(The following was released by the rating agency)\
HONG KONG, January 16 (Fitch) Fitch Ratings has published China-based Hengdeli Holdings Limited's (Hengdeli) Long-Term Issuer Default Rating (IDR) of 'BB+' with Stable Outlook. The agency has also published Hengdeli's senior unsecured rating of 'BB+'. The company is a retailer for Swiss watches in China.
In addition, Fitch has assigned Hengdeli's proposed USD-denominated senior unsecured notes an expected 'BB+(EXP)' rating. The final rating is contingent upon the receipt of final documents conforming to information already received. The ratings reflect Hengdeli's exposure to cyclical demand for watches and inventory risk.
The ratings also reflect its leading market position in the Swiss watch retail sector in China, its exclusive watch distribution arrangements for selected Swiss brands and its established distribution network. Fitch estimates Hengdeli to have captured a combined market share of around 25% for Swiss watch sales in mainland China and Hong Kong in 2011. This large operating scale gives Hengdeli strong bargaining power with major global watch brand owners for new stock supply and in negotiating rental or securing new retail location.
The risk of non-renewal of its distribution agreements is mitigated by Hengdeli's strong bargaining power and watch brand owners' strategy to tap China's long-term demand growth. Hengdeli also benefits from low fixed costs and operational flexibility, including an ability to reduce stock purchases when sales slow.
The ratings are moderated by Hengdeli's exposure to cyclical demand for watches, which can lead to rising inventory risk. Its days inventory lengthened to about 220 days during H112 from 167 days in 2011 when sales slowed at its mature stores in China and in Hong Kong, where the focus is on premium brands. Fitch expects inventory days to gradually normalise as the company cuts back on orders and adjusts its product mix in favour of more fast-moving items.
The proposed senior unsecured notes would increase Hengdeli's funds from operations (FFO) net adjusted leverage to above 2x for the next two years (2011: 1.49x), a level that is still commensurate with its rating. Fitch expects Hengdeli to report positive free cash flow in 2013 after taking into account likely moderate improvement in its cash cycle and capex averaging at CNY300m per annum. The company is planning to use the notes proceeds to refinance its out-of-the-money CNY2.5bn bonds when they become due for conversion in October 2013. Failure to refinance the convertible bonds would put pressure on liquidity, although this is not Fitch's base-case scenario.
What could trigger a rating action?
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-Inventory days being sustained over 220 days
-FFO net adjusted leverage rising above 2.75x on a sustained basis
-Weakening of Hengdeli's current leading market position
-Material negative change to key distribution agreements with major suppliers
Positive: No positive rating action is expected unless Hengdeli is able to substantially increase its scale without compromising its financial metrics. This is not expected over the next 2 years.