TEXT - S&P cuts Central Garden & Pet Co.
Overview -- U.S. consumer products company Central Garden & Pet Co. has remained unable to increase prices sufficiently to protect margins, and we believe it will take several years to achieve meaningful benefits from its transformation activities. -- We are lowering the corporate credit rating to 'B' from 'B+'. -- The stable outlook reflects our expectation that credit ratios will remain near recent levels even though the company will remain vulnerable to the decisions of its top customers. Rating Action On Jan. 18, 2013, Standard & Poor's Ratings Services lowered its corporate credit rating on Walnut Creek, Calif.-based Central Garden & Pet Co. to 'B' from 'B+'. The outlook is stable. At the same time, we lowered our issue rating on the company's $375 million revolving credit facility due 2016 to 'BB-' from 'BB'. The recovery rating remains '1', which indicates our expectation of very high recovery (90% to 100%) for creditors in the event of a payment default or bankruptcy. We also lowered our issue rating on the company's $450 million senior subordinated notes due 2018 to 'CCC+' from 'B'. We revised the recovery rating on the notes to '6' from '5', which indicates our expectation of negligible recovery (0% to 10%) for noteholders in the event of a payment default or bankruptcy. As of Sept. 29, 2012, the company had $449.8 million in reported debt outstanding. Rationale The downgrade reflects Standard & Poor's assessment that Central Garden & Pet's business risk profile has worsened to "vulnerable" from "weak." The company shows a continued inability to raise prices sufficiently to protect margin and we believe transformation-related expenses will continue over the next several years. Also, the company is vulnerable to the decisions of its top five customers, which represented about 45% of fiscal 2012 revenue. We believe the financial risk profile remains "aggressive," based on our forecast for credit ratios to remain weak, our opinion that financial policy is "aggressive," and our view that the liquidity profile remains "less than adequate." Our credit ratio forecast through the end of 2014 is as follows: -- Total debt to EBITDA between 4.3x and 5.3x. -- Funds from operations (FFO) to total debt between 12% and 15.5%. -- EBITDA interest coverage between 2.7x and 2.8x. -- We forecast peak borrowing under the revolver of up to $120 million in the fiscal second quarters of 2013 and 2014, which is consistent with the fiscal second quarters of 2011 and 2012. We forecast no borrowing under the revolver in the fiscal fourth quarters of 2013 and 2014, which is consistent with the fiscal fourth quarters of 2011 and 2012. Credit ratios indicative of an "aggressive" financial risk profile includes 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 is between 10% and 15%, down from between 15% and 20% in December 2012. We expect GDP growth of 3.0% in 2013 and 3.0% in 2014, consumer spending growth of 2.7% in 2013 and 3.2% in 2014, crude oil per barrel (WTI) finishing 2013 near $90 and finishing 2014 near $87, and the unemployment rate finishing 2013 at 7.3% and finishing 2014 at 6.6%. With these economic expectations in mind, our base-case forecast for the company's operating performance is as follows: -- Revenue growth in the low-single-digit percent area over the next two years. We note there was an extra week of sales in fiscal 2012. We also note revenue could greatly exceed our forecast if costs significantly increase. We believe the incremental revenue growth would be equal to or less than the increase in the cost of goods sold, resulting in a gross profit similar to or lower than gross profit in our base-case forecast. -- Gross margin (excluding depreciation and amortization) declines 30 basis points to 31.7% in 2013 and increases 20 basis points to 31.9% in 2014. This assumes costs modestly increase but do not significantly increase, such as in 2011 when gross margin declined from nearly 36% to 32%. -- Selling, general, and administrative expenses increase in line with our base-case revenue growth forecast. Management plans to continue increasing marketing-related expenses, mainly for brand-building initiatives. We believe this is necessary given the competitive landscape, especially in the Garden Products segment where The Scotts Miracle-Gro Co. commands a significant competitive advantage. -- Adjusted EBITDA margin remains between 6.4% and 6.9%, which translates to trailing-12-months EBITDA remaining between $108 million and $120 million over the next eight quarters. -- No debt amortization is required within the current capital structure. We assume peak borrowing of up to $120 million during the fiscal second quarter, which is consistent with prior years. We assume no revolver borrowing at the end of fiscal 2013 and 2014. The basis for our view that financial policy is "aggressive" is primarily rooted in the company's share repurchase history and stated acquisition strategy. Share repurchases totaled $200 million from fiscal 2010 to fiscal 2012, and were nearly $110 million in fiscal 2011, the same year gross margin declined over 300 basis points. Share repurchases declined to $25 million in fiscal 2012. We forecast they will remain at or below $20 million per year. There is about $50 million remaining on the current share repurchase authorization. Acquisition activity has remained limited, with none in fiscal 2012. Still, the company continues to indicate they are open to the idea. We believe significant acquisition activity could disrupt the current transformation initiative, which is already behind schedule and missed its fiscal 2012 cost savings plan. The transformation is now scheduled to be completed by the end of 2015. The company achieved cost savings of $20 million, versus the planned $30 million, in fiscal 2012. The plan aims to transform the company from a portfolio of separately run businesses into an integrated, multibrand company by executing on the following initiatives: consolidate warehouse and distribution space, optimize manufacturing capacity utilization, rationalize SKU counts 30% to 35%, consolidate purchasing across the organization, and integrate sales and marketing functions. The company incurred about $12.1 million in transformation-related expenses during 2012, which we do not add back to EBITDA because management indicates these types of expenses will continue over the next several years. We believe the company will remain unable to increase prices in order to protect margin. Costs increased significantly in 2011 and continued at a lower rate in 2012. For example, the weighted average cost per pound of the company's primary bird feed grains increased 41% in fiscal 2011 and another 11% in fiscal 2012. The drought was a contributing factor to the fiscal 2012 cost increase. Also, the company's negotiating power with its customer base continues to weaken. Its top five customers, including Walmart, Lowe's, Home Depot, PetSmart, and PETCO, accounted for 45% of fiscal 2012 revenue, and these companies are increasing their retail market share. We believe any successful price increases can hurt volume, with customers switching to lower-margin products or competing products, or reducing consumption given these are discretionary purchases. Liquidity We view the company's liquidity profile as "less than adequate" even though we expect the company's cash sources can cover cash uses over the next 24 months. The primary reason for the "less than adequate" profile is because EBITDA cushion under the interest coverage covenant can return below 15% with only a slight drop in profitability. Plus, management stated in the fourth-quarter earnings call that first-quarter profitability will be down over the prior year given disruptions in the Northeast from hurricane Sandy. The company's cash flows are highly seasonal, with negative cash flow generation in the fiscal second quarter ended March followed by robust cash flow generation in the fiscal third quarter ended June. We forecast revolver borrowing of up to $120 million in the fiscal second quarter, with no revolver borrowing at the end of each fiscal year. As of Sept. 29, 2012, we calculate total liquidity was $296.7 million, which included $225.5 million of availability under its $375 million revolving credit facility and $71.2 million of cash. Total liquidity was in a range between $144.3 million and $296.7 million over the four quarters of fiscal 2012. We forecast a similar total liquidity range over the next four quarters. We forecast free cash flow of less than $25 million per year through 2014, which incorporates our expectation for working capital investment of up to $6 million per year and capital expenditures of about $40 million per year. We believe share repurchases and potential acquisitions will consume free cash flow. Additional relevant aspects of Central Garden & Pet's liquidity profile are as follows: -- We forecast cash sources will exceed uses by more than 1.2x over the next two years. -- We forecast net sources will remain positive, even if EBITDA declines by 15%. We note the company would violate its interest coverage financial maintenance covenant if EBITDA were to decline by more than 15%, though. -- The company's debt maturity profile is manageable. There is no debt amortization. The revolving credit facility is due in 2016 and the senior subordinated notes are due in 2018. Recovery analysis For the complete recovery analysis, please see the recovery report on Central Garden & Pet Co., to be published on RatingsDirect following this report. Outlook The outlook is stable, which reflects our forecast for credit ratios to remain near recent levels even though we believe the company will remain vulnerable to the decisions of its top customers. We could lower the ratings if the liquidity profile worsens to "weak" from "less than adequate," possibly due to the inability to repay peak revolver borrowing, which could result in a covenant breach, especially if peak revolver borrowing meaningfully exceeds our forecast. While unlikely over the next year, we could raise the ratings if our assessment of the company's business risk profile improves to "weak," which could follow a rise in margins to 2009 and 2010 levels, including gross margin above 35%. This could occur through the successful execution of the company's transformation plan. Related Criteria And Research -- U.S. Economic Forecast: New Year's Resolutions, Jan. 16, 2013. -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Methodology and Assumptions: Liquidity Descriptors for Global Corporate Issuers, Sept. 28, 2011 -- Corporate Ratings Criteria 2008, April 15, 2008 Ratings List Downgraded To From Central Garden & Pet Co. Corporate credit rating B/Stable/-- B+/Negative/-- Senior secured $375 mil. revolver due 2016 BB- BB Recovery rating 1 1 Subordinated $450 mil. notes due 2018 CCC+ B Recovery rating 6 5