S&P Global Ratings lowered the debt ratings of YS Garments LLC, doing business as Next Level Apparel, as the Gardena, CA-based clothing company has disclosed that it has entered into an agreement with its lender group to waive its financial covenant for the second quarter ended June 30, 2023 through Sept. 30, 2024.

As a result, S&P said Next Level Apparel would have breached its covenant in the second quarter, and its equity holder, Blue Point Capital Partners, has contributed payment-in-kind (PIK) preferred equity to repay debt. The company’s nonextending portions of its term loan and revolver have now become current, further pressuring liquidity in the near term.

As a result, S&P lowered its issuer credit rating to ‘CCC’ from ‘B-‘, as it believes a default due to a balance sheet restructuring (including a potential debt repurchase below par) or liquidity crisis can be envisioned without unforeseen positive developments within the next 12 months. Concurrently, S&P lowered its issue-level rating on the company’s nonextended portion of its senior secured debt due in 2024 and extended tranches due in 2026 to ‘CCC’ from ‘B-‘. The ‘3’ recovery rating is unchanged and indicates S&P’s expectation for meaningful (50 percent-70 percent; rounded estimate: 65 percent) recovery in the event of a default.

The negative outlook reflects the potential for a lower rating if a default appears inevitable within the subsequent six months, including an inability to repay the nonextending portion of its term loan and revolver ahead of its maturity in August 2024 or the potential for a restructuring of the company’s capital structure, or a conventional default.

S&P said in its analysis, “Next Level’s amendment has provided some relief, but default scenarios remain.

“On Aug. 15, 2023, Next Level entered into a waiver agreement and amendment to its credit facilities with its lender group for the next five quarters through Sept. 30, 2024, to address its near-term total net leverage covenant, which the company would have otherwise breached due to recent underperformance. The amendment also granted a delayed filing of its second-quarter financial statements. The group received an equity injection of $25 million, in the form of preferred equity from its sponsor, Blue Point Capital. The company will use this to pay down approximately $2.5 million of its revolver borrowings and $22.5 million of its term loan, with the paydowns applied ratably towards the extended and nonextended portions of its capital structure.

“We expect this to temporarily alleviate some near-term liquidity pressure. However, approximately $15.7 million of Next Level’s nonextending term loan remains current and due on Aug. 9, 2024, and the company remains dependent upon near-term working capital improvement from lowering its inventory levels to cover this repayment.

“We revised our assessment of Next Level’s liquidity to less than adequate to reflect its constrained liquidity position that relies on near-term working capital improvements.

“As part of the terms of its amendment and waiver agreement, the company’s revolving commitments have been reduced to $42.5 million from $50 million. Additionally, we no longer consider approximately $1.3 million of the nonextended portion of Next Level’s revolver as a liquidity source because it is now current. The lower commitment of its revolver, coupled with approximately $33 million drawn in the second quarter ended June 30, 2023 and low undrawn revolver availability, has limited liquidity sources over the next 12 months to its cash on hand of approximately $22.8 million and the company’s ability to generate cash flow from operations and working capital reversal.

“However, given tough operating conditions, we expect its liquidity sources could become inadequate to cover uses if its working capital position does not improve as expected and cash flow generation weakens further. The amendment also requires all amounts due under its excess cash flow sweep in excess of its $10 million minimum liquidity covenant to be due and payable in cash in 2024.

“In place of its original net leverage covenant, Next Level is now subject to a minimum last-12-months EBITDA covenant, tested quarterly, and a minimum liquidity covenant of $10 million, tested monthly. We forecast the company to be in compliance with this covenant due to our expectation for $25 million–$30 million of free operating cash flow (FOCF) in 2023 and 2024. The amendment also features an equity cure right, limited to two times during the covenant relief period, as well as a monthly financial reporting requirement accompanied by a compliance certificate extended through Dec. 31, 2024. Given our expectation for headroom under the minimum EBITDA covenant to be tight towards the end of the waiver period, we expect Next Level could utilize these two equity cures if it cannot remain compliant when the requirement steps up, should its EBITDA shortfall continue for longer than expected.

“Next Level’s near-term path to recovery remains challenging as macroeconomic headwinds persist.

“The company’s S&P Global Ratings-adjusted leverage was 13.8x as of the 12 months ended June 30, 2023. The company reported a 32 percent decline in its second-quarter 2023 revenue relative to the same period last year, following a similar decline in first-quarter 2023. This top-line decline was primarily driven by low consumer demand and distributor inventory destocking trends persisting for longer than originally anticipated.

“In preparation for a demand rebound in early 2021, Next Level had increased its fabric purchases and inventory balance during a peak in inventory costs. However, recent weak demand and increased consumer trade down beginning in late 2022 have impaired the company’s margins. Next Level has been unable to pass through further price increases and work through its high-cost inventory as inventory destocking and normalization at its distributors have continued for longer than our original expectations.

“Contrary to our original expectation of a rebound in 2023 following underperformance in 2022, we now expect leverage of about 8.2x in 2023, with revenue and S&P Global Ratings-adjusted EBITDA declining approximately 16 percent and 50 percent, respectively, from the end of 2022, as distributor inventory destocking continues through the rest of the year and into the first part of 2024. We expect this to result in overall lower volumes and a continued inability to take price and forecast EBITDA margins will remain depressed and leverage will remain high.

“However, we expect some margin improvement between June and the end of the year as Next Level continues to make progress in offloading higher cost inventory throughout the year and sees benefit from selling, general, and administrative cost-savings initiatives that come online in the next two quarters. We treat the $25 million of sponsor-preferred equity as debt in our analysis given its PIK feature. Our S&P Global Ratings-adjusted leverage expectation is 7.4x without including the preferred equity as debt.

“The negative outlook reflects the potential for a lower rating if a default appears inevitable within the subsequent six months.”