Overview -- U.S.-based Quiksilver's credit metrics have weakened and liquidity has become constrained from declining profitability amid a highly promotional retail environment. -- We are lowering our corporate credit rating on the company to 'B-' from 'B'. -- We are also lowering the issue-level ratings on the company's EUR200 million European senior unsecured debt to 'B-' from 'B', and the rating on its $400 million senior unsecured debt to 'CCC' from 'CCC+'. The recovery ratings are '4' and '6', respectively. -- The outlook is negative, reflecting our view that weaker operating performance could continue over the next year, and our view that the company has less than adequate liquidity. Rating Action On Oct. 16, 2012, Standard & Poor's Ratings Services lowered its corporate credit rating on Huntington Beach, Calif.-based Quiksilver Inc. to 'B-' from 'B'. The outlook is negative. At the same time, we lowered our issue-level rating on Quiksilver's EUR200 million European senior unsecured debt to 'B-' from 'B'. We also revised the recovery rating on this debt to '4', indicating our expectation of average (30% to 50%) recovery for noteholders in the event of a payment default, from '3'. In addition, we also lowered our issue-level rating on the company's $400 million senior unsecured debt to 'CCC' from 'CCC+', with a '6' recovery rating, which indicates our expectation of negligible (0% to 10%) recovery in the event of a default. Rationale Today's rating actions reflect our view that Quiksilver's profitability has materially declined, liquidity has become constrained, and covenant cushion has tightened to below 10%. Given the tight covenant cushion, we have revised the company's liquidity descriptor to "less than adequate" from "adequate." We believe the company's operating performance could continue to be pressured by headwinds from unfavorable foreign currency exchange, weak macroeconomic conditions (particularly in certain European countries where youth unemployment is high), and a highly promotional retail environment. We forecast covenant tests could potentially be breached when the interest coverage steps up next quarter. The ratings on Quiksilver reflect our view that the company has a "highly leveraged" financial risk profile based on its weakening credit metrics and less than adequate liquidity. We also continue to characterize the business risk profile as "vulnerable" because of its exposure to the cyclical apparel industry, its relatively narrow niche focus in the competitive apparel industry, and the fashion risk inherent in its target market. We estimate adjusted total debt to EBITDA is high at 5.8x for the 12 months ended July 31, 2012, compared with 4.7x in the prior-year period, due mainly to lower profitability from higher input costs and promotional activity. The ratio of funds from operations (FFO) to total debt was 12.6% and EBITDA interest coverage was 2.2x, compared to 18.3% and 1.7x, respectively, in the prior year. We expect credit measures will remain near current levels, including adjusted leverage in the low-6x area at fiscal year ending October 2012 and high-5x area in fiscal 2013. We also project break-even free cash flow in fiscal 2013 (due to lower working capital requirements as cotton costs decline) compared with negative free operating cash flow in fiscal 2012 (from higher input costs and capital expenditures). We expect credit metrics to remain commensurate with the indicative ratios for the "highly leveraged" financial risk descriptor, which includes adjusted leverage above 5x, over the next year. Our forecast includes still-difficult economic conditions, including weak economic growth, high unemployment, and weak consumer spending through 2013. Our operating performance assumptions for the company over the next year include: -- Low-single-digit sales growth, given the economic weakness, particularly in Europe, offsetting our expectation of positive revenue growth in the Americas. -- EBITDA margins remaining pressured and below 10%. The margin decline primarily reflects higher promotional activity and input costs. The company may begin to benefit somewhat from lower cotton costs in the second half of the year but we do not expect EBITDA margins to recover to historical 13%-14% levels. -- Capital expenditures of about $75 million. -- No debt-financed acquisitions, dividends, or share repurchases. -- No debt prepayments, other than required annual amortization. The company maintains a portfolio of well-known niche brands, such as Quiksilver, Roxy, and DC Shoes. In our view, the brand portfolio continues to be narrowly focused in young men's and women's surfboard- and skateboard-related apparel and accessories. Fashion risk in this segment is especially high as customer tastes tend to change frequently, which could lead to excess inventories and promotional activity, and has in the past resulted in inconsistent operating performance. Liquidity We assess Quiksilver's liquidity as less than adequate. Though sources of cash are likely to exceed cash uses for the next 12 months, we believe covenant cushion could remain below our 15% threshold for "adequate" liquidity. Cash sources include about $82 million of cash on hand, about $117 million of availability on its committed $150 million Americas asset-based revolver ($62 million outstanding) due 2014, and about $91 million of uncommitted European and Asia-Pacific lines of credit at July 31, 2012. We also expect the company to generate about $145 million of adjusted funds from operations over the next year. We expect cash uses to include capital spending of about $75 million and relatively modest debt amortization of about $3 million. The company does not pay a dividend and we did not factor in any acquisitions or share repurchases. Our assessment of Quiksilver's liquidity profile also includes the following: -- We expect coverage of uses to be in excess of 1.2x for the next 12 months. -- The only maintenance financial covenant is a minimum interest coverage test for the company's Americas term loan, of which covenant cushion decreased to under 10% in the recent July quarter. There is a covenant step-up in the October quarter and we assess that covenant tests could be breached if EBITDA (as calculated per the credit agreement) does not materially increase to satisfy the covenant step up in the October quarter. There is about $26 million outstanding on the Americas term loan as of July 31, 2012. The covenant resets after each fiscal year. -- We do not believe the company would be able to absorb high-impact, low probability stress events. Recovery analysis The rating on the EUR200 million European senior unsecured debt issue held at subsidiary Boardriders SA is 'B-' (the same as the corporate credit rating on Quiksilver), and the recovery rating is '4', indicating our expectation that lenders would receive average (30% to 50%) recovery in the event of a payment default. The rating on the $400 million senior unsecured debt issue is 'CCC' (two notches lower than the corporate credit rating), and the recovery rating is '6', indicating our expectation that lenders would receive negligible (0% to 10%) recovery in the event of a payment default. For the complete recovery analysis, see Standard & Poor's recovery report on Quiksilver Inc. to be published shortly on RatingsDirect. Outlook The rating outlook is negative, reflecting our expectation that Quiksilver's operating performance could continue to be pressured by foreign currency exchange rates, weak macroeconomic conditions, and a highly promotional retail environment. We believe liquidity will continue to be constrained and less than adequate, given the company's interest coverage covenant could potentially be breached. We could revise the outlook to stable if the company is able to improve profitability or if lenders provide covenant relief, leading to forecasted covenant cushion sustained above 10%. We estimate this could occur if EBITDA (as defined per the credit agreement) increases 58% next quarter, which is unlikely. Because covenant levels reset annually, it is difficult to estimate covenant cushion in fiscal 2013 at this time. Alternatively, we could lower the ratings if liquidity becomes further constrained, perhaps from a material sales decline (possibly because of changes in consumer tastes, a weak back-to-school season, or the soft global economy), and/or if the company is unable to amend or obtain a waiver on its Americas credit agreement, defaults on its credit facility, and cross-defaults on its other debt. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Methodology and Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Key Credit Factors: Criteria For Rating The Global Branded Nondurable Consumer Products Industry, April 28, 2011 -- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009 Ratings List Downgraded; Outlook Action To From Quiksilver Inc. Corporate Credit Rating B-/Negative/-- B/Stable/-- Senior Unsecured CCC CCC+ Recovery Rating 6 6 Boardriders SA Senior Unsecured B- B Recovery Rating 4 3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.