TEXT-S&P raises Foot Locker rating to 'BB+'
Overview -- New York-based footwear retailer Foot Locker Inc. has strengthened operating results ahead of our expectations because of revenue increases and significant margin gains. -- We are raising Foot Locker's corporate credit rating to 'BB+' from 'BB', as credit protection metrics have improved ahead of our forecasts. -- The stable outlook reflects our expectation for further performance growth in the next year because of continued comparable-store sales expansion and operating leverage enhancement. Rating Action On Oct. 17, 2012, Standard & Poor's Ratings Services raised its corporate credit rating on Foot Locker Inc. to 'BB+' from 'BB'. The outlook is stable. At the same time, we raised our issue-level rating on the company's unsecured debt to 'BB+' from 'BB'. The recovery rating remains unchanged at '4', indicating our expectation of average (30% to 50%) recovery for noteholders in the event of a payment default or bankruptcy. Rationale The rating on specialty athletic footwear retailer Foot Locker reflects Standard & Poor's expectation that the company will maintain its "intermediate" financial risk profile and "fair" business risk profile in the coming year. The intermediate financial risk profile reflects Foot Locker's improved credit protection measures as a result of EBITDA growth, as well as higher free operating cash flow generation. This improvement is in spite of increased capital spending and shareholder-friendly initiatives, including dividends and share repurchases in the past year. The fair business risk profile reflects the company's solid market position, good brand recognition, and improved operating efficiency. These strengths are partly offset by significant supplier concentration and participation in the intensely competitive athletic footwear and apparel retail industry. Other risk factors include weak economies in the U.S. and Europe reducing consumer spending, increased competition from vendors, sensitivity to fashion trends, and popularity of athletes with branded merchandise, given a substantial portion of sales are to young males ages 12 to 25. We expect Foot Locker's ongoing focus on improving Lady Foot Locker spurring online traffic, and expanding higher-margin apparel sales to continue to propel profit growth in the coming year. Foot Locker has performed ahead of our expectations in the first half of 2012, as athletic shoes and apparel remain on trend and select basketball merchandise sells at higher price points than in previous years. Same-store sales were up 9.8% in the latest quarter and gross margin increased 140 basis points (bps) to 32.5%, mainly because of improvements in fixed-cost leveraging as the company continues to shut less-productive stores. We also anticipate further enhancement in sales-per-gross-square-foot in the next 12 months. Our forecast for key credit ratios for fiscal 2012 is as follows: -- Lease-adjusted total debt to EBITDA will improve to 2.4x by the end of fiscal 2012 from 2.9x in fiscal 2011. -- Funds from operations (FFO) to total debt will increase 3% to 41% by the end of fiscal 2012. -- EBITDA coverage of interest will improve to 5.0x by the end of fiscal 2012 from 4.3x in fiscal 2011. Standard & Poor's economists believe the risk of another U.S. recession during the next 12 months is between 20% and 25%. We expect GDP growth of just 2.2% this year and only 1.8% in 2013, consumer spending growth of between 2.0% and 2.3% per year through 2013, and the unemployment rate remaining at or above 8% through late 2013 (see "U.S. Economic Forecast: He's Buying A Stairway To Heaven," published Sept. 21, 2012, on RatingsDirect). Considering these economic forecast items, our base-case forecast for the company's operating performance over the next year is as follows: -- Mid-single-digit percent sales increase because of a mid-single digit percent same-store sales increase and mid-teens percent direct sales growth from stronger holiday performance. -- We expect gross margins to increase in the mid-double-digits basis points range, as gains from operating leverage offset pressure on merchandise margin through input cost increases. -- We anticipate selling, general, and administrative expenses will increase in the mid-single-digit percent range because of slightly increased marketing costs. -- We project funds from operations to debt will remain above 40% for 2012, as the company continues to maintain low levels of markdown activity. We have revised the company's financial risk profile upward to intermediate from "significant," principally because we believe credit protection metrics will continue to demonstrate gains in the coming year. We expect Foot Locker to benefit from better inventory controls and reduced promotional activity, especially in footwear, as a result of strong merchandising across the casual, running, and basketball categories. We anticipate a 22% increase in EBITDA in fiscal 2012, which will leverage and coverage, given the company's minimal debt. Foot Locker has significant vendor concentration, but has built strong relationships with key branded vendors such as Nike, Adidas, and Reebok. The company enjoys significant allocation of exclusive and limited distribution products because of these strong relationships. However, dependence on a few select suppliers has increased rather than lessened over the past few years as the industry has consolidated. As of year-end 2011, Foot Locker purchased approximately 61% of its merchandise from Nike and about 82% of its merchandise from its top five vendors. Liquidity We assess Foot Locker's liquidity as "strong," with cash on hand and cash generated from operations likely to exceed uses for the next 12 months. Cash sources include about $850 million of cash on hand, free operating cash flow in the mid-$300 million area, and nearly $200 million of availability under the company's credit facility as of July 28, 2012. Foot Locker's light maturity schedule over the next two years and limited revolver usage bolsters its liquidity. We anticipate cash uses could remain moderate and will be primarily composed of capital expenditures and investments in working capital, dividends, and share repurchases. The company announced approval of a new, three-year $400 million share repurchase program earlier this year extending through January 2015. It also announced a 9% increase in its quarterly dividend. As a result we expect about $110 million in dividends and between $125 million to $150 million in share repurchases in 2012. Relevant aspects of the company's liquidity, in our view, are as follows: -- We expect coverage of sources over uses to be above 1.5x. -- We also expect that net sources would be positive, even with a 30% decline in EBITDA. -- The company has no financial performance covenants and no debt maturities over the next 12 months. -- We believe that the company has sound relationships with the banks. Recovery analysis For the complete recovery analysis, see the recovery report on Foot Locker Inc., to be published on RatingsDirect following this report. Outlook The stable outlook reflects our view that Foot Locker should continue to improve moderately over the next 12 months because of comparable-store sales growth. However, our fair assessment of the business risk profile limits the potential for an upgrade in the near to intermediate term. To consider an upgrade, we would need to reassess business risks, including vendor concentration and exposure to fashion trends, such as high-profile athlete endorsements. We could lower the rating in the next year if Foot Locker performs worse than our expectations because of a material weakening of consumer demand, severe merchandise missteps or increased competition. Under this scenario, leverage would approach the low-4.0x area because of a 10% decline in sales and a more than 200 bps gross margin decline. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Upgraded; Recovery Rating Unchanged To From Foot Locker Inc. Corporate Credit Rating BB+/Stable/-- BB/Stable/-- Senior Unsecured BB+ BB Recovery Rating 4 4