NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the Long-Term Issuer Default Rating (IDR) for Signet Jewelers Limited (Signet) to 'BB+' from 'BBB-'. The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
The downgrade is due to weakening operating trends across Signet's brands, coupled with the announcement of a $625 million preferred equity investment by Leonard Green & Partners (Leonard Green), which Fitch treats as debt. Together, these issues are expected to elevate Signet's leverage profile over the medium term.
The ratings continue to reflect Signet's leading share in the specialty jewelry market in the U.S. as well as the U.K. and Canada. The ratings also reflect EBITDA upside from both long term sales growth opportunities and expense synergies related to the company's 2014 acquisition of Zale.
KEY RATING DRIVERS
Recent Trends Show Softness
Following strong annual comps in recent years, 2016 comps have weakened to 2.4% in Q1 and -2.3% in Q2. While the overall U.S. jewelry category has somewhat slowed, the sharp comps deceleration has been unexpected and the source of weakness is somewhat unclear. Fitch forecasts comps will remain in the negative low-single digits for the remainder of 2016. The company is implementing or strengthening initiatives around marketing, product introductions, and customer service, and Fitch projects these initiatives will improve comps to the low-single digit range beginning 2017.
Fitch currently projects modestly negative comps and sales growth in 2016. EBITDA margin pressure due to unplanned promotional events and fixed-cost deleverage is expected to be mitigated by Zale synergies, which continue to track in-line with management forecasts. As a result, 2016 EBITDA is expected to be $1 billion, flattish to 2015 levels, with EBITDA growth resuming in 2017 on improved sales and continued realization of Zale synergies. The company continues to expect $225 million - $250 million of annual synergies by the end of 2017.
Long Term Prospects Remain Favorable
Fitch expects Signet, on a standalone basis, to generate mid-single digit top-line growth beginning in 2017, assuming it laps the current weakness. The mid-single digit growth would be driven by comps growth in the 2% range and modest contribution from store expansion as the company focuses on off-mall expansion for Kay. Zale-related brands are expected to grow in the low-single digit range mainly on same store sales, with some modest contribution from square footage expansion. As a result, consolidated EBITDA is expected to grow to approximately $1.2 billion by 2018 from 2016 projected and 2015 base of $1 billion.
Debt Notching and Treatment of Hybrid Security
Fitch has downgraded the existing $400 million senior unsecured notes at Signet UK Finance plc to 'BB+' from 'BBB-' and assigned Recovery Ratings (RR) of RR4, indicating average recovery prospects. The ratings on the senior unsecured notes reflect the consolidated credit profile of Signet. Signet and certain subsidiaries of Signet will fully and unconditionally guarantee the payment obligations of Signet UK Finance plc's notes. The notes will be pari passu with all the existing and future unsecured and unsubordinated obligations at Signet and certain subsidiaries of Signet.
The company has announced a $625 million convertible preferred investment by Leonard Green, with proceeds to be deployed toward share repurchase. Fitch believes the investment and repurchase are being driven by both challenging operations as well as negative media attention on Signet, alleging aggressive accounting treatment of its bad debt expense and diamond-switching (both of which the company has denied).
Fitch has given 0% equity credit to the $625 million of convertible preferred securities. Permanence of the capital structure - in this case the proposed convertible preferreds - is necessary for equity credit recognition. Fitch has taken a view that the new proposed securities are not conducive to maintaining them as a permanent part of the capital structure, with the main purpose to support the company's stock price. As a result, Fitch does not believe this transaction will enhance the credit protection measures. Fitch would expect the company to refinance the convertibles with debt over the medium term.
Fitch has assigned the convertible securities a rating of 'BB-/RR6', two notches below the IDR to reflect their subordination in the capital structure.
Leverage Expected to Move Above Mid-3x
As a result of reduced EBITDA expectations and incremental debt, Fitch expects the consolidated leverage ratio to increase from 3.7x in 2015 to the low-4.0x range in 2016, before trending to the 4.0x range by 2018. Fitch's assessment of Signet's credit profile incorporates a retail adjusted leverage. Signet is one of a select group of retail companies that still own their credit card receivables and assigns a portion of the company's debt to the more highly leveraged credit card business. This is consistent with Fitch's practice of treating debt for companies that fund their own credit card receivables.
Fitch assumes Signet's net credit card receivables could be financed using a mix of 70% debt and 30% equity, with a cap of $1 billion, which translates into approximately $1 billion of debt attributed to the receivables financing business. This includes the $600 million asset-backed facility. Retail-related debt therefore is composed of corporate debt that is not allocated to the credit card business and leases capitalized using 8.0x rent expense.
Based on these adjustments, core retail debt/EBITDAR is expected to increase to the high 3.0x range in 2016 from a 2015 level of 3.3x, and trend toward the mid-3.0x range over the following 24 months.
The company has announced a strategic review of its receivables business, which could result in a strategic partnership or sale.
Implicit in Fitch's above assumptions is that if Signet ever sold its receivables portfolio, it would pay down debt directly secured by credit card receivables as well as allocated unsecured corporate debt to a level consistent with Fitch's assumption.
Leading Share in Specialty Jewelry
Signet generated $6.6 billion in revenue and roughly $1 billion in adjusted EBITDA (adding back acquisition related charges) in 2015 (ending January 2016), which includes a full year of contribution from Zale.
Signet operates over 3,600 stores in the U.S., UK and Canada under various well-known brands, post its acquisition of Zale Corporation in May 2014. Kay Jewelers, Jared the Galleria of Jewelry, and Zale hold a combined share of approximately 16% to 17% of the U.S. specialty jewelry market ($30 billion in industry sales in 2015 according to U.S. Census Bureau). Kay and Zale hold the number 1 and 2 market position in the U.S. mall-based specialty retail jewelry space, respectively, and Jared is the number 1 off-mall specialty retail jeweler. In addition, Zale is number 1 in Canada under its Peoples brand (roughly 3% of total revenue) and Signet holds the leading market shares in the UK under its H.Samuel and the Ernest Jones brands (roughly 11% of total revenue).
Signet has generated strong annual top-line and EBITDA growth since the recession, driven by the growth of the specialty jewelry industry of roughly 3% annually over the past five years; continued industry consolidation; and the company's strong execution of its growth initiatives. The expanded retail footprints of its strong concepts such as Kay and Jared, restructuring of regional brand stores, increasing penetration of its exclusive brand portfolio (representing approximately 32.6% of Jared and Kay sales and 42.9% of Zale sales in 2015) and increasing vertical integration of its supply chain have helped drive mid-to-high single-digit growth in same store sales and EBITDA margin improvement to 15.2% in 2015 from 9.7% in 2007.
Zale, which has underperformed historically, was in a turnaround mode since 2010 and turned profitable in 2013 on a net income basis on EBITDA of $76 million or EBITDA margin of 4%. Fitch expects Zale's adjusted EBITDA margin to improve to the high single digit range by 2018.
--For 2016, Fitch expects Signet topline to be flattish and Zales down low-single digits, both on comps of around -1%. Assuming sales trends recover in 2017, Fitch expects Signet on a standalone basis will generate mid-single digit top-line growth and revenue for Zale-related brands to grow in the low-single digit range, mainly on same-store sales.
--Fitch expects 2016 EBITDA to be flattish around $1 billion, as negative comps trends are mitigated by Zale synergies. Over the following 24 months, the combination of positive sales trends and further synergies could drive EBITDA toward $1.2 billion.
--Fitch expects FCF in 2016 to be in the $160 million range, with the potential to decline to $70 million in 2017 and 2018 due to increased capex and dividends.
--Fitch expects that Signet's retail adjusted leverage will increase to the high-3.0x range in 2016 from a 2015 level of 3.3x, based on flattish EBITDA and the addition of $625 million of preferred equity investment. Leverage is expected to modestly decline over the following 24 months but remain above 3.5x.
A positive rating action could result in the event of better than expected top-line and profitability trends and/or higher than expected debt reduction that would lead to retail adjusted leverage being sustained under 3.5x.
A negative rating action could result in the event of one or more of the following: (i) continued weakness in top-line trends and EBITDA into 2017, and (ii) a more aggressive financial policy that keeps retail adjusted leverage above 4.0x over the medium term.
Signet had $119 million in cash at the end of the second quarter of 2016, borrowings of approximately $200 million under its $700 million unsecured revolving credit facility (recently increased from $400 million), and a fully drawn $600 million asset-backed securitization facility. The company has generally generated positive free cash flow (FCF) over the past four years, averaging approximately $100 million once removing 2014, which was FCF-neutral due to the Zale integration. Annual FCF is expected to be around $150 million in 2016, similar to 2015, but could decline to the $50 million - $100 million range beginning 2017 on increased capital expenditures and dividends.
FULL LIST OF RATING ACTIONS
Fitch has downgraded Signet's ratings as follows:
Signet Jewelers Limited (Signet):
--Long-Term IDR to 'BB+' from 'BBB-'.
Signet UK Finance plc:
--Guaranteed senior unsecured debt securities to 'BB+/RR4' from 'BBB-'.
Fitch has also assigned the following rating:
Signet Jewelers Limited:
--Convertible preferred securities 'BB-/RR6'.
The Rating Outlook is Stable.
Additional information is available on www.fitchratings.com.
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 added back $16 million in noncash stock based compensation to its EBITDA calculation and excluded $79 million of one-time transaction and Zale integration expenses.
--Fitch has adjusted the historical and projected debt by adding 8x annual gross rent expense.
Corporate Rating Methodology - Including Short-Term Ratings and Parent
and Subsidiary Linkage (pub. 17 Aug 2015)
Dodd-Frank Rating Information Disclosure Form