MILAN: Breitling Holdings can achieve profitable growth, with consolidation of distributors, positive performance of new collections, and increasing penetration in China supporting S&P Global Ratings-adjusted debt to EBITDA of 6.5x-7.0x.

Breitling Holdings intends to increase its senior secured debt by Swiss franc (CHF) 295 million euro-equivalent to pay a special CHF 158 million dividend to its private equity owner CVC Capital Partners and partly refinance debt.

This follows Breitling’s positive performance in the 12 months ended Aug. 31, 2019, with 24% top line growth and a reported EBITDA margin of almost 22% on the integration of distributors and successful product relaunches.

S&P assigned ‘B’ ratings to Breitling and the CHF564 million-equivalent euro-denominated senior secured term loan B (including the proposed add-on) issued by Breitling Financing Sarl.

S&P also assigns a recovery rating of ‘3’ to the debt, indicating our estimate of recovery prospects in the 50%-70% range (rounded estimate 55%).

Breitling’s new management team’s strategy will likely deliver positive results in fiscal year 2020. CVC Capital Partners, Breitling’s majority shareholder (80%) since 2017, acquired the remaining 20% of the group in 2018. It then appointed a new management team, which is overhauling Breitling’s strategy to strengthen the company’s leading position in the chronometer segment of the Swiss luxury watch industry.

“We expect Breitling to expand by double digits in FY 2020, with sales reaching CHF520 million-CHF530 million and adjusted EBITDA margins of about 22%. Key growth drivers are expected to be Breitling’s consolidation of agents and distributors acquired in 2018-2019 in countries such as Germany, Netherlands, Spain, China, Korea, and Japan, and across South East Asia, as well as higher volumes and average sales prices from relaunches of products, including Navitimer and SuperOcean”.

Increasing exposure to China should help boost growth. The group benefits from relatively good geographic diversification, with sales spread across Europe (about 39% of revenues for the 12 months to Aug. 31, 2019), the U.S. (20%), Japan (10%), and Asia-Pacific (excluding Japan) and the rest of the world (31%).

Breitling’s relatively lower exposure to China has protected it from the drop of sales other major luxury goods players experienced after demand from China started declining in 2014. The revised strategy contemplates a greater presence in China, which we still regard as a key growth engine for the global luxury market. “We expect this will entail selective openings of new boutiques and accelerating Breitling’s wholesale footprint. Currently, we estimate China accounts for roughly 5% of total sales, thanks to new stores opened in 2018 and e-commerce sites launched in 2019”.

Breitling, a relatively small, niche player in the global luxury watch market, has a limited assortment of products. Top two watch models–Navitimer and SuperOcean Heritage–accounted for roughly 42% of sell-out value for the year to Aug. 31, 2019.

“We estimate that Breitling will generate less than 10% of its sales through directly operated boutiques”.

Breitling’s capital structure is highly leveraged. Following the debt issuance and refinancing, our adjusted debt figure for Breitling will be in the CHF750 million-CHF800 million range, including the CHF564 million term loan B and CHF30 million-CHF35 million of other bank liabilities. “Our adjustments include adding CHF100 million-CHF110 million of lease liabilities, CHF20 million-CHF25 million of pension obligations, and close to CHF30 million of put options on minority stakes. We project adjusted debt to EBITDA at 6.5x-7.0x over 2020-2022, with EBITDA interest coverage comfortably at 3.5x-4.0x.”

The strong growth expected in 2020 will likely generate exceptional working capital outflows of CHF40 million-CHF45 million, undermining the group’s ability to report positive free operating cash flow in FY 2020. “We anticipate normalization of working capital from FY 2021, supporting annual free operating cash flow exceeding CHF20 million”.

“The stable outlook on Breitling reflects our view that the group will successfully deliver its growth agenda, with consolidation of distributors, increasing penetration in China, and positive customer reactions to new collections. We expect the S&P Global Ratings-adjusted EBITDA margin to expand to about 22% by the end of FY 2020 on the back of a favorable price mix and more focused marketing investments”.

“Under our base case, we project adjusted debt to EBITDA will remain in the 6.5x-7.0x range and adjusted EBITDA interest coverage higher than 3.0x. The company’s reported free operating cash flow is likely to be flat or slightly negative in FY 2020, due to exceptional working capital outflows that we expect will normalize from next year”.

We could consider a negative rating action if a significant decline in demand for luxury Swiss watches limits Breitling’s expansion, translating into weaker-than-expected EBITDA margins and negative free operating cash flow for a prolonged period. Rating pressure could also arise if adjusted debt to EBITDA increases above 7.0x or if EBITDA interest coverage weakens to 2.0x or lower”.

“We could upgrade Breitling if the group’s credit metrics improved, including healthy and recurring positive free operating cash flow and adjusted debt to EBITDA consistently below 5.0x. An upgrade would also hinge on a clear commitment from the financial sponsor to a long-term investment strategy that implies a low risk of releveraging beyond 5.0x”.