OREANDA-NEWS. Fitch Ratings has placed China-based watch retailer Hengdeli Holdings Limited's (Hengdeli) Long-Term Issuer Default Rating (IDR) and senior unsecured rating of 'BB' on Rating Watch Negative (RWN). Fitch has also placed on RWN the 'BB' ratings on the company's USD350m 6.25% senior notes due 2018.

The action follows the Hengdeli's profit warning on 17 February 2016. The company expects net profit attributable to equity shareholder to decrease by about 70% in 2015, due to a decline in revenue and gross profit, the absence of a one-off gain from property sales in 2014, goodwill impairment and mark-to-market loss of listed investments.

Fitch is unable to determine the extent of the decline in revenue and profit because of the lack of financial and operation details in the announcement. Fitch will conduct a review of the ratings after the company announces its results in mid-March 2016, at which point a negative rating action is highly likely. We believe that Hengdeli is no longer meeting the financial and operational metrics for its current rating, even after excluding the impact of non-cash items on its net profit.

KEY RATING DRIVERS
Net Loss in 2H15: The profit warning implies net profit of CNY151m in 2015, compared to CNY504m in 2014. This means that Hengdeli made a net loss of CNY104m in 2H15, a substantial deterioration from the CNY255m net profit in 1H15. The poor 2H15 result also suggests that that there may have been a drastic slowdown in the China operations, which only recorded a mild revenue decline of 4% yoy in 1H15,compared with a 32% revenue increase for Hong Kong. The China market has been a major profit driver for Hengdeli since 2012, and accounted for over 44% of total gross profit in 2014 and 1H15.

Profitability Continues to Decline: Fitch expects the pressure on profitability to persist in 2016 due to the weak consumer spending in China and Hong Kong, sales discounting and appreciation of the Swiss franc, the currency of the country where the company sources many of its watches. Hengdeli's EBITDA margin contracted to 8.1% in 1H15 from 8.7% in 1H14. The decline in Hengdeli's same-store sales in mainland China further deteriorated to 4.5% in 1H15 from 0.8% in 2014; in particular, the same-store sales for mid-end retail in China fell 1.7% in 1H15 compared with growth of 2.2% in 2014.

The efforts to raise EBITDA margin through optimising its product portfolio and reducing distribution costs may not be sufficient to offset the impact of continued weakness in consumer spending in China and Hong Kong. Traditional watch retailing also faces competition from online sales and marketing channels, as well as wearable gadgets such as smart watches, which are gaining popularity.

Increase in Inventory: Hengdeli had negative free cash flow and high FFO-adjusted net leverage of over 5x in 1H15 (2014: 3.6x) due to larger working capital needs that stem from an increase in average inventory days to 233 days in 1H15 (2014: 224 days) and a fall in payable days to 48 in 1H15 (2014: 52). The high inventory and low payables were the result of slowing sales growth in Hong Kong from 4Q14 as well as in China from mid-2015. Fitch expects the inventory days and net leverage to continue rising over the next 12 months, assuming no significant asset disposal in 2016 and 2017. Hengdeli sold investment properties in Shenzhen and Taiwan for CNY114m in 2014.

Relatively 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 1H15, Hengdeli maintained a share of around 35% of the market for Swiss watch sales in China and further fine-tuned its business strategy to focus on mid-end products with higher margins in lower-tier cities. Tier 3 and Tier 4 cities accounted for 32% of total sales in 1H15, up from 21% in 2011.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Stable gross margins for different business segments in 2015-2018 from 2014 levels
- EBITDA margin hovers around 8% into 2017
- 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 rating is on Watch Negative; the likelihood of positive action is low.