(Debtwire) Douglas targets refi within 12 months, positive momentum continues into Q2

20 February 2020 | 15:54 GMT

Douglas is targeting a bond refinancing within the next 12 months after blockbuster 1Q19/20 earnings showed that the group’s turnaround is well underway, management said on an investor call yesterday (19 February). The German perfume and jewellery retailer is still 5.4x net levered and endured a challenging FY19/20, during which earnings went backwards. But its return to growth, dominance in the key online market and ability to start generating a decent amount of cash following the completion of its operational restructuring suggests it should have no problems in getting the refi away, according to three analysts and three buysiders.

The company yesterday (19 February) released stellar 1Q19/20 results for the quarter-end 31 December with adjusted EBITDA surging 5.1% YoY to EUR 195.8m. This was well ahead of sellside estimates but in line with buysider expectations of quarterly earnings getting close to EUR 200m, as reported.

Douglas was 5.4x senior secured and 6.3x total net levered at 4Q18/19 but metrics reduced down to 4.5x senior secured and 5.4x total net leverage this quarter as the group generated swathes of free cashflow in the seasonal cash building first (Christmas) quarter. It benefitted from a EUR 97m working capital release in 1Q19/20 with an additional cash inflow of EUR 61m from other items.

“The pricing mechanism in Germany has improved their conversion rate and basket size and they have kept gross margins stable while they are improving on the EBITDA side. The AI-driven pricing mechanism supports sales while private label sales have increased and there are exclusive launches to come while free cashflow is better,” one of the buysiders said. “It is an impressive set of results and they have the tools to improve operations and the capital structure to refinance or be attractive for a trade buyer.”

“It’s not completely out the woods as this is the biggest free cashflow quarter and then leverage could tick up for the rest of the year. 1Q17/18 had low net leverage and then it all went wrong so 5.4x still doesn’t leave a lot of room for error,” one of the analysts countered. “They are moving in the right direction but are not quite there for a refinancing. They could pull something out the bag, and I’m constructive but the subs are still a tough one. It’s not a home run even if one can’t complain.”

Great E-xpectations

Any refinancing prospects will be built around the strong growth in the online business. E-commerce net sales rose some 23.2% YoY in 1Q19/20, reaching EUR 632m for the LTM 1Q19/20 period (see chart below). E-commerce was 19.3% of 1Q19/20 group sales with online sales now accounting for 31.9% of German total sales.

“They have performed on all levels, not only with strong sales growth but also an acceleration on like-for-like online growth meaning e-commerce has contributed positively. Douglas now has a sizeable online presence in the beauty segment and is clearly the leader,” the first buysider said. “In Germany, e-commerce is a bigger proportion of sales and they’ve previously been below the market in Germany, but now they have materially turned this around and are the fastest growing online player. This can be translated into other markets such as France and Spain for example, and this is an interesting investment case for a prospective buyer or equity holder.”

Both reported and adjusted earnings increased this quarter. 1Q19/20 reported EBITDA grew 9.2% YoY to EUR 191m while adjusted EBITDA rose 5.1% YoY to EUR 196m. LTM adjusted EBITDA is now up at EUR 360m for LTM 1Q19/20, although still down from EUR 380m a year back and EUR 372m two years back. Germany had above average sales growth of 7.9% YoY.

Crucially the gap between reported and adjusted EBITDA continued to compress. LTM 1Q19/20 adjusted EBITDA was EUR 360m versus reported EBITDA of EUR 299m, which compares to a EUR 163m gap a year back with LTM 1Q18/19 adjusted EBITDA of EUR 380m and reported EBITDA of EUR 217m.

“The leverage decline was due to seasonality as there was a strong Christmas and a lot of cash coming in, but YoY leverage actually increased even if it is still minor. LTM adjusted and reported EBITDA both increased so they are heading in the right direction,” the second analyst said. “There was online and organic growth in markets so there was not much to criticize. Margins are under some pressure but they had smarter pricing so the reduced normalized EBITDA adjustments mean they should generate free cashflow this year.”

The group will need to deliver more quarters of sustained earnings growth but positively management noted on the earnings call that 2Q19/20 current trading year-to-date had had no negative surprises and that they would “take the tailwind” from 1Q19/20.

Cashflow Douglasticity

Douglas guided to around EUR 110m of capex for FY19/20, faces around EUR 112m of interest, and should have less than the EUR 51m cash taxes it faced last fiscal year, which would leave room for at least EUR 26m of free cashflow, or 0.1x deleveraging based on LTM EUR 299m reported EBITDA, with upside as more adjustments roll off.

Management remained tight-lipped on any possible IPO plans, noting it cannot comment on shareholder plans. Douglas is being prepped for an exit by its private equity owner CVC, which hired Goldman Sachs to evaluate a potential IPO or trade sales in 2H20, according to a recent press report. CVC acquired a majority shareholding in Douglas in 2015 and holds around 85%, with the Kreke family still holding a 15% stake.

“It was smiles all around. 2Q20 trading should have a tailwind which is good to hear, and the road ahead seems pretty clear. We did our work over Christmas and interviewed about every Douglas staff we could find. We then came out super bullish at the start of the year and along with several clients have been long the senior unsecured notes since early January. It is very nice,” independent deep-dive research firm Sarria said. “A refi later this year? There was the IPO rumour, which is way out of reach. The company has only just stabilised and is now beginning to grow. We don’t know CVC’s constraints around the fund, but why sell now when they generate positive net cashflow to grow the business organically? And why IPO when a secondary buyout would be the more attractive option in this market? But a refi, yes, absolutely.”

Asked about potential M&A, management said it is monitoring the market and if there is the right target at the right price then it could consider this route, although there is not a priority. The group also closed 12 stores in 1Q19/20 and plans to close 70 stores in FY19/20.

“[The store closures] will be positive for the cost base while they are opening stores in Eastern Europe. Kylie Jenner will bring revenues and drive footfall and ultimately the doom scenario was addressed. They stabilized gross margins with online growth and have shown they can generate cash and delever potentially,” the first buysider said. “If they keep the momentum, the capital structure is easily refinanceable and the business is solid. It is a credible operational restructuring story as they have a stable online presence and while bringing the business to the forefront of beauty retail.”

Liquidity rocketed this quarter given the seasonal cash build with Douglas now boasting EUR 362m of cash on balance sheet and retaining full access to its undrawn EUR 200m revolving credit facility.

Douglas’ EUR 300m 6.25% senior secured 2022s climbed 1.5 points yesterday to 101.75-mid yielding 1.7% to worst, while the EUR 335m 8.75% senior unsecured 2023s rose over 13 points to 92.75-mid yesterday and continued their ascent today to 96.75-mid yielding 9.8% to worst, according to Markit. Both bonds become callable at par in mid-July 2020.

“The subs rallied but still yield 9.8%. They need another set of good results in 2Q20 and if they then do some roadshows, they can present a convincing case of online growth and could refinance the unsecured notes at the same coupon. It doesn’t look bad, they’ve found a pricing algorithm in Germany that saves margin and are going in the right direction so the refinancing will not be a hurdle,” the second analyst said. “It’s a tremendous recovery for bondholders who bought at the lows. The refinancing will get done and the covenants could have carve-outs for the IPO allowance. With their online growth momentum, this is a convincing argument for both credit and equity. As long as this holds it compensates for the store footprint needing to be adjusted over time.”

“The level of optionality has increased, and the business connects with younger consumers and is at the forefront of the digital retail offering. Similar to the L’Oreal model they could integrate along the value chain and team-up with [US beauty products manufacturer] Coty for example to acquire a higher margin. Having an attractive growth proposition is key and Douglas is still too levered but with its online growth rates the value for a marginal buyer has increased and on an LTV perspective there is not an issue,” the first buysider said. “They have followed the Sephora model of a store-led footprint and online presence and have formed a strategy to emulate Sephora and sustain a growing business. They have executed well, and this has been an impressive turnaround.”

The earnings beat and encouraging outlook has resulted in a number of sellside analysts revising their recommendations.

Barclays maintained its Underweight rating on the secured 2022s on valuations and maintained its preference for the term loans. Given its expectation of a stronger set of Q2 results following the margin improvement achieved in Q1, it upgraded its rating on the senior 23s to Overweight from Underweight. It recommends pairing a long in the senior notes with a short in the secured notes and sees scope for the differential to compress further as the possibility of a refinancing becomes more palatable, especially in the context of the increased M&A activity in the beauty space.

JPMorgan upgraded its recommendation on the senior secured 2022s to neutral and senior 23s to Overweight.

Bank of America Merrill Lynch remains Underweight on both the secured 2022s and unsecured 2023s.

Douglas declined to comment. It will report 2Q19/20 results on 25 May.

by Adam Samoon