OREANDA-NEWS. Fitch Ratings has downgraded French retailer Financiere IKKS S.A.S.' (IKKS) Issuer Default Rating (IDR) to 'B-' from 'B'. The Outlook is Stable.

Fitch has also downgraded HoldIKKS S.A.S.' senior secured notes to 'B' from 'B+' and IKKS Group S.A.S.'s super senior revolving credit facility (RCF) to 'B+' from 'BB-'.

The downgrades are based on our review of the company's new business plan, which will see the pace of store openings and profit growth materially slow down, leading to limited growth of funds from operations (FFO). Additionally, a competitive trading environment in the French clothing retail industry is leading to pricing pressure, albeit less pronounced in the key premium segment. Consequently, we expect IKK's currently elevated leverage to continue into 2015-2017, which is outside our forecasts for the previous 'B' IDR. These risks are partly mitigated by the company's above-average profitability and the ability to maintain a small positive free cash flow (FCF).

KEY RATING DRIVERS

Lower Growth Expectations
We have lowered our revenue expectations for IKKS to reflect the new business plan introduced since LBO France acquired control of the company in July 2015. Additionally, we expect volume growth to be challenged by a sluggish macro-economic environment in France, characterised by cautious consumer spending behaviour and reduced pricing power. The sector is facing intense competition, which is encouraging price mark-downs.

Compared with an original rating case that assumed revenue growth in the mid-teens, our revised rating case now foresees mid-single digit annual growth rates until 2018. Providing some mitigation is IKKS's position as a niche player with an established market position in France and its long-term track-record with annual sales growth averaging at 5%.

Persistently Weak Credit Metrics
Our lower revenue growth expectations result in a material weakening of the credit metrics over the next four years. We project FFO adjusted gross leverage, already stretched at 7.8x in 2014, to remain at around 7.0x until end-2016, before gradually improving to 6.5x thereafter. We project FFO fixed charge cover ratios to remain at around 1.6x over FY15-FY17. We consider such levels of leverage and coverage ratios insufficient for a 'B' rated non-food retailer, breaching our previous downgrade sensitivity guidance for IKKS.

Profitability to Remain Stable
We expect IKKS to maintain its above-average operating profitability with EBITDA margins of around 20%. This is due to its unique business model, which uses a cost-efficient affiliate concept, an outsourced manufacturing process and has benefitted from lower price pressure due to its premium segment positioning. At the same time, given the absence of scale-driven efficiencies, we do not expect any margin upside.

Change in Control Rating-Neutral
The acquisition of a majority stake in IKKS by LBO France in July 2015 has had no impact on the ratings. Early notes redemption could be avoided given the portability clause. The change in control has involved, apart from a transfer of ordinary shares, the addition to the capital structure of a vendor loan, convertible bonds and preferred shares, to which we have assigned a 100% equity credit.

Above-Average Recoveries
Recovery rates for the debt instruments are based on Fitch's post-restructuring going concern estimate. Fitch applied a discount of 25% to the LTM EBITDA as of end-March 2015. After using a distressed EV/EBITDA multiple of 5.0x and customary restructuring charges, the rating for the super senior RCF would be 'B+' with a Recovery Rating 'RR2' reflecting a cap of 90% recoveries by the French jurisdiction.

We expect IKKS to frequently draw on a separately provided uncommitted ancillary facility amounting to EUR15m. We treat this debt as de-facto committed and have included it into our super senior recovery analysis.

The EUR320m notes, which are secured by certain share pledges, bank accounts and inter-company receivables, are rated 'B', one notch higher than the IDR, due to a Recovery Rating of 'RR3' and 56% recoveries.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for IKKS include:
- Overall revenue growth between 5%-7%, driven mainly by the store network's expansion
- EBITDA margin stable at around 20% over the next four years, with small scale-driven cost improvements offset by increased marketing spend
- Capex at 5% of sales per annum, driven by the pace of the store roll-out.

RATING SENSITIVITIES

Given slower than expected de-leveraging as a result of residual volume risks we consider an upgrade or revision of the Outlook to Positive to be unlikely over the next 18-24 months.

Future developments that may, collectively or individually, lead to positive rating action include
-- FFO adjusted gross leverage at or below 6.0x
-- FFO fixed charge coverage at or above 2.0x
-- EBITDA margin remaining sustainably above 20% and FCF margin above 2.0%
-- double-digit revenue growth and positive like-for-like growth.

Future developments that may, collectively or individually, lead to the IDR being downgraded or the Outlook being revised to Negative include
-- FFO adjusted gross leverage at or above 8.0x
-- FFO fixed charge coverage at or below 1.2x
-- Sustained negative free cash flows (FCFs) in combination with the need to draw on the RCF to top up liquidity
-- Sustained negative like-for-like sales growth and EBITDA margin dilution towards 15%, implying an impaired business model and inability to respond to operating challenges and absorb market risks.

LIQUIDITY

The maturity of the senior secured bond in July 2021 allows significant time before refinancing pressure arises. The coupon is fixed at 6.75%, eliminating interest rate-hike risk.

Fitch expects IKKS to generate stable FFO margins of 8%-9% in the coming years, of which a large amount will be used for capex. The scalability of capex linked to the pace of the store network expansion provides some protection to FCF from turning negative. We therefore expect FCF in the low-single digit range (2%-4%) from 2015 onwards. In addition, IKKS has access to external funding in the form of a RCF (EUR33m, currently fully undrawn) and an ancillary facility (EUR15m), which should help meet intra-year inventory-led working capital peaks.