OREANDA-NEWS. Fitch Ratings has revised the Outlook on China-based watch retailer Hengdeli Holdings Limited's (Hengdeli) Long-Term Issuer Default Rating (IDR) to Negative from Stable while affirming the IDR and senior unsecured rating at 'BB'.

The Outlook revision is due to the continued weakness in Chinese retail spending that could hamper Hengdeli's margin recovery and deleveraging.

KEY RATING DRIVERS

Lower Profitability: Hengdeli's EBITDA margin further contracted to 7.53% in 2014 from 8.32% in 2013, due to heavier sales discounting, particularly for high-end watches, and higher distribution cost in Harvest Max, a Hong Kong-based souvenir and watch retailer it acquired in 2013. While Hengdeli could raise its EBITDA margin if it upgrades its product mix, restructures the Harvest Max business and cuts down its heavy distribution cost, this would be challenging to achieve because general consumer spending continues to be weak in China and it will likely have to persist in giving discounts, especially for high-end watches. It is unlikely that Hengdeli will return to its pre-2013 EBITDA margin of above 11% in next 24 months.

Weak Retail Environment: In 2014, Hengdeli managed to stem the sharp drop in sales experienced in 2013 amid a slow retail environment. The contraction in same-store sales in mainland China slowed to 0.8% in 2014 from 7.1% in 2013; the decline in same-store sales for high-end watches decelerated to 6.5% from 18.5%. This was due to the company's efforts to diversify product offerings, improve customer service and spruce up stores. Nevertheless, the current sluggish general consumer environment will continue to hamper Hengdeli's efforts to improve its financial performance.

High Working Capital: The company had negative free cash flow and high FFO adjusted net leverage of 3.63x in 2014 (2013: 3.57x) due to high working capital needs that stem from high average inventory days of 224 days in 2014 (2013: 223 days) and shorter payable days of 52 in 2014 (57 in 2013). The high inventory and low payables were the result of slow sales in Hong Kong from 4Q14 due to the pro-democracy protests, which exacerbated a long-term decline in mainland tourists to the city. Fitch expects Hengdeli's Hong Kong business, which contributed to about 25% of group EBITDA (including Harvest Max), to improve from the 4Q14 trough, but continue to be weak. Fitch expects the company's net leverage to trend towards 3.0x over the next 12 months, provided its inventory and payables improve and there are no significant acquisitions in 2015.

Strong Business Positioning: Hengdeli's rating is still supported by its leading position in the market for retailing of Swiss watches in China, its established distribution network and exclusive distribution arrangements that support its wholesale business. In 2014, Hengdeli maintained an approximate 36% market share of Swiss watch sales in China and further fine-tuned its business strategy to focus on mid-end products, which have higher margins and faster turnover, in lower tier cities. Tier 3 and Tier 4 cities accounted for 31% of total sales in 2014, up from 21% in 2011. The shift towards mid-end watches will help Hengdeli to optimise its product mix, achieve a higher margin and trim inventory.

Adequate Liquidity: Hengdeli maintained sufficient cash of CNY2.0bn as end-2014 to cover its short-term bank loans of CNY992m and estimated capital expenditure of around CNY100m for the next 12 months.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Neutral same-store sales growth in China
- EBITDA margin hovers around 8% into 2017
- Inventory turnover days and payable days to improve from 2014 levels
- Annual capex plus acquisition budget of about CNY150m

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to negative rating action include
- Contraction in same-store sales in China
- Sustained weakening in EBITDA margin to below 8%
- FFO adjusted net leverage sustained above 3.5x

Positive: The Outlook may be revised back to Stable if retail spending recovers, and the company's profitability, sales and leverage do not reach the levels that may lead to negative rating action.