OREANDA-NEWS. Fitch Ratings has revised the Outlook on Financiere IKKS S. A.S.'s (IKKS) Issuer Default Rating (IDR) to Negative from Stable and affirmed the IDR at 'B-'. Fitch has also affirmed HoldIKKS S. A.S.'s senior secured notes at 'B' with a Recovery Rating of 'RR3' and IKKS Group S. A.S.'s super senior revolving credit facility (RCF) at 'B+' with a Recovery Rating of 'RR2' as constrained by the French soft cap due to the legal jurisdiction.

The revision of the Outlook reflects the weak 2016 interim performance, which is likely to affect the annual results. It also challenges our view of the sustained level of operating profitability at IKKS, and ultimately, the degree of the execution risks embedded in its operations. We also highlight the largely utilised liquidity reserve under the committed facilities, and the exhausted leverage headroom of 8.0x calculated on a funds from operations (FFO) adjusted leverage basis. Fitch views negatively IKKS' recently announced intention to approach its RCF creditors to reset the covenant levels following a review of the EBITDA calculation by reclassifying certain collection development costs from operating expenses into capex.

Fitch considers that a slow start to 2016 does not necessarily signal a fundamental weakening of the commercial profile. However, the combination of adverse factors creates a degree of uncertainty over the near-term credit performance, which could translate into an increasingly unsustainable leverage profile. We note the scalability of capex as a means to support cash flow generation.

The 'B-' IDR reflects IKKS's small business scale with heavy geographic concentration, exposure to cyclicality and shifting seasonality patterns. The company is confronted with unpredictability on the demand side and the need to reinforce its brand to retain its commercial viability. At the same time, IKKS benefits from an established position in the premium market segment, and generally relatively high profit margins in the industrial context, even after the release of record low EBITDA margin for 1H16.

KEY RATING DRIVERS

Muted Network Performance

After a slow start in 2016 with two consecutive quarters of negative like-for-like (LfL) growth, which will materially impact the annual performance, Fitch has cut its sales growth expectations for FY16 to 1% from 7% in our previous rating case forecasts, followed by 2%-4% thereafter as new shops opened in 2015/2016 begin generating revenues. Each collection carries individual commercial/fashion risks, but a repeat subdued seasonal sale would quickly jeopardise the company's sales profile, its profit margin progression and cash flow and liquidity.

Profitability Breakdown in 2016

After a record low 1H16 EBITDA margin of 12.5% (including creation costs) Fitch projects the annual EBITDA margin will reach 16%, as the gap between this year's interim trading and last year's results would be difficult to bridge in 2H16. This low profitability contrasts with our previous view of its relative stability. As our understanding of the sustainable through-the-cycle profitability for the business evolves, Fitch considers there is some upside potential for the margin to recover in the medium term, albeit possibly not to the high levels of 19%-20% previously reported, as the company plans to step up its marketing/communications efforts. Fitch therefore projects a gradual steady margin recovery to 17% by FY19.

Reclassification of Creation Costs

Fitch sees no economic rationale behind the recent reclassification of creation costs from operating into capital expenditures amortisable over 12 months. In our view, capitalisation of certain development costs is warranted if the economic benefit ensures sustained viability of the business model over multiple business cycles. The economic benefit from the creation costs incurred to design a new collection is effectively fully consumed with the release of the collection, and therefore may not contribute to the strength of the business model over the longer term, particularly if a collection does not sell as expected. Consequently, Fitch adds back the annual creation costs of approximately EUR5m as operating costs and decreases the capex figure by the same amount.

Tightening Liquidity Reserves

Fitch expects an inventory led slowdown of the cash conversion cycle in 2016 leading to permanent use of RCF and/or ancillary facilities of EUR30m during the rest of the year, and likely increasing further by EUR5m-EUR10m in 3Q when inventories tend to peak. In FY16 organic liquidity is projected to be negative at around EUR5m, fully relying on debt drawdowns. Thereafter Fitch anticipates gradually recovering internal cash generation building up towards EUR13m per year in FY19. However, in our view this will be insufficient to fund working capital without permanent use of short-term debt. The extensive perpetual use of short-term funding sustainably reduces the amount of external liquidity reserves available to the business.

Covenant Breach, Leverage Headroom Exhausted in 2016

The EBITDA contraction is likely to result in a covenant breach under the RCF during 2016. IKKS has recently announced its intention to amend the covenant threshold to allow for wider headroom. Fitch sees little risk in the creditors rejecting the amendment, but loosening covenant levels signals anticipated lower earnings. Moreover, we project weak trading results to push FFO adjusted leverage at the end of 2016 to the edge of the negative sensitivity guidance of 8.0x calculated on FFO adjusted leverage basis. Thereafter, Fitch anticipates a gradual de-leveraging towards 7.0x at the end of 2019. We consider this residual leverage less than two years prior to bond maturity as very aggressive for a business such as IKKS.

Sustainably Positive Free Cash Flows

With the exception of 2016, where Fitch anticipates a sizeable working capital outflow of EUR11m leading to negative free cash flow (FCF), we project IKKS to generate stable FCF at 2%-3% of sales from 2017. Tighter working capital control is expected to result in only moderate cash outflows of around EUR2m between 2017 and 2019. With a scalable capex estimated by Fitch of EUR15m per year matching the pace of sales development, the affirmation is supported by our expectation of sustainably positive FCF generation to mitigate high leverage given the commercial risks involved in the business.

Above-Average Recoveries for Debt Instruments

Recovery rates for the debt instruments are based on Fitch's post-restructuring going concern estimate. Fitch applied a discount of 10% to the 2016E EBITDA of EUR56m (including creation costs). After applying a distressed EV/EBITDA multiple of 5.0x and customary restructuring charges, the rating for the super senior RCF is 'B+' with a Recovery Rating 'RR2' reflecting a cap of 90% recovery rate by the French jurisdiction. We expect IKKS to frequently draw on an uncommitted ancillary facility separately provided, which currently amounts to EUR17m. We treat this debt as a de-facto committed line and have included it as a super senior claim in the debt waterfall. The EUR320m senior secured notes, which are secured by certain share pledges, bank accounts and intercompany receivables, are rated 'B', one notch higher than the IDR, with a Recovery Rating of 'RR3' (55% recovery rate).

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for IKKS include:

- Sales growth ranging between 1-4% p. a.

- EBITDA margins (incl. creation costs) range 16-17%

- Inventory-led working capital outflow of EUR11m in 2016 followed by ca EUR2m outflow thereafter

- Capex assumed at EUR15m per year throughout (excluding creation costs)

- Need to draw under the RCF of EUR30m during 2016-2019.

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to the IDR being downgraded, include:

- FFO adjusted gross leverage at or above 8.0x.

- FFO fixed charge coverage at or below 1.2x.

- Sustained negative FCF combined with the need to continuously 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.

Positive: Future developments that may, individually or collectively, lead to the stabilisation of the Outlook to Stable include:

- Reset of the RCF maintenance covenants removing the risk of a covenant breach.

- Evidence of improved operating cash generation and working capital management in 2016 leading to greater self-funding and more comfortable liquidity headroom under the RCF of at least EUR15m.

- Positive FCF for 2016.

- Reversal of the negative LfL trend in the 2H16 and stabilisation of the EBITDA margin (incl. creation costs) at around 18% with prospects of further margin improvement towards 20% thereafter.

- 2016 FFO adjusted gross leverage below 8.0x.

LIQUIDITY

To support operations, most notably, to finance working capital needs, Fitch projects IKKS will consistently use in 2H16 the RCF and/or ancillary facilities of at least EUR30m, or higher in 3Q, when inventory investments tend to be the highest during the year. Without external funding, Fitch projects IKKS will face a funding gap of EUR4m at the end of FY16. In our liquidity assessment, we deduct EUR15m per year as not readily available cash, which Fitch deems necessary to partly self-fund working capital.