OREANDA-NEWS. Fitch Ratings has downgraded Hengdeli Holdings Limited's (Hengdeli) Long-Term Foreign-Currency Issuer Default Rating and senior unsecured rating to 'B+' from 'BB'. The Recovery Rating is RR4. The Outlook on the IDR is Stable. The ratings have been removed from Rating Watch Negative.

The downgrade reflects Hengdeli's higher business risk that led to continued financial deterioration in 2015. The Hong Kong and China market for luxury watches slowed down drastically in 2H15, and there is little sign of imminent recovery. Hengdeli's EBITDA margin narrowed further - to 6.2% from 7.5% in 2014; and FFO-adjusted net leverage increased to 4.4x from 3.4x as a result. Fitch expects Hengdeli's margins and leverage to remain flattish over the next 12 months.

KEY RATING DRIVERS
Faster Decline in Sales: Hengdeli's sales shrank in all its markets in 2015. The decline in same-store sales growth (SSSG) widened to 9.5% for the China market from 4.5% in 1H15 and 2.7% in 2H14, due to a drastic slowdown in mid-end watch sales in 2H15. Sales in Hong Kong (excluding Harvest Max, a souvenir and watch retailer acquired in 2013) plunged by 27% as tourist arrivals fell. The overall stagnation in luxury watch spending may persist in the medium term due to the economic slowdown, weakening real disposable income and middle-class spending shift.

Continued Margin Pressure: Fitch expects the pressure on profitability to persist in 2016 due to the weak consumer spending, sales discounting and flattish distribution cost. Hengdeli's EBITDA margin contracted by 130bp to 6.2% in 2015 (2014: 7.5%), resulting in a 26% EBITDA decline. Fitch expects a mid-single-digit EBITDA margin in 2016 and 2017.

Rising Leverage: The reduced EBITDA and slower inventory turnover (252 days in 2015 versus 224 days in 2014) resulted in a higher FFO-adjusted net leverage of 4.4x (3.4x at end-2014). Fitch expects leverage to remain high in 2016, pending the pace of inventory reduction with practicable sales discounts, as well as the extent of profit margin erosion.

Modest Operational Flexibility: Hengdeli has taken proactive measures to adapt to the changing market. These steps include a significant store closure plan, product mix optimisation and lease-contract renewal at lower rates. Hengdeli closed net 31 stores (16 stores in China, seven in Hong Kong/Macau and eight in Taiwan) in 2015, and shows a willingness to continue to close underperforming stores in 2016.

Adequate Liquidity. Hengdeli maintained sufficient cash of CNY1.9bn to cover its current borrowings of CNY704m as of end-2015. Besides, the company has sufficient bank facilities to bridge working-capital purposes. Fitch expects Hengdeli to generate positive cash flow even at the current low profitability as capex has been cut back significantly.

Leader Position Remains. Hengdeli has maintained the leading position in Swiss watch retailing in China, with a dominant market share of over 35%. In addition, Hengdeli's wholesale business segment also remained stable due to its established exclusive distribution arrangements with brand owners. Fitch expects Hengdeli to keep its overall leading market position over the next two years.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Low- to mid-single-digit revenue decline in 2016-2017
- EBITDA margin hovers around 5.3%-6.7% in 2016-2019
- Annual capex plus acquisition budget of about CNY150m

RATING SENSITIVITIES
Positive: Developments that may, individually or collectively, lead to positive rating action include:
- Sales stabilisation or re-acceleration in China and Hong Kong
- EBITDA margin sustained above 8%
- FFO-adjusted net leverage sustained below 3.0x

Negative: Developments that may, individually or collectively, lead to negative rating action include:
- Persistent and material sales contraction in China and Hong Kong
- EBITDA margin sustained below 5%
- FFO-adjusted net leverage sustained above 4.0x