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March 28 (The following statement was released by the rating agency)
Fitch Ratings has downgraded China-based watch retailer Hengdeli Holdings Limited's (Hengdeli) Long-Term Issuer Default Rating (IDR) and senior unsecured rating to 'BB' from 'BB+'. The Outlook is Stable. The downgrade reflects Hengdeli's deteriorating credit metrics amid a weak operating environment. It will be challenging for Hengdeli to demonstrate a sustained strong recovery to its previous level in the medium term.
The Stable Outlook reflects Hengdeli's ability to maintain its strong business positioning and sufficient liquidity position despite the current down cycle.
KEY RATING DRIVERS
Weak environment increases recovery uncertainties. China's overall weak consumer sentiment and the government's anti-graft campaign in H213 continued to affect Hengdeli's performance. The company's active reshuffling of its product mix to fast-moving mid-range watches was not enough to offset the rapid decline in high-end watches sales. The company's overall same-store-sales growth (SSSG) in mainland China declined 7.1% in 2013 (H113: -7.5%) as high-end watch SSSG contracted 18.5% (H113: -18.9%) while mid-range watch SSSG remained flat (+0.6%) (H113: +0.6). Hengdeli's SSSG in mainland China and wholesale segment had exhibited positive growth YTD Feb 2014. However, sales visibility of Hong Kong operations remained weak. Fitch views uncertainties in the economic conditions and the weak buying sentiment would continue to dampen Hengdeli's sales rebound in the medium term.
Profitability Pressured by Slower Sales. Hengdeli's EBITDA margin narrowed to 8.32% in 2013 (2012: 11.51%) due to heavier sales discounting and increased rental costs. Fitch estimated that one percentage point of decline was attributed to margin dilution from its new Harvest Max business. Fitch expects the company's EBITDA margin to demonstrate slight recovery to around 9%, which is still lower than the previous level. A higher contribution from mid-segment watches which yields stronger margins would improve Hengdeli's profitability in 2014, but this benefit would partially be offset by ongoing sales discounting. Acquisition and Working Capital Increased Leverage. Hengdeli's high inventory days of 223 days (H113: 225 days) and about CNY300m of acquisition costs drove higher FFO adjusted net leverage of 3.5x in 2013 (H113: 3x). With Hengdeli finalising its inventory mix adjustments towards more fast moving mid-end products by 2014, Fitch expects some alleviation in working capital with positive free cash flow generation; the company's leverage would trend below 3x over the next 12-18 months.
Strong business positioning. Despite a weaker performance, Hengdeli's rating is still supported by its leading market position in the Swiss watch retail sector in China, its established distribution network and exclusive watch distribution arrangements that support its wholesale business. In 2013, the company was able to lengthen its days payables with suppliers in light of the weaker environment, which is a reflection of the company's business positioning and close relationship with its suppliers.
Adequate Liquidity. Hengdeli maintains sufficient cash of CNY2.3bn to cover its short-term bank loans of CNY1.35bn and estimated capital expenditure of around CNY150m for the next 12 months. The company also has CNY2bn in unutilised facilities to bridge working capital purposes, if required. As expected, the company had redeemed most of its convertible bonds in 2013, with outstanding balance of HKD95m as at end-2013.
Negative: Future developments that may, individually or collectively, lead to negative rating action include
-Negative SSSG for China
-Sustained weakening in EBITDA margins below 8%
-FFO adjusted net leverage sustained above 3.5x
Positive: Future developments that may, individually or collectively, lead to positive rating action include
-Sustained EBITDA margin above 10%
-FFO adjusted net leverage sustained below 2.75x
-Average inventory days sustained below 210 days