related to a merger, Fitch would review the company at the earlier of the close of the merger process or 12 months.

In addition, Fitch has affirmed the following ratings:

--$3 billion secured revolving credit facility at 'BBB-/RR1';

--$2.5 billion secured term loan at 'BBB-/RR1'.

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. In 2015, Fitch excluded $38 million in accelerated depreciation and expenses related to its proposed acquisition of Office Depot. Fitch added back $63 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.

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

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 05 Apr 2016)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=879564

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1002207

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1002207

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings, Inc.
Primary Analyst
David Silverman, CFA
Senior Director
+1-212-908-0840
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Monica Aggarwal, CFA
Senior Director
+1-212-908-0262
or
Committee Chairperson
David Peterson
Senior Director
+1-312-368-3177
or
Media Relations
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings, Inc.
Primary Analyst
David Silverman, CFA
Senior Director
+1-212-908-0840
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Monica Aggarwal, CFA
Senior Director
+1-212-908-0262
or
Committee Chairperson
David Peterson
Senior Director
+1-312-368-3177
or
Media Relations
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com