NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded both Macy's Inc. (Macy's) and Kohl's Corporation (Kohl's) to 'BBB' from 'BBB+' on continued operational challenges in the mid-tier department store sector and on our expectations that comparable store sales (comps) will be flat to modestly up over the next few years for these two retailers and EBITDA will remain under pressure as they invest in their omni-channel initiatives.
Fitch affirmed Nordstrom, Inc. (Nordstrom) at 'BBB+' given that it has a well-developed offering and footprint in the full price, off-price and online channels which should enable the company to generate mid-single digit top line growth over the intermediate term. In addition, unlike its mid-market department store peers, Nordstrom's higher-priced and fashion-forward merchandise positioning at full line stores should continue to provide market share protection against lower-end competitors. Fitch expects Nordstrom to reverse negative EBITDA trends in 2017 as it starts to see a return on investments in its various channels and entry into Canada.
"The ratings divergence between Nordstrom, Macy's and Kohl's reflects the challenges department stores face given changing consumer shopping patterns," said Monica Aggarwal, Managing Director. "Retailers like Nordstrom are reaping the benefits of loyal customers due to its long history of differentiated merchandise and customer service, as well as a well-developed multi-pronged strategy including ecommerce and off-price."
CONTINUED MID-MARKET APPAREL WEAKNESS
Industry fundamentals have been weak for several years, driven by a number of factors. First, other than athleisure, the apparel sector has not seen a compelling fashion trend; thus, shopping has been more focused on replacement cycles than the quest to be trend-right. Second, the eroding stigma of discount shopping has led to significant growth in the off-price and fast-fashion channels, which has negatively impacted department store market share. Finally, apparel sales continue to move online. While most department stores offer online shopping and omni-channel strategies to varying extents and online represents about 14% of Kohl's and Macy's total sales currently, the growth in this business is essentially expected to offset the decline in in-store sales.
In addition to the above challenges, winter 2015 trends were complicated by erratic weather patterns, which further pressured in-season sales and promotional activity needed to clear seasonal merchandise. The trend appears to have continued in 2016, with a late March cold snap potentially hampering spring 2016 sales momentum.
HEAVY INVESTMENT IN OMNI-CHANNEL TO PROTECT TOP LINE
The largest players in the industry, including Macy's, Kohl's, and Nordstrom, have reacted to these challenges in somewhat similar ways. Unlike cash-strapped Sears and struggling regional players like Bon-Ton, these companies have the cash flow generation necessary to reinvest in growth. Growth initiatives have generally centered around omni-channel capabilities, enhanced customer service and the expansion of lower-priced store formats. In each of these areas, Nordstrom has been a leader, given investments in its online business - both internal investment and acquisition of third-party ecommerce brands - and rollout of the off-price Nordstrom Rack channel.
Fitch believes Nordstrom's heavy investment in growth and higher-end assortments will allow it to generate positive mid-single digit top line growth over the next 24-36 months compared to flattish to slightly negative growth at Kohl's and Macy's. Fitch projects Nordstrom's full-line stores, which currently account for 53% of Nordstrom's will decline to 43% by 2020, as full-line store sales remain flat over the next few years. Fitch expects Nordstrom Rack sales to grow in the high-single digits over the next two to three years and account for 27% of sales versus 25% currently, while its various ecommerce platforms grow in the low mid-teens and contribute 30% of total revenue in five years versus 20% today.
Positive sales growth projections for Nordstrom distinguish the company from most of its department store peers. However, Nordstrom's growth investments are expected to limit cash flow generation over the next 24 months, with free cash flow (FCF) after dividends expected to be negative $150 million in 2016 before turning modestly positive in 2017.
Looking at the overall domestic apparel, accessories, and home-related categories, Kohl's and Macy's would have to generate top-line growth 2% or above to prevent share loss to other channels such as specialty, discount, and online. This could be achieved by relatively flat comps growth at the store level and low-to-mid-teens growth from online sales. Fitch projects in-store sales to be negative 1% to 2% for Kohl's and Macy's which will essentially be offset by growth in their online businesses.
LEVERAGE EXPECTED TO BE HIGH 2X FOR KOHL'S AND MACY'S
Fitch projects Kohl's EBITDA could decline another 10%-15% over the next 24-36 months from 2015 levels of $2.5 billion. For Macy's, Fitch expects EBITDA to decline another 5% in 2016, after a 14% drop in 2015 and remain range bound in the $3.2 billion to $3.3 billion range thereafter. As a result, leverage is expected to be in the high 2x range for both companies (compared to the 2.2x-2.4x range maintained between 2012 and 2014) on operational weakness. Fitch expects FCF will be diverted towards share buybacks instead of debt pay down to maintain a healthy level of shareholder returns. Macy's is also exploring various real estate opportunities to enhance shareholder returns, and Fitch believes that any change to Macy's capital structure will be credit neutral at best.
Please see individual press releases on Macy's, Kohl's and Nordstrom for more details on the rating actions:
Fitch Downgrades Macy's, Inc. to 'BBB'; Outlook Stable
Fitch Downgrades Kohl's Corporation to 'BBB'; Outlook Stable
Fitch Affirms Nordstrom, Inc.'s IDR at 'BBB+'; Outlook Stable
Additional information is available at 'www.fitchratings.com'.