TEXT-S&P affirms Michaels Stores 'B' rating
Overview -- U.S. arts and crafts retailer Michaels Stores is offering a $200 million add-on to its existing 7.75% senior notes due 2018, using the proceeds to pay down the secured term loan. -- The add-on offering likely means the anticipated IPO will not be completed within the next 90 days. -- We are affirming our 'B' corporate credit rating on the company and removing it from CreditWatch with positive implications. -- The positive outlook reflects our view that potential debt reduction may help to improve the financial risk profile to "aggressive" from "highly leveraged," especially if the anticipated IPO is completed within the next year. Rating Action On Sept. 20, 2012, Standard & Poor's Ratings Services affirmed its 'B' corporate credit rating on Irving, Texas-based arts and crafts retailer Michaels Stores Inc. Following our review of the add-on offering, we removed the company from CreditWatch with positive implications, where it had been placed on April 12, 2012. The outlook is positive. We also affirmed our issue-level rating on the company's senior secured term loan B-1, B-2, and B-3 tranches at 'BB-'. The recovery rating is unchanged at '1', which indicates our expectation for very high recovery (90% to 100%) in the event of a payment default. In addition, we raised our issue-level rating on the company's $800 million 7.75% senior unsecured notes due 2018, which will increase to $1 billion following the add-on offering, to 'B-' from 'CCC+'. We are revising the recovery rating to '5' from '6'. The '5' recovery rating indicates our expectation that noteholders would receive modest (10% to 30%) recovery in the event of a payment default. Finally, we affirmed our 'CCC+' issue-level rating on the company's $400 million 11.375% senior subordinated notes due 2016 and $250 million 13% subordinated discount notes due 2016. Both note issues have a recovery rating of '6', indicating our expectation that noteholders would receive negligible recovery (0% to 10%) in the event of a payment default. As of July 28, 2012, the company had about $3.4 billion in reported debt outstanding. Rationale The rating action reflects Standard & Poor's analysis that the proposed add-on offering likely means that Michaels' anticipated IPO will not be completed within the next 90 days, but maybe within the next year. Given our change in expectations regarding the timing of an IPO, coupled with the company's ongoing search for a full-time CEO, we believe a positive rating outlook is more appropriate than a CreditWatch placement. The ratings on Michaels reflect Standard & Poor's analysis that the company's business risk profile will remain "fair," based on the risks associated with the competitive and highly fragmented arts and crafts industry, the risks surrounding new store growth, and the substantial seasonality in quarterly operating performance. The ratings also reflect our expectation for the company's financial risk profile to potentially improve to "aggressive" from "highly leveraged," especially if an IPO is completed within the next year and proceeds are used for debt reduction. Below is our financial ratio forecast for the fiscal year ending January 2013 and for the following year, respectively: -- Lease-adjusted total debt to EBITDA decreases to 5.5x and then decreases to 4.9x, from profit growth and debt reduction. This does not reflect the potential debt reduction from an IPO, which we estimate could improve leverage by up to one-half turn. -- Funds from operations (FFO) to total debt increases to over 13% and then to over 15%, from growth and debt reduction. This does not reflect the potential debt reduction from an IPO, which we estimate could improve FFO to total debt by up to 200 basis points (bps). -- EBITDA coverage of interest increases to 2.5x and then to 2.8x, primarily from growth and slightly lower interest expense. Financial ratios indicative of a highly leveraged financial risk profile include adjusted total debt to EBITDA above 5x, and FFO to total debt below 12%. Financial ratios indicative of an aggressive financial risk profile include total debt to EBITDA between 4x and 5x, and FFO to total debt between 12% and 20%. Standard & Poor's economists believe the risk of another U.S. recession during the next 12 months remains at 25%. We expect GDP growth of just 2.1% this year and only 1.8% in 2013, consumer spending growth of between 1.9% and 2.2% per year through 2013, the unemployment rate remaining at or above 8% through late 2013, and crude oil (WTI) finishing 2012 at $92 per barrel and finishing 2013 at $90 per barrel. (See "U.S. Economic Forecast: Keeping The Ball In Play," published Aug. 17, 2012, on RatingsDirect). Considering these economic forecast items, our base-case forecast for the company's operating performance over the next two years is as follows: -- Revenue growth in the mid-single-digit percent area through 2013, with slightly stronger growth in 2012, given the 53rd week; -- Gross margin expansion of about 70 bps through 2013 from continued progress on private-label and direct sourcing initiatives; -- Selling, general, and administrative expenses continuing to grow at a slower rate than revenue; and -- Adjusted EBITDA margin improvement of about 90 bps through 2013. Reducing debt and extending debt maturities appears to remain a financial policy priority. We estimate Michaels will use proceeds of the senior unsecured notes to repay about $200 million of its $501 million senior secured term loan B-1, due in October 2013. In the S-1 Amendment No. 1 filing dated May 21, 2012, the use of IPO proceeds section indicates the company intends to repurchase or redeem all of its subordinated discount notes ($180 million outstanding as of July 28, 2012) and all, or a portion, of its senior subordinated notes ($393 million outstanding as of July 28, 2012). Even without the IPO, we forecast the company will repay the subordinated discount notes, either with internally-generated cash or with revolver borrowings, by the end of fiscal 2012. Our business risk profile assessment is fair. In our view, the industry is competitive and highly fragmented. We believe the top three companies control about one-third of industry share. Michaels has the largest share, with Hobby Lobby and Jo-Ann Stores trailing, in that order. 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. Michaels is highly dependent on consumer spending and relies on a loyal base of repeat customers for growth. As such, reaching new customers is important for growth. We believe the company is ahead of the industry in terms of expanding its customer base and broadening its customer profile. For example, a fair portion of the company's store base is in heavily populated Hispanic areas and the company is expanding its offering of specific products, classes, and events appealing to these customers. The company is also increasing its focus on "tween" customers (ages 8 to 13) and teen customers (ages 11 to 18) by introducing specific products, classes, and events appealing to these customers. There is significant seasonality in the company's business. We estimate the fourth quarter (November to January) accounts for roughly one-third of sales and nearly 50% of operating income. Heightening this risk is the long ordering lead times the company's suppliers require. For example, Michaels typically orders holiday season merchandise in February or March. As such, misjudging consumer preference or demand could materially harm financial results. The company's initiatives to increase its private-label product mix, to increase the amount of direct sourced products, and to reduce operating costs has helped its competitive position-this should continue. Private-label now accounts for nearly 44% of net sales compared with about 32% in 2010. Private-label products carry higher margins and help the company's pricing strategy. In fiscal 2011, the company directly sourced 26% of its products, compared with 23% of its products in 2010 and 17% of its products in 2009. The company has kept operating expense growth below revenue growth. Since fiscal 2006, we calculate operating expenses have grown at a compound annual growth rate (CAGR) of 0.9%, while revenue has grown at a CAGR of 1.8%. We believe the company will continue to benefit from operating expense leverage. Liquidity We believe Michaels Stores' liquidity is "adequate" and we expect cash sources to exceed cash uses over the next 24 months. Cash sources primarily include surplus cash, FFO, and revolver availability. Cash uses primarily include working capital, capital expenditures, and debt repayment. Our liquidity assessment includes the following factors, expectations, and assumptions: -- We expect 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 declined 15%. -- We estimate the company will maintain more than $50 million of availability, or 10% of the borrowing base or commitments under its revolving credit facility, so that no material financial ratio maintenance covenants would apply. -- We believe the company has a generally satisfactory standing in credit markets and has sound relationships with banks. We expect Michaels will continue to proactively refinance its debt maturities. The company recently amended its revolving credit facility, extending its maturity to April 2017 from April 2014. In addition, we estimate the proposed add-on offering of its senior unsecured notes due 2018 will reduce the balance of its senior secured term loan B-1 due October 2013 to about $300 million from $501 million. The remaining debt maturities range between 2016 and 2018. As of July 28, 2012, we calculate total liquidity was about $740 million, which included revolver availability of $627 million and cash of $113 million. Over the past four quarters, the average revolver availability was $620 million and the average borrowing base was $709 million. The recent amendment reduced the revolver size by up to $650 million, subject to a borrowing base, from up to $850 million, also subject to a borrowing base. We forecast free cash flow will range between $225 million and $250 million per year through 2013. This incorporates our expectation for capital expenditures of between $130 million and $150 million per year and for modest working capital growth. Our forecast considers the company's plans to open between 45 and 50 stores during 2012. Recovery analysis For the complete recovery analysis, please see the recovery report on Michaels, to be published on RatingsDirect following this report. Outlook The positive outlook on Michaels reflects our expectation that potential debt reduction may improve the financial risk profile to aggressive from highly leveraged, especially if an IPO is completed within the next year. We could raise our ratings if ratios reach levels indicative of an aggressive financial risk profile, including leverage below 5x. Based on second-quarter fiscal 2012 results, debt reduction of over $800 million or EBITDA growth of over 20% is necessary for leverage to decline below 5x. We could revise our outlook to stable if it becomes clear further debt reduction is not likely, possibly from cancelling the anticipated IPO, or if operating performance improvement stalls or weakens, likely from a poor holiday season. These scenarios, or any other variation, would cause financial ratios to remain near current levels, including leverage of about 6x. Related Criteria And Research -- Use of CreditWatch and Outlooks, published Sept. 14, 2009 -- Corporate Ratings Criteria 2008, published April 15, 2008 -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Methodology and Assumptions: Liquidity Descriptors for Global Corporate Issuers, Sept. 28, 2011 Ratings List Ratings Affirmed And Off CreditWatch To From Michaels Stores Inc. Corporate Credit Rating B/Positive/-- B/Watch Pos/-- Senior Secured BB- BB-/Watch Pos Recovery Rating 1 1 Subordinated CCC+ CCC+/Watch Pos Recovery Rating 6 6 Upgraded To From Michaels Stores Inc. Senior Unsecured B- CCC+/Watch Pos Recovery Rating 5 6
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