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Fitch Assigns Shop Direct 'B+(EXP)' Rating; Senior Secured Notes 'B+(EXP)'
October 20, 2017 / 11:59 AM / a month ago

Fitch Assigns Shop Direct 'B+(EXP)' Rating; Senior Secured Notes 'B+(EXP)'

(The following statement was released by the rating agency) LONDON, October 20 (Fitch) Fitch Ratings has assigned Shop Direct Limited (SDL) a Long-Term Issuer Default Rating (IDR) of 'B+(EXP)' with a Stable Outlook. Fitch has also assigned Shop Direct Funding plc's planned GBP700 million senior secured notes an expected senior secured rating of 'B+(EXP)'/'RR4'. The final rating is contingent upon the receipt of final documents conforming to information already received by Fitch. The 'B+(EXP)' IDR reflects management's track record of generally implementing a coherent and successful strategy with limited execution risk, leading to a robust business model with solid presence in online retail, improving market shares and a commercial offer enabled by consumer financing. Such features, mitigated by moderate scale and limited geographic diversification, indicate a business profile commensurate with the 'BB' rating category. Profitability and financial flexibility are also strong, supporting the assigned rating. However, the rating is constrained at 'B+' due to high Fitch-adjusted funds from operations (FFO) net leverage of 5.0x at financial year-end June 2017 (FYE17) and our expectation of neutral to mildly positive free cash flow (FCF). A potentially high dividend pay-out exceeding GBP100 million by FYE19 could result in permanently increased FFO adjusted net leverage above 5.5x and diminished financial flexibility, if not offset by a material improvement in profitability, which would lead to a notch downgrade to 'B'. However, our forecasts show net leverage strengthening mildly over the rating horizon. KEY RATING DRIVERS Subsidised Online Retail Operations: SDL provides wholly owned consumer financing as a complementary core offering to its online general merchandise retail operations. Its profitable consumer finance operations allow spending on operating, IT and marketing costs to support retail sales volume growth in a symbiotic way. We view this feature as supportive of the company's superior business model but it exposes the group to non-bank financial institution-type risks, namely receivable asset quality through the economic cycle, and funding/liquidity for that purpose. Growing Very Offsets Declining Littlewood: SDL has increased market share in UK retail despite competition from traditional retailers with increasing online presence and pure-play internet providers (eg Amazon, ASOS and Boohoo). This is critically driven by the success of Very. However, our positive view of SDL's market position is offset by management's conscious decision to run down its Littlewoods brand, managing it for profit and cash, and its sole presence in the UK's highly competitive market with a number of innovations in retail technology and customer reach. Profitability Supported by Asset-Light Structure: SDL has solid profitability adjusted for consumer financing based on our criteria relative to pure internet retailers of comparable scale. SDL is capable of generating adequate profits and solid FCF from its inherently asset-light structure dominated mainly by distribution centres and consumer interface technological platforms. The EBITDAR margin is lower than bricks-and-mortar retailers but this is mitigated by better cash conversion. PPI-related exceptional costs and the securitisation interest are incurred purely by Shop Direct Finance Company Limited (SDFC). SDFC profit is generated largely by Very as 80% of Littlewoods' sales are on interest-free terms. SDFC Funding and Liquidity Constraints: Most of the group's debt is secured despite the solid cash flow generation capabilities at group level and the lack of meaningful debt maturities. The encumbered nature of the assets reduces financial flexibility in our view, particularly at the SDFC level. Pricing Mitigates High Impaired Receivables: SDL's asset quality is relatively weak, despite improving, as indicated by a four-year average of impaired and non-performing loans of 11.2%, which translates to a 'b'/'bb' rating for asset quality under Fitch's non-bank financial institution criteria. This reflects SDL's targeted customer base at the medium/lower end of the credit spectrum and is mitigated by adequate pricing, reflecting a degree of pricing power, and limited variability in SDL's asset quality indicators since 2009. Risk management procedures, including write-off and provisioning policies, are sound. Increased Leverage Following Refinancing: FFO adjusted net leverage (retail only) is likely to peak at 5.5x by FYE19 following the issuance of GBP700 million bonds, from 5.0x at FYE17, and reduce towards 4.9x over the rating horizon, mainly due to improving sales and our conservative view of a moderately stable retail-only EBITDA margin. Such leverage is high but acceptable for the 'B+' rating given the solid business profile. Our working assumption is that most of the existing cash and equivalents and cash overfunding will stay initially in the business for investments and general flexibility and partly for dividend distributions subject to maintaining solid operating performance. Adjustments Follow Hybrid Business Model: In our approach we make adjustments by stripping out the results of SDFC to achieve a proxy to retail cash flows available to servicing debt at SDL. In our analysis we also deconsolidate the GBP1.3 billion non-recourse securitisation financing outside of the group under SDFC. This securitisation debt is core to the group's consumer financing offer and is repaid by the collection of receivables predominantly originated from retail. However, on the basis of our view of below-average asset quality and funding and liquidity constraints for SDFC, we add back GBP274 million of debt to SDL's retail operations. This is because we consider a hypothetical equity injection from the rated entity to SDFC (GBP274 million) to attain a capital structure for SDFC that would require no cash calls to support finance service operations over the rating horizon. Adequate Financial Flexibility: The low use of operating leases and a robust business model suggest that the FFO fixed charge cover ratio will remain strong and above 3.0x over the rating horizon despite the contemplated higher debt amount relative to FYE17, which results in a lower FFO fixed charge cover ratio. In addition, financial flexibility at group level is supported by the lack of meaningful debt maturities over the next four years, initial cash overfunding, and access to enlarged GBP150 million revolving credit facilities. Some Commitment to Deleveraging: Management and the group's owners may remain opportunistic about part debt-financing shareholder distributions as authorised by loan and bond indentures despite an intention to generally reduce debt and leverage over time. We assume that dividend distributions will depend on future financial performance, but SDL's governance structures are rather opaque, with concentrated ownership and some lack of transparency or independent oversight. This could translate into potential misalignment between shareholders and creditors' interests over time; however, SDFC's board has three non-executive directors among its six members. We assess financial transparency as adequate even though SDL conducts related-party transactions with affiliate logistics entities Yodel and Arrow XL. These contracts run until 2022, albeit on an arm's-length basis. DERIVATION SUMMARY The asset base is inherently different from other traditional retailers as over 50% of the group's consolidated total assets related to trade receivables relative to 4% equivalent figure for Marks and Spencer Group plc (BBB-/Stable) or 6% for New Look Retail Group Ltd (CCC). Financial services income is driven by the retail customer base, with over 95% of transactions including credit. The cost base is also different from that of traditional retailers, with a focus on online retail operations and client base and without any meaningful fixed assets or operating leases. This is reflected in a stronger EBITDAR-based profit margin conversion into FCF after dividends. Shop Direct's dedicated online retail activities are enabled (subsidised) by consumer finance operations via intra-group loans. This is an unusual corporate business arrangement but it helps support the company's commercial proposition. Shop Direct's product and service offering to clients is very compelling relative to key competitor Amazon, Inc. or pure online start-ups such as Bohoo and ASOS. Shop Direct also benefits from efficient distribution infrastructure, with the lowest picking costs and an established online platform without duplication of costs/capex compared to M&S, New Look or other bricks-and-mortar retailers with expanding online presence. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - annual retail revenue growth rate averaging 3.2% by FY20 over the rating horizon; - retail-only EBITDA margin reaching 11.5% in FY18, then gradually reducing, reflecting weaker gross margin to help recruit customers; - capex/revenue ratio of around 4%, in line with the management's revised projections; - pension contribution of GBP15 million a year until 2021 recorded as other items before FFO; - non-operating/non-recurring cash outflows in line with the management plan mainly related to distribution centres; - up to GBP100 million shareholder distribution assumed by Fitch spread between FY18 and FY19. KEY RECOVERY RATING ASSUMPTIONS The recovery analysis assumes that SDL would be considered a going concern in bankruptcy and that the company would be reorganised rather than liquidated. We have assumed a 10% administrative claim. Going-Concern Approach We follow a going-concern approach for recovery analysis as we expect better valuation in distress than liquidating the assets (and extinguishing the securitisation debt) after satisfying trade payables. Our analysis focuses on a surviving online retailer with consumer finance structured differently (joint venture or owned by a third-party bank), and therefore a corporate. We use our proxy retail-only EBITDA of GBP80.8 million excluding marketing contribution from SDFC. We also strip out the GBP1.3 billion non-recourse securitisation financing outside the group under SDFC as we assume that consumer finance can be arranged or structured by a third-party bank or in a joint venture after restructuring. We apply an 8% discount to EBITDA, which results in stabilised post-restructuring EBITDA of GBP74 million. We use a 5.0x distressed enterprise value/EBITDA multiple, reflecting the growing online retail and technology platform and competitive position enabled by consumer finance, which mitigates the lack of tangible asset support. Other retail peers such as M&S conduct consumer finance activities in a JV where financing is effectively provided by external party bank. Therefore in a hypothetical distressed situation a relatively undamaged asset-light online retail brand with adjacent (instead of core) consumer financing could realise 5.0x post-restructuring EBITDA in our view. For the debt waterfall we assumed a fully drawn super senior revolving credit facility of GBP100 million and GBP4.3 million of debt located in non-guarantor entities. This debt ranks ahead of the planned bonds. After satisfaction of these claims in full, any value remaining would be available for noteholders (GBP700 million notional) and a GBP50 million pari passu revolving credit facility issued by Shop Direct Funding plc. This translates into an instrument rating for the proposed bonds of 'B+(EXP)'/'RR4'/31%. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - Retail-only FFO adjusted net leverage consistently below 4.5x (FY17: 5.0x) - Improvement in the business model through increasing diversification and scale, and a proven track record of strategy implementation over the medium term, leading to a retail-only FFO margin sustainably above 8% (FY17: 8.7%) and continuing positive FCF generation through the cycle with FCF margin in the low to mid positive single digits - Significant improvements in asset-quality metrics translating into improved profitability within SDFC - Maintenance of solid FFO fixed charge cover and liquidity cushion Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - Inability or lack of commitment to bring retail-only FFO adjusted net leverage below 5.5x over the rating horizon, for example prompted by dividend payments of more than GBP100 million by FY19 if not offset by material improvement in profitability - Weak business growth (neutral to mildly positive sales growth) and profitability under more challenging market conditions in the UK reflected in FFO margin below 7% - Neutral to positive FCF before exceptional dividend distributions over the rating horizon along with FFO fixed-charge cover metrics below 3.0x - Deterioration in SDL's asset quality negatively affecting its SDFC profitability and cash flows, and ultimately its ability to support its retail activities through SDFC's profitability LIQUIDITY Comfortable Liquidity: Sufficient availability exists under the enlarged committed credit lines (GBP150 million) and headroom under covenants to temporarily cover short-term liquidity requirements for operational needs. SDL will benefit from a comfortable level of liquidity comprising readily available cash of GBP117 million as of FYE17, cash overfunding, and our expectation of at least mildly positive FCF. However, the level of liquidity may fluctuate with the amount and timing of dividends to be paid over time. FULL LIST OF RATING ACTIONS Shop Direct Limited --Long-Term IDR at 'B+(EXP)' Shop Direct Funding plc --Senior secured notes at 'B+(EXP)/RR4' Contact: Principal Analyst Louise Liu Analyst +44 20 3530 1660 Supervisory Analyst Pablo Mazzini Senior Director +44 20 3530 1021 Fitch Ratings Limited 30 North Colonnade London E14 5GN Non-Bank Financial Institutions Analyst Nalini Kaladeen Director +44 20 3530 1806 Committee Chairperson Paul-Antoine Conti Senior Director +44 20 3530 1292 Summary of Financial Statement Adjustments - Operating leases: Fitch used a multiple of 8x, as the company is based in the UK, to capitalise GBP9 million of annual operating leases resulting in GBP72 million off-balance-sheet debt added to total adjusted debt in our leverage calculation. - Pensions: SDL has two defined-benefit pension schemes that require a contribution of GBP15 million a year from July 2016 to December 2021, reducing to GBP10 million a year by December 2024. Such ongoing cash contributions are reflected above the FFO line. - Adjustments for finance service entities: In our approach we make adjustments by stripping out the results of SDFC to achieve a proxy to retail cash flows available to servicing debt at SDL. In our analysis we also deconsolidate the GBP1.3 billion non-recourse securitisation financing outside the group under SDFC. However, on the basis of our view of below-average asset quality and less stable funding and liquidity for SDFC we add back GBP274 million of debt to SDL's retail operations. This is because we consider a hypothetical equity injection from the rated entity to SDFC (GBP274 million) to reduce its debt and attain a capital structure for SDFC that would require no cash calls over the rating horizon. Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Additional information is available on www.fitchratings.com. 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