TEXT-S&P revises Jo-Ann Stores outlook to positive
April 12 - Overview -- U.S. fabrics and crafts retailer Jo-Ann Stores Inc.'s financial ratios improved last year from sales growth and margin expansion. -- We are affirming all ratings, including the company's 'B' corporate credit rating, and revising the outlook to positive from stable. -- The positive outlook reflects our expectation that recent financial ratio improvement can continue even in a low-growth economy, with the possibility for ratios to reach levels indicative of an aggressive financial risk profile within the next 12 months. Rating Action On April 12, 2012, Standard & Poor's Ratings Services affirmed its 'B' corporate credit rating on Hudson, Ohio-based Jo-Ann Stores Inc. and revised the outlook to positive from stable. At the same time, we affirmed the 'B+' (one notch above the corporate credit rating) issue-level rating on the company's $650 million senior secured term loan B facility due 2018. The recovery rating is '2', indicating our expectation of substantial (70% to 90%) recovery for lenders in the event of a payment default. We also affirmed the 'CCC+' (two notches below the corporate credit rating) issue-level rating on the company's $450 million senior unsecured notes due 2019. The recovery rating is '6', indicating our expectation of negligible (0% to 10%) recovery for note holders in the event of a payment default. Rationale The rating action reflects Standard & Poor's Ratings Services' forecast that Jo-Ann Stores Inc.'s recent financial ratio improvement from sales growth and margin expansion can continue, even in a low-growth economy. The ratings on Jo-Ann Stores reflect Standard & Poor's business risk profile assessment of "weak" and its financial risk profile assessment of "highly leveraged." Our business risk assessment reflects our analysis that continued capital investment in store enhancement is necessary to maintain its competitive position. It also reflects the company's participation in the competitive and highly fragmented craft and hobby retail industry, as well as the seasonal nature of its earnings. Our financial risk assessment reflects our expectation for financial policies to remain very aggressive under financial sponsor ownership. It also reflects our forecast for financial ratios to remain indicative of a highly leveraged financial risk profile this year, but to possibly reach levels indicative of an aggressive financial risk profile within the next 12 months. Below is our financial ratio forecast for fiscal year-end January 2013 and for fiscal year-end January 2014, respectively: -- Operating lease-adjusted total debt to EBITDA decreases to 5.6x and then decreases to 5.2x, primarily from profit growth. -- Funds from operations (FFO) to total debt increases to about 15% and then increases to nearly 16%, primarily from profit growth. -- EBITDA coverage of interest increases to 2.5x and then increases to 2.7x, primarily from profit growth. Principal economic factors we considered in our company forecast include weak economic growth, high unemployment, weak consumer spending growth, and elevated raw material costs through 2013. More specifically, Standard & Poor's economists currently forecast GDP growth of 2.1% in 2012 and 2.3% in 2013, consumer spending growth of 2.0% in 2012 and 2013, the unemployment rate remaining at or above 8% through 2013, and crude oil per barrel (WTI) finishing 2012 near $105 and finishing 2013 near $115. We currently estimate there is a 20% probability of a recession occurring in the U.S. Considering these economic forecast items, our forecast for the company's operating performance is as follows: -- Revenue growth in the mid- to high-single-digit percent area, boosted by an extra week in fiscal 2013 and the company's plan to continue adding new stores and remodeling existing ones. -- Gross margin is flat to slightly higher, as elevated input costs continue to offset modest gains from private-label and direct sourcing initiatives. -- Operating expenses grow at a lower rate than revenue, with growth principally from store development initiatives. -- Debt repayment is limited to contractual debt amortization plus excess cash flow payment to be paid in the fiscal 2013 first quarter, based on fiscal 2012 results. We view the company's financial policies to be very aggressive, primarily because of the majority equity ownership by the financial sponsor, Leonard Green & Partners L.P. Our view incorporates our expectation for the company to deploy excess cash for capital investments, and possibly dividends, as opposed to accelerated debt repayment, given the typical transient nature of financial sponsor ownership. Leonard Green took Jo-Ann Stores private through a leveraged buyout in March 2011. Our business risk assessment incorporates our opinion that the industry will remain competitive and highly fragmented. We believe the top three companies control about one-third of industry share, with Jo-Ann Stores trailing behind Michaels Stores and Hobby Lobby. We believe these three companies will continue to invest in store expansion to gain industry share. New store expansion will continue to contribute to growth. Jo-Ann is highly dependent on discretionary consumer spending, and we believe the company relies on a loyal, yet narrow base of repeat customers for growth. For same-store sales growth to consistently exceed GDP growth, the company will need to expand its customer base and broaden its customer profile, likely through targeted marketing campaigns via multiple channels. We believe such initiatives are underway, but it is still too early to gauge the potential benefits. There is significant seasonality in the company's business. The majority of sales take place in the third and, to a greater extent, fourth quarter. Heightening this risk is the long ordering lead times the company's suppliers require. For example, it typically orders holiday season merchandise in February or March. As such, misjudging consumer preference or demand could materially harm financial results. We believe the company will be able to continue to benefit from operating expense leverage, though not to the extent it achieved in recent years. An enhanced store base and increased direct sourcing of products has helped profitability. We calculate gross margin has improved nearly 350 basis points since fiscal 2007, and we believe increased direct product sourcing contributed meaningfully to this improvement. The company has also efficiently managed its operating expenses. Since fiscal year 2007, operating expenses have increased at a compound annual growth rate (CAGR) of less than 1.5%, while revenue has increased at a CAGR of about 3.5%. Liquidity We believe Jo-Ann Stores has adequate liquidity, and we expect cash sources to exceed cash uses over the next 24 months. Cash sources primarily include surplus cash, funds from operations, and revolver availability. Cash uses primarily include working capital, capital expenditures, and debt amortization. Our liquidity assessment includes the following factors, expectations, and assumptions: -- We forecast cash sources to exceed cash uses by more than 1.2x over the next 12 months and to remain positive over the next 24 months. -- We forecast net sources would remain positive even if EBITDA were to decline 15%. -- We believe the company will maintain excess availability under its revolving credit facility so that no material financial ratio maintenance covenants would apply. -- Contractual debt amortization is low, at $6.5 million per year. -- Debt maturities are favorable, with the revolving credit facility due in 2016, the term loan due in 2018, and the senior notes due in 2019. -- As of Jan. 28, 2012, we calculate total liquidity of about $350 million, with revolver availability of about $280 million. Recovery analysis For the complete recovery analysis, please see the recovery report on Jo-Ann Stores, to be published on RatingsDirect following this report. Outlook Our positive rating outlook reflects our expectation that recent financial ratio improvement can continue even in a low-growth economy, with the possibility for ratios to reach levels that indicate an aggressive financial risk profile within the next 12 months. We could raise our ratings if positive operating performance trends continue and it becomes clear that financial ratios will improve to levels indicating an aggressive financial risk profile, including operating lease-adjusted total debt to EBITDA reaching the low-5x area and funds from operations to total debt exceeding 15%. Based on last fiscal year's fourth-quarter results, EBITDA would have to increase nearly 20% for leverage to reach the low-5x area and FFO would have to increase about 15% for FFO to total debt to exceed 15%. We could revise our outlook to stable if positive operating performance trends reverse, causing financial ratio improvement to stall or worsen and leading us to revise our forecast to reflect financial ratios remaining firmly within levels indicative of a highly leveraged financial risk profile, including operating lease-adjusted total debt to EBITDA remaining near 6x and FFO to total debt decreasing to about 12%. Based on last fiscal year's fourth-quarter results, EBITDA growth would have to remain flat for leverage of about 6.0x and FFO would have to decrease 9% for FFO to total debt of about 12%. Related Criteria And Research -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Ratings Affirmed; Outlook Action To From Jo-Ann Stores Inc. Corporate Credit Rating B/Positive/-- B/Stable/-- Ratings Affirmed; Recovery Ratings Unchanged Jo-Ann Stores Inc. Senior Secured B+ Recovery Rating 2 Senior Unsecured CCC+ Recovery Rating 6 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.