The Long and Short
Rating risk for Falabella SA
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Though management has repeatedly affirmed Falabella SA’s intention to remain investment grade, continuing deterioration in consumption in its core Chilean market has resulted in a steady decline in cash generation, with EBITDA falling 57% over the last year to $161 million in the first quarter of 2023. This leaves the ratio of net debt to EBITDA at 7.32x, well beyond the normal investment grade ratings leverage of about 4.0x for the sector. Leverage looks set to rise in the second quarter, putting ratings at risk.
The second quarter is likely to see further weakness for Falabella despite potentially better sequential margin, as the year-ago EBITDA print falls out of the calculation. For example, a 25% increase in EBITDA over the first quarter would result in net leverage increasing to >9x, as the y/y delta would be a negative 25%.
Both S&P and Fitch downgraded the credit this year, with Stable/Negative outlooks now in place, respectively. S&P appears to have built in more flexibility to the process from here, with a potential 2-year review period; Fitch however is likely the more responsive agency to further misses in the coming quarters.
Management has outlined a series of cost saving initiatives in logistics, marketing, facilities management and the usual host of targets in a broad corporate ‘efficiency improvement’ initiative—targeting a total of more than $200 million annually— with the impacts beginning to be visible in the second half of 2023. In concert with this strategy, management cited expectations to reach 10% margins once again “in the next quarter or two”. Backing into this informal guidance, without the benefit of improving macro support, this implies an EBITDA of about $350 million in the third quarter, more than double the first quarter print. If this new reality is sustained in the last quarter of the year and if cash burn is not material, net leverage would return to below 5.0x and the investment grade rating would probably be sustained.
However, anticipate cash burn and macro conditions look unlikely to tread water in the coming quarters. With little visualization of better consumption metrics so far, the data are thus more likely to worsen in the near term, offsetting the positive impacts from cost cutting in the process, with the added challenge of inventory management to avoid margin-dilutive discounting, if demand fails to recover (given the higher inventory levels of 131 days in the quarter). To that end, a sub 5x net leverage by the end of the year appears unlikely. This leads to other methods that management hinted at in the earnings call for the first quarter. These include asset divestments (possible but hardly expedient, particularly if real estate based, where transactions take time and the current environment appears unsupportive to good valuations); a capital raise (more expedient though dilutive given the 75% decline since the 2022 peak and thus unlikely a top choice of the owners) or unspecified “other measures” to deleverage and maintain the investment grade ratings.
Managing the remaining 2023 amortization schedule of $338 million and the $286 million scheduled to mature in 2024 appears feasible through a combination of existing cash, local market access and tapping an existing though uncommitted $600 million credit line. So, liquidity risk does not appear to be ramping in the near term, providing some cover to the agencies to allow time.
The 3.375% 2032 notes, at $77.625 for a 6.78% YTW are not panicking, though if we compare the 3.75% 2027 notes ($88.875 for a 6.7% YTW) to the CENSUD 3.375 2027s ($96.75 for a 5.25% YTW), the deterioration is more apparent with the spread differential having widened from a low of 13 bp this year to the current level around 150 bp. Granted, the CENSUD credit profile is built off exposure to more defensive food and supermarket sectors compared to BFALA’s more retail profile. But given the near-term trajectory of operations and continued balance sheet and ratings uncertainty, the differential looks set to worsen in the coming months, leading to better relative value in CENSUD. Given the liquidity flexibility, the rating agency runway to improve margin is longer. However, credit metrics and market pricing seem likely to worsen for BFALA before the data turns the corner.
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