Fitch Places Future Retail on Rating Watch Positive On Sale to Reliance

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(The following statement was released by the rating agency) Fitch Ratings-Sydney-02 September 2020: Fitch Ratings has placed Indian retailer Future Retail Limited (NS:)’s (FRL) Issuer Default Rating (IDR) of ‘C’ and the rating on its USD500 million 5.6% senior secured notes due in 2025 of ‘C’ with a Recovery Rating of ‘RR4’ on Rating Watch Positive. This follows the announcement on 29 August 2020 that FRL has agreed to sell its business to Reliance Retail and Fashion Lifestyle Limited (RRFLL), a wholly owned subsidiary of Reliance Retail Ventures Limited (RRVL) that is itself a subsidiary of Reliance Industries Ltd (NS:) (RIL; BBB-/Stable).

The IDR at ‘C ‘reflects the financial stress on the company, notwithstanding the agreed sale of FRL to RRFLL. Risks remain over FRL’s liquidity and its ability to continue to finance its ongoing obligations until the transaction with RRFLL closes, particularly as the Reserve Bank of India‘s moratorium on debt servicing requirements ended on 31 August 2020. FRL believes that the announcement of the transaction and impending sale of its assets should allow the release of the pre-approved working capital facilities by its syndicate banks or allow it to obtain additional bank financing, which had previously not been forthcoming. In our view, these actions would resolve the short-term liquidity strain that constrain the ratings.

Key Rating Drivers Support from New, Stronger Owner: The Rating Watch Positive (RWP) reflects our expectation that the sale proceeds will help FRL meet its debt obligations and that the US dollar bond will be transferred to RIL, or a related subsidiary, at par and will benefit from its stronger credit profile compared with FRL. RIL has a strong liquidity position, which Fitch expects to benefit from proceeds from the sale of a stake in Jio Platforms and its rights issue, and strong access to domestic and international capital markets. We expect to resolve the RWP once the deal has been completed, with the final IDR and bond rating to be determined by the final structure of the deal. Bond Rating, IDR to Differ: The rating on the bond and IDR will diverge given that FRL will be merged into Future Enterprises Limited, which will then sell the assets to RRFLL, whilst we believe the bond will be transferred to an RIL subsidiary.

The bond rating will depend on which RIL entity assumes the debt, including any potential enhancements, such as a guarantee, as well as a review of the legal, operational and strategic ties under Fitch’s Parent and Subsidiary Rating Linkage criteria. Nevertheless, we expect RIL’s better credit profile to be reflected in the rating on the bonds in the future. Severe Liquidity Risks: FRL’s liquidity position remains under severe pressure as a result of the impact of the India-wide coronavirus-related lockdown measures, and we believe that this will continue to be the case if the deal with RRVL is not completed. Recent localised outbreaks led to several states reimposing restrictions – which do not currently have an end-date – and these continue to limit FRL’s ability to generate sufficient cash flows to meet its obligations.

This stress is likely to increase after the end of a moratorium on its domestic debt servicing requirements on 31 August 2020. ESG – Management Strategy: FRL has an ESG Relevance Score of 5 for Management Strategy. The inability of management to secure the release of the additional peak working capital facilities to pay the US dollar bond coupon shows that while the strategy may be coherent, other factors, including the main shareholder’s negotiations to sell FRL and the ongoing significant impact of the coronavirus on the business, have meant that its ability to implement the strategy has been hindered – and we believe that this will continue to be the case should the announced deal with RIL fail to close.

Shareholder’s Debt, Change of Control Risks: Fitch believes that the agreed sale will decrease the impact of the main shareholder’s debt on FRL’s ability to access external financing, and that the change of control triggers in the bond indenture are unlikely to be triggered. However, these weaknesses remain if the deal is not completed, with a subdued valuation of FRL, a high level of share pledges at the group’s other listed entities and a lack of liquidity in the current environment still posing risks. Lenders enforcing their rights following the breach of collateral cover requirements could also present significant challenges. ESG – Governance: FRL has an ESG Relevance Score of 5 for Governance Structure. The constrained financial flexibility and impending risk of default at its main shareholder – Future Corporate Resources Pvt Ltd (FCRPL) – underscores the shareholder’s aggressive approach in balancing growth investment at its operating companies with limiting leverage and preserving balance-sheet flexibility, which negatively affects FRL’s rating. We believe the restrictions in the bond documentation limit the risk of cash leakage to the shareholder’s entities.

Nonetheless, a default at those entities will cause significant reputational damage and could constrain FRL’s ability to secure additional working capital lines to tide it over during the period of pressured liquidity due to the coronavirus pandemic. Derivation Summary FRL’s business profile compares well with China-based retailer, Golden Eagle Retail Group Limited (BB/Negative). FRL has larger scale, better diversification across India and exposure to a fast-growing consumer market, but heightened liquidity risk due to adverse credit developments at its founder family entity and coronavirus-related shutdowns, along with a weaker financial profile, results in a rating nine notches below that on Golden Eagle. Both FRL and US-based retailer Burlington Stores, Inc. (BB-/Negative) are supported by exposure to expanding markets and have competitive advantages.

Nonetheless, Burlington benefits from a larger scale, which, combined with FRL’s vulnerable liquidity position, justifies a multiple-notch higher rating. Key Assumptions Fitch’s Key Assumptions Within Our Rating Case for the Issuer – Sales to rise by 6% in the financial year ending 31 March 2021 (FY21). We have assumed the shutdown will last to September 2020 with 1HFY21 representing 30%-35% of normalised sales and limited to groceries. From October-March, sales to increase to 60% of normalised sales and improve gradually thereafter. – Sales to rise by more than 20% in FY22 following normalisation after the pandemic and growth from new stores and the tie-up with Amazon.com (NASDAQ:), Inc. (A+/Positive). – EBITDA margin to decline to 4.5% in FY21 (FY20 estimate: 5.3%), despite the benefit of lower rental expenses following the purchase of in-store assets from Future Enterprises. The decline is likely to be caused by a falling non-food segment margin due to the pandemic.

The EBITDA margin should improve to 8.0% in FY22. – Annual capex as percentage of sales to remain at around 3% over FY20-FY22. – Dividends to resume in FY22. Recovery Rating Assumptions – Fitch’s recovery analysis is based on FRL’s liquidation value in a distressed scenario of around INR27 billion from the liquidation of assets, which are comprise inventory, receivables and owned property, plant and equipment (PP&E), as that is higher than its going-concern value of INR25 billion. – The going-concern value is based on a going-concern EBITDA of INR5 billion and a 5x multiple. The EBITDA assumes a right-sizing of the business if interest, operating expenditure and maintenance capex are covered. The 5.0x multiple is towards the higher end of the 5.4x median multiple for retail going-concern reorganisations to reflect FRL’s leading market position in India. It is lower than around 8x – the level that FRL was trading on 31 August 2020. – Fitch has applied a 25% advance rate against receivables and a 10% rate against inventory and 25% against PP&E as a proxy for the orderly liquidation value of the assets. We have applied 10% for administrative claims.

We assume debt of INR66.4 billion at end-March 2020. Secured working capital and secured US-dollar notes account for the majority of FRL’s debt. We assume that FRL’s available but undrawn lines will be fully drawn. -The recovery waterfall results in a recovery-rate estimate corresponding to a ‘RR4’ Recovery Rating for the USD500 million secured notes, even after assuming that the remainder of secured debt has a priority claim ahead of the notes. In any event, Fitch has assigned the notes a Recovery Rating of ‘RR4’, because under Fitch’s Country-Specific Treatment of Recovery Ratings Criteria, India falls into group D of creditor friendliness. The Recovery Ratings of securities of issuers with assets in this group are capped at ‘RR4’. RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: – We expect to resolve the Rating Watch Positive on the closure of the sale of FRL to RRFLL and the transfer of FRL’s outstanding debt obligations as part of this process.

An improvement in FRL’s liquidity position via the signing of new bank facilities or release of funds under existing facilities could also result in positive rating action. Factors that could, individually or collectively, lead to negative rating action/downgrade: – FRL’s defaulting, entering into a default-like process on its debt obligations or entering into a formal winding up procedure, such as bankruptcy or administration. Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance.

For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure New Owner May Alleviate Liquidity Crisis: FRL’s management says that the sale agreement may help it access financing and meet ongoing obligations until closure of the sale agreement. Without this support, FRL faces increasing pressures on its liquidity due to its limited ability to operate and restricted access to external capital, as evidenced by the non-release of approved peak working capital facilities for the payment of the coupon on the US dollar bond. We believe that FRL is unlikely to be able to secure external financing to meet its obligations without this external support. ESG CONSIDERATIONS FRL has an ESG Relevance Score of 5 for Management Strategy, which reflects the limitations on management’s ability to implement its strategy in 2020 due to the shareholder’s negotiations relating to the announced sale of FRL and the significant ongoing impact of the coronavirus on the business. This has a negative impact on the company’s credit profile and is highly relevant to the rating. FRL has an ESG Relevance Score of 5 for Governance Structure, which reflects the shareholding concentration and presence of highly leverage related parties. This has a negative impact on the company’s credit profile and is highly relevant to the rating. FRL has an ESG Relevance Score of 4 for Social Impact reflecting the risk to its business from a shift by consumers towards online shopping. This has a negative impact on the credit profile and is relevant in the rating in conjunction with other factors. FRL has an ESG Relevance Score of 4 for Financial Transparency reflecting the limited information provided on liquidity and access to capital. This has a negative impact on the credit profile and is relevant in the rating in conjunction with other factors. Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3 – ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies). For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. Future Retail Limited; Long Term Issuer Default Rating; Rating Watch On; C; RW: Pos —-senior secured; Long Term Rating; Rating Watch On; C; RW: Pos Contacts: Primary Rating Analyst Kelly Amato, CFA Director +61 2 8256 0348 Fitch Australia Pty Ltd Suite 15.01, Level 15 135 King Street Sydney 2000 Secondary Rating Analyst Snehdeep Bohra, Associate Director +91 22 4000 1732 Committee Chairperson Vicky Melbourne, Senior Director +61 2 8256 0325 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: [email protected] Additional information is available on www.fitchratings.com Applicable Criteria Corporate Rating Criteria (pub. 01 May 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10120170) Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10090792) Country-Specific Treatment of Recovery Ratings Rating Criteria (pub. 27 Feb 2020) (https://www.fitchratings.com/site/re/10111386) Sector Navigators – Addendum to the Corporate Rating Criteria (pub. 26 Jun 2020) (https://www.fitchratings.com/site/re/10125796) Additional Disclosures Solicitation Status (https://www.fitchratings.com/site/pr/10133917#solicitation) Endorsement Status (https://www.fitchratings.com/site/pr/10133917#endorsement_status) Endorsement Policy (https://www.fitchratings.com/site/pr/10133917#endorsement-policy) ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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