S&P Global Ratings reduced its debt ratings outlook at VF Corp. on the company’s fiscal second-quarter report which came in below the rating agency’s base-case forecast with leverage increasing further to 4.4x compared with 3.6x in the same prior year period.
S&P noted that VF pulled its full-year guidance and further cut its dividend to free up cash flow for debt reduction. Proceeds from the company’s contemplated sale of the Packs business (JanSport, Eastpak, and Kipling) could reduce debt. However, its largest brand, Vans, continued to decline in the quarter, and the timing of its recovery and the ability of the company to restore its credit metrics remains uncertain.
S&P affirmed its ‘BBB’ issuer credit rating and its ‘A-2′ short-term and commercial paper (CP) ratings. The outlook was revised the outlook to negative from stable.
The negative outlook indicates that S&P could lower the ratings if credit metrics do not improve within the next 12-24 months, including achieving S&P Global Ratings-adjusted debt to EBITDA below 3x.
S&P wrote in its analysis, “We forecast leverage will remain above 3x through fiscal 2025, but capital allocation decisions could support leverage reduction to support the current rating.Despite announcing capital allocation changes and cost-savings initiatives, we forecast VF’s leverage will remain above 3x through fiscal 2025. Further leverage reduction will be dependent on restoring EBITDA, which will be challenging in a weaker demand and macroeconomic environment, as well as with potential asset sales. At this time, it is also unclear how costs required to achieve the $300 million in potential cost-savings will impact profitability. The company ended the second quarter with sales down 2 percent and S&P Global Ratings-adjusted EBITDA margin weakening to the 15 percent-16 percent range, reflecting a higher promotional environment from lower demand and an attempt to clear excess inventory.
“VF lost the appeal regarding its tax treatment of IP related to its purchase of Timberland and will not receive any of its $876 million deposit made to the IRS back. This led to VF announcing a second dividend cut this year, from approximately $465 million to approximately $140 million annually. Prior to both cuts, VF’s annualized dividend was $775 million in fiscal year ended March 2022. The newly announced reduction will result in $325 million of additional cash flow that can be used for permanent debt reduction. Management also indicated the potential for further portfolio changes in addition to its previously announced potential sale of its Packs business. These contemplated sales could help reduce leverage faster but are not included in our base-case forecast. We expect VF will repay about $1.75 billion of its upcoming debt maturities, namely those due December 2024 and April 2025, with discretionary cash flow (after capital expenditure, dividends, and share repurchases) and some CP borrowings. This is prudent because refinancing this debt at higher interest rates will pressure cash flows.
“At this time, VF remains committed to a conservative financial policy and will abstain from mergers and acquisitions (M&A) and share repurchases with a goal of restoring gross leverage to its target of 2.5x. We note Engaged Capital’s and Legion Partners’ recent activist campaigns, which could result in meaningful changes if they acquire a meaningful stake. We also note the campaigns are focused on debt reduction and cost-savings, which are in line with improving credit quality.
“We revised downward our view on VF’s business risk to satisfactory from strong due to underperformance of its brands, limited brand diversity, and potential asset sales.VF is largely concentrated in its core four brands, but the business is led by The North Face (37 percent of sales), which grew 19 percent in the quarter, while Timberland declined 7 percent and Dickies declined 8 percent. Vans, the company’s largest brand (recent annual peak sales of $4.1 billion in VF’s fiscal year 2022), faced declines of 21 percent and is on track to lose $1 billion in sales since fiscal year 2020. While VF has made decisions to remedy the declines at Vans–such as focusing on reinvigorating its classic product lines, instilling greater product innovation and brand-building capabilities into the brand through investments, and leveraging its newly created global commercial model and Americas region platform–weakness specific to demand in the North America wholesale channel and an increasingly competitive landscape will make it challenging to achieve these targets in the near term.
“The company pulled its financial guidance for the fiscal year ending March 2024, primarily due to the uncertainty around Vans and the wholesale channel in the U.S. and to a lesser degree demand weakness in Europe, Middle East, and Asia (EMEA). The company is searching for a new brand head to remedy declines for the brand faster, which comes 18 months after a former brand head was brought back to lead Vans.
“Additionally, the company’s new CEO indicated the potential for portfolio pruning, implying no brands are off the table, but no details were released. While asset sales will allow the company to reduce its high debt burden faster, it also reduces its brand diversity and puts more pressure on Vans to perform.
“Free operating cash flow (FOCF) will turn positive in 2024, but at lower levels due to excess inventory at Vans. Inventories were down 10 percent compared to last year but up 8 percent from the first quarter ended June 2023, given it is the company’s seasonal peak. The excess inventory remains in core and excess replenishment. We believe a majority of the inventory is now in Vans and Dickies and is due to declines in demand and pressure in the wholesale channel. The company also booked a distressed inventory reserve of $15 million in the second quarter, which will depress gross margins. We forecast inventory will continue to come down through the remainder of the year, leading to positive FOCF generation. However, we now forecast FOCF in fiscal 2024 near $600 million (down from $750 million) as Vans’ performance will no longer improve this year.”
