Fitch Places Hengdeli on Rating Watch Negative after Profit Warning

Hengdeli Holdings

22/02/2016 08:19

(The following statement was released by the rating agency)

HONG KONG/SHANGHAI, February 22 (Fitch) Fitch Ratings has placed China-based 
watch retailer Hengdeli Holdings Limited's (Hengdeli) Long-Term Issuer Default 
Rating (IDR) and senior unsecured rating of 'BB' on Rating Watch Negative (RWN). 
Fitch has also placed on RWN the 'BB' ratings on the company's USD350m 6.25% 
senior notes due 2018. 

The action follows the Hengdeli's profit warning on 17 February 2016. The 
company expects net profit attributable to equity shareholder to decrease by 
about 70% in 2015, due to a decline in revenue and gross profit, the absence of 
a one-off gain from property sales in 2014, goodwill impairment and 
mark-to-market loss of listed investments. 

Fitch is unable to determine the extent of the decline in revenue and profit 
because of the lack of  financial and operation details in the announcement. 
Fitch will conduct a review of the ratings after the company announces its 
results in mid-March 2016, at which point a negative rating action is highly 
likely. We believe that Hengdeli is no longer meeting the financial and 
operational metrics for its current rating, even after excluding the impact of 
non-cash items on its net profit. 

KEY RATING DRIVERS

Net Loss in 2H15: The profit warning implies net profit of CNY151m in 2015, 
compared to CNY504m in 2014. This means that Hengdeli made a net loss of CNY104m 
in 2H15, a substantial deterioration from the CNY255m net profit in 1H15. The 
poor 2H15 result also suggests that that there may have been a drastic slowdown 
in the China operations, which only recorded a mild revenue decline of 4% yoy in 
1H15,compared with a 32% revenue increase for Hong Kong. The China market has 
been a major profit driver for Hengdeli since 2012, and accounted for over 44% 
of total gross profit in 2014 and 1H15. 

Profitability Continues to Decline: Fitch expects the pressure on profitability 
to persist in 2016 due to the weak consumer spending in China and Hong Kong, 
sales discounting and appreciation of the Swiss franc, the currency of the 
country where the company sources many of its watches. Hengdeli's EBITDA margin 
contracted to 8.1% in 1H15 from 8.7% in 1H14. The decline in Hengdeli's 
same-store sales in mainland China further deteriorated to 4.5% in 1H15 from 
0.8% in 2014; in particular, the same-store sales for mid-end retail in China 
fell 1.7% in 1H15 compared with growth of 2.2% in 2014.

The efforts to raise EBITDA margin through optimising its product portfolio and 
reducing distribution costs may not be sufficient to offset the impact of 
continued weakness in consumer spending in China and Hong Kong. Traditional 
watch retailing also faces competition from online sales and marketing channels, 
as well as wearable gadgets such as smart watches, which are gaining popularity.

Increase in Inventory: Hengdeli had negative free cash flow and high 
FFO-adjusted net leverage of over 5x in 1H15 (2014: 3.6x) due to larger working 
capital needs that stem from an increase in average inventory days to 233 days 
in 1H15 (2014: 224 days) and a fall in payable days to 48 in 1H15 (2014: 52). 
The high inventory and low payables were the result of slowing sales growth in 
Hong Kong from 4Q14 as well as in China from mid-2015. Fitch expects the 
inventory days and net leverage to continue rising over the next 12 months, 
assuming no significant asset disposal in 2016 and 2017. Hengdeli sold 
investment properties in Shenzhen and Taiwan for CNY114m in 2014.

Relatively Strong Business Positioning: Hengdeli's rating is still supported by 
its leading position in the market for retailing of Swiss watches in China, its 
established distribution network and exclusive distribution arrangements that 
support its wholesale business. In 1H15, Hengdeli maintained a share of around 
35% of the market for Swiss watch sales in China and further fine-tuned its 
business strategy to focus on mid-end products with higher margins in lower-tier 
cities. Tier 3 and Tier 4 cities accounted for 32% of total sales in 1H15, up 
from 21% in 2011. 

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

- Stable gross margins for different business segments in 2015-2018 from 2014 
levels

- EBITDA margin hovers around 8% into 2017

- Annual capex plus acquisition budget of about CNY150m

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to 
negative rating action include

- Contraction in same-store sales in China 

- Sustained weakening in EBITDA margin to below 8% 

- FFO-adjusted net leverage sustained above 3.5x 

Positive: The rating is on Watch Negative; the likelihood of positive action is 
low.

Contact: 

Primary Analyst

Yee Man Chin

Director

+852 2263 9696

Fitch (Hong Kong) Limited

19/F, Man Yee Building

68 Des Voeux Road, Hong Kong

Secondary Analyst

Yi Zhang

Analyst

+86 21 5097 3390 

Committee Chairperson

Kalai Pillay

Senior Director

+65 6796 7221

Media Relations: Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: 
wailun.wan@fitchratings.com.

Additional information is available on www.fitchratings.com

Applicable Criteria 

Corporate Rating Methodology - Including Short-Term Ratings and Parent and 
Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

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