Licensed sports merchandise giant Fanatics Commerce Intermediate Holdco LLC plans to issue a $500 million senior secured term loan to fund investments at its parent entity, Fanatics Holdings Inc. S&P assigned a ‘BB-‘ credit rating to the debt issuance while Moody’s assigned a Ba3 CFR rating.
The proceeds will be used to fund a dividend to the parent company, Fanatics Holdings, Inc., for continued investment in other related verticals. Revenue for the twelve-month period ended June 2021 was approximately $3 billion.
S&P Assigns ‘BB-‘ Issuer Credit Rating
S&P assigned its ‘BB-‘ issuer credit rating to both companies, Fanatics Commerce and Fanatics Holdings. At the same time, it assigned its ‘BB-‘ issue-level rating and ‘3’ recovery rating to the proposed term loan.
S&P said, “The rating reflects our wholistic view of Fanatics Holdings Inc., the parent entity, though we attribute most of the company’s revenue to Fanatics Commerce. We view Fanatics Commerce as a core subsidiary of Fanatics Holdings because it is integral to the group’s identity and strategy and accounts for almost all of Holdings’ operating revenue and profit. Our assessment of the broader group also incorporates its trading cards, non-fungible tokens (NFTs), and online gaming subsidiaries, as well as its nearly 50 percent stake in LIDS Sport Group, which we expect will provide it with a consistent stream of dividends.
“Fanatics’ long-term partnerships and robust customer database are at the core of its retail and wholesale expansion. The company has secured long-term deals with colleges and major sports leagues, including the NFL, MLB, and NBA, for the rights to manufacture and distribute fan apparel and other merchandise. Many of these contracts offer Fanatics Commerce exclusive rights to manufacturing and distribution via online retail channels. The company has secured these rights by developing relationships with the leagues and their teams, including by offering lucrative revenue sharing deals and granting access to customer data. The company also partners with sports apparel brands, such as Nike, to manufacture and sell branded league merchandise. We expect Fanatics to expand its partnerships with retailers and sportswear brands over the intermediate term given its broad portfolio of exclusive rights and captive customer base.
“The company has built a vast database of customer information that enables it to forecast purchasing behavior and effectively target its advertising. This database of over 80 million fans tracks transactions conducted through the hundreds of websites Fanatics operates. In addition to optimizing its sales potential, we believe sharing this customer data with its major league partners strengthens its relationships. This, along with its new partnerships and the recent trend toward the casualization of apparel, supported the double-digit percent increase in the company’s sales.
“Fanatics’ low profitability reflects the costs of entering into its long-term partnerships, though its verticalization strategy will likely lead to an improvement in its margins. In our view, the company’s low profitability reflects the onerous revenue sharing agreements and royalty payments it has used to secure its deals with leagues, teams, colleges, and other partners. Fanatics’ already thin margins are also being negatively affected by the ongoing international supply chain bottlenecks, though we believe its U.S. manufacturing facilities provide it with some flexibility and partially mitigate the risk for supply interruptions. We forecast the company’s EBITDA margins will be in the mid-single digit percent area in 2021 and 2022.
“Fanatics’ vertical merchandise accounts for nearly half of its sales and provides significantly better gross margins than its third-party manufactured merchandise. The company has developed its proprietary merchandise offerings through various acquisitions, including those of sportswear manufacturers Majestic (in 2017), Top Of The World (2020), and WinCraft (2020). Its recent investments have increased its vertical sales penetration by about 10 percent relative to 2019, which led to an approximately 200 basis point (bps) improvement in its gross margin. We believe Fanatics can continue to steadily expand its profitability as it strengthens its manufacturing and wholesaling segment. Nevertheless, we view its business risk profile as weak given its low level of profitability relative to other retailers and its lack of an established track record.
“We believe the company benefits from the favorable competitive environment and its diversified revenue sources, though its minimum royalty guarantees present some risk. We anticipate relatively stable (albeit low) profitability at the Fanatics Commerce business. In addition, we believe the company’s long-term exclusive licensing rights provide reasonable insight into its future performance and limit its potential competitive threats. Nevertheless, its licensing agreements include guaranteed minimum royalty payments that it must pay to the intellectual property owners regardless of its sales volume. We believe these royalty guarantees could potentially weaken its profitability if it is unable to increase its sales in line with its contractual obligations. While we forecast a significant increase in its sales relative to the requirements under its guarantees, an economic downturn could lead to a rapid decline in its sales and pressure its ability to meet its contractual obligations.
“Fanatics powers over 900 e-commerce websites through its cloud-based e-commerce platform as part of its online exclusivity agreements and partnerships. For example, the company operates the back end of the Dallas Cowboys’ online store and is responsible for product fulfilment and shipping. It also recently announced a similar deal with Macy’s for its fan apparel product offerings. In our view, these partnerships enable significant point-of-sale diversification that broadens Fanatics’ customer reach. Additionally, its broad portfolio of exclusive merchandising and retailing rights provides it with a favorable competitive environment. We apply a positive one-notch comparable ratings analysis adjustment to our anchor on the company to reflect our view that these factors positively differentiate Fanatics from other retailers.
“The company also generates revenue through its wholesale segment (about 20 percent of its sales) by distributing its proprietary merchandise to retail partners, including Walmart, Target, Dick’s Sporting Goods, and Kohls. Through its in-venue retail (IVR) segment (about 5 percent of sales), Fanatics also operates multiple partner flagship and in-stadium stores. In our view, these channels provide the company with some revenue diversification and contribute to its improving brand recognition. We expect Fanatics to increase the sales in its wholesale and IVR segments about in line with the expansion across the rest of its business over the next several years.
“Specifically, we anticipate it will raise its consolidated revenue by over 25 percent in 2021 and by the double-digit percent area in 2022 and 2023 on improving consumer spending and its healthy pipeline of new e-commerce and league partnerships.
“We assess Fanatics’ financial risk profile as aggressive, which reflects our forecast for S&P Global Ratings-adjusted leverage in the low-4x area and negative free operating cash flow (FOCF). We expect the company’s S&P Global Ratings-adjusted leverage, pro forma for the term loan issuance, to be in the low-4x area through 2022. Our forecast incorporates incremental expenses at its trading cards, NFTs, and online gaming businesses in 2022, which offset some of the expansion in the EBITDA from Fanatics Commerce. We include dividends received from its equity affiliates (such as Lids) in our measure of its EBITDA but exclude Fanatics’ share of the profits from those affiliates. Our assessment of the company’s financial risk also incorporates some anticipated profit volatility at Fanatics Holdings, which we expect could lead to fluctuations in its credit metrics.
“We forecast negative FOCF of about $100 million over the next 12 months as the company invests in working capital, expands its technology platform, and opens two new fulfilment centers. Our forecast for negative FOCF also incorporates anticipated expenses and investments at Fanatics Holdings’ other subsidiaries, as well as an offsetting benefit from its investment in LIDS Sport Group, which we expect will provide it with a consistent stream of dividends. Overall, we expect the company will improve its cash flow in 2023.
“Management treats its various businesses separately under independent funding structures. In our view, the individual subsidiaries are currently sufficiently funded to absorb their respective near-term operating expenses with cash on the consolidated balance sheet. We also expect these subsidiaries will remain sufficiently funded over the next several years through potential equity capital fundraising, dividends from Fanatics Holdings’ equity affiliates, and dividends from Fanatics Commerce.
“The stable outlook reflects our expectation for good operating performance over the next 12-24 months at Fanatics Commerce, including an approximately 25 percent increase in its revenue in 2021 and 20 percent in 2022, as the company expands its partnerships with leagues, teams, colleges, and retailers. We also expect about a 100 bps expansion in Fanatics Commerce’s EBITDA over the next two years as it further improves its penetration of proprietary merchandise. We expect operating losses at Fanatics Holdings’ other subsidiaries to be a drag on its consolidated EBITDA, though we anticipate it will partially offset these with the dividends from its equity affiliates. We forecast the company’s S&P Global Ratings-adjusted leverage will be in the low-4x area and anticipate it generates negative FOCF in 2021 and 2022. We also anticipate Fanatics’ leverage will improve to the low- to mid-3x area by 2023.”
Moody’s Assigns Ba3 CFR To Fanatics
Moody’s Investors Service assigned first time ratings to Fanatics Commerce Intermediate Holdco, LLC including a Ba3 corporate family rating (CFR) and a Ba3-PD probability of default rating. In addition, Moody’s assigned a Ba3 rating to the proposed $500 million senior secured term loan. The outlook is stable. The proceeds will be used to fund a dividend to the parent company, Fanatics Holdings, Inc., for continued investment in other related verticals. Moody’s ratings and outlook are subject to receipt and review of final documentation.
Moody’s said, “The Ba3 CFR assignment reflects governance considerations, particularly an expectation that Fanatics will maintain balanced financial strategies and solid credit metrics under its current ownership which includes its founder who has majority voting stock. Pro forma for the transaction, leverage is high with Moody’s adjusted debt/EBITDA in the high-6x range for the LTM period June 30, 2021. However, leverage is expected to rapidly recover to the high-4x range in the second half of 2021 and below 4x in 2022 as continued rapid sales growth along with margin enhancement will drive solid EBITDA growth.
“Fanatics’ Ba3 CFR reflects its leading position as an online retailer of licensed sports merchandise. The rating is supported by its long-term partnership agreements with major sports leagues and relationships with key suppliers. The company purchases finished product from vendors but also manufactures licensed product at a higher margin through its private label, owned brands and licensed brands. Sales growth from a meaningful pipeline of new potential exclusive relationships is expected to lead to margin expansion. However, margins are still considered low which is a constraint on the rating. The rating is also constrained by the company’s narrow product focus on sports related apparel.
“The stable outlook reflects the expectation of good liquidity and reduced leverage from earnings growth.
“Fanatics has good liquidity reflecting Moody’s expectation for minimum cash balances to approximate $100 million. Free cash flow generation is expected to fluctuate significantly throughout the year due to seasonality of working capital which is supported by the proposed $700 million asset-based lending (ABL) revolving credit facility due five years after the close of the transaction. Cash flow is expected to be used for capital investment such as technology and a new fulfillment center to support growth. Excess cash is also expected to be allocated to Fanatics Holdings, Inc., for continued investment in other verticals.
“The credit facility is expected to contain covenant flexibility for transactions that could adversely affect creditors.
“The ratings could be upgraded if the company sustainably expands revenue and EBIT margins, and maintains conservative financial policies and good liquidity. Quantitatively, an upgrade would require average lease-adjusted debt/EBITDA sustained below 3.25 times and EBIT/interest expense above 3.5 times.
“The ratings could be downgraded if revenue or earnings deteriorated, or if liquidity materially weakened or financial policies turned more aggressive, such as through shareholder returns or debt-financed acquisitions, that led to sustainably higher leverage. Failure to renew major licenses or sustainably reduce leverage ahead of major license expirations could also lead to a downgrade. Specific metrics include average lease-adjusted debt/EBITDA sustained above 4.0 times or EBIT/interest expense below 2.25 times.”
