TEXT - S&P cuts Big Lots Inc to 'BBB-'
Overview -- U.S. closeout retailer Big Lots' second-quarter performance was meaningfully below our expectations. -- We are removing the ratings on the company from CreditWatch and lowering them to 'BBB-' from 'BBB'. -- The negative outlook reflects our view that Big Lots' future profits may remain below historical levels partly because of its cash-strapped customer base. Rating Action On Nov. 9, 2012, Standard & Poor's Ratings Services removed all of its ratings on Columbus, Ohio-based Big Lots Inc. from CreditWatch, where they were placed with negative implications on Aug. 23, 2012, and lowered the ratings to 'BBB-' from 'BBB'. The outlook is negative. As of July 28, 2012, Big Lots had about $243 million of debt outstanding. Rationale The downgrade reflects our expectation that operating weakness will continue as Big Lots' core customer base remains cash strapped and the company continues to modify its merchandise offering following an unenthusiastic consumer response to its discretionary offerings. We forecast that for the remainder of fiscal 2012, sales and profit pressure will continue as consumers modify their purchasing behavior, including overall reduced spending on higher-cost discretionary items and a shift toward lower-margin consumables. In our opinion, Big Lots' planned testing of coolers and freezers and of full market remodels may be indicative of some weakness in its underlying business model. Big Lots' performance for the quarter ended July 28, 2012, included a 30% drop in core U.S. store operating profit and commensurate credit measure deterioration. The ratings on Big Lots reflect our opinion that the company has a "satisfactory" business risk profile with a competitively priced product offering, partly due to the generally lower cost nature inherent to closeout retailing, and what we still consider to be a good management team. Key risk factors include substantial competition from large mass-merchant discounters and a customer base that includes less affluent, moderate income consumers who are more susceptible to inflationary pressures and persistently high unemployment. view Big Lots' financial risk profile as "intermediate", mainly reflecting its moderate financial policy as demonstrated by limited use of on balance sheet debt and satisfactory free cash flow generation. The continuation of its moderate financial policy is a key rating factor. The company is testing the introduction of coolers and freezers in some of its stores. We believe the intent is to evaluate whether a more complete product offering-including food items-will result in incremental purchases of higher margin discretionary items by driving store traffic, including winning business with Supplemental Nutritional Assistance Program (SNAP) customers. It is not clear to us that offering low margin food items will necessarily drive significant purchases of higher margin discretionary items, especially by SNAP customers. We are also skeptical Big Lots could effectively compete on price for food items against large grocers and mass merchants. Big Lots is also testing a full market remodel plan, which is intended to provide a "like-new" in-store experience. We think a rollout of this plan to a meaningful number of its stores would require a large capital investment. Our forecast for fiscal 2012 (year-end January 2013) and fiscal 2013 include the following assumptions: -- We forecast modestly lower comparable store sales as core customer disposable income remains under pressure and the economy remains weak. -- EBITDA declines by 10%-15% in 2012, followed by a low single digit decline the following year as lower margin consumables account for an increased proportion of Big Lots' sales. Although its performance is improving, we do not anticipate its Canadian subsidiary to break even before fiscal 2014. -- Annual capital expenditures fall to about $115 million, reflecting the potential for a pared back store expansion program. -- Our forecast does not assume a large scale rollout of Big Lots' planned cooler and freezer or full market remodel tests, the latter of which could add considerably to capital expenditures. -- Share repurchases of around $300 million for fiscal 2012 and $200 million annually thereafter. Under this scenario, we forecast debt leverage at 2.25x-2.5x over the next 18 months, about 50% funds from operations (FFO) to total debt, and 6.5x EBITDA interest coverage. These credit ratios are only slightly weaker than levels reported for the 12 months ended July 28, 2012. However, we believe Big Lots' short average store lease tenor makes our adjusted credit ratios appear stronger than they would be if longer lease tenors were used. If we adjust its lease tenor to levels more typical of most retailers, leverage increases to about 3.3x, FFO to total debt declines to 40%, and EBITDA interest coverage falls to about 4x. In our opinion, these ratios are more indicative of Big Lots' credit health. Liquidity We view Big Lots' liquidity as "adequate" considering its existing liquidity sources, absence of meaningful debt maturities, and ample financial covenant cushion. Relevant aspects of the company's liquidity profile, based on our criteria and assumptions, are as follows: -- We expect the company's sources of liquidity over the next 12-24 months to exceed uses by more than 1.2x, and believe net sources would be positive, even if EBITDA fell 15%. -- As of July 28, 2012, Big Lots had $62 million cash and $383 million availability under its $700 million revolving credit facility (net of $243 million borrowings and about $74 million letters of credit) due July 2016. Seasonal revolver borrowing particularly in the third quarter occurs to support holiday inventory growth. -- We expect cushion under financial covenants to remain above 30%. -- We forecast capital expenditures to decline to around $115 million. It is possible capital expenditures could increase starting in 2014 depending on whether Big Lots' rolls out its tests. -- We forecast around $200 million of annual free cash flow generation. -- Big Lots appears to have satisfactory relations with its banks. Outlook The outlook is negative. We expect demand for Big Lots' merchandise to remain weak if spending by its customers, which we believe includes less affluent, moderate income households, declines because of general inflation pressure, potentially reduced transfer payments from governments, and continued high unemployment. It is also possible Big Lots could be more aggressive than we assume with respect to financial policy, particularly share repurchases. We could lower the ratings if financial policy becomes more aggressive than we currently expect or if profitability declines further, resulting in leverage exceeding 3.5x using a rent multiple that is more typical of retailers. We think this could occur if EBITDA falls by about a high single digit rate. An outlook revision to stable could occur if we believe Big Lots will maintain an overall moderate financial policy and if profitability stabilizes and begins to improve, leading to leverage (adjusted to a more typical rent multiple) under 3x, which we think can occur if EBITDA improves by around 10%. Related Criteria And Research -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 -- Use of CreditWatch and Outlooks, Sept. 14, 2009 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Corporate Ratings Criteria 2008, published April 15, 2008 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 Ratings List Downgraded; CreditWatch/Outlook Action To From Big Lots Inc. Corporate Credit Rating BBB-/Negative/-- BBB/Watch Neg/-- Big Lots Stores Inc. Senior Unsecured BBB- BBB/Watch Neg