-- 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
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
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
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.
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
-- 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
-- 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
-- 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.
For the complete recovery analysis, please see the recovery report on
Michaels, to be published on RatingsDirect following this report.
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 Affirmed And Off CreditWatch
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
Michaels Stores Inc.
Senior Unsecured B- CCC+/Watch Pos
Recovery Rating 5 6