S&P Cuts PetSmart (PETM) to ‘B+’; Sees Higher Leverage Stemming from Merger

Standard & Poor’s Ratings Services lowered its corporate credit rating on Phoenix, Ariz.-based pet retailer PetSmart Inc. (Nasdaq: PETM) to ‘B+’ from ‘BB+’. At the same time, we removed the rating from CreditWatch, where we placed it with negative implications on Dec. 15, 2014.

At the same time, we assigned our ‘BB-‘ issue-level rating to the company’s proposed $4.3 billion seven-year term loan, with a ‘2’ recovery rating, indicating our expectation for substantial (70% to 90%) recovery in the event of default. In addition, we rated the $1.9 billion unsecured notes due 2023 ‘B-‘ with a ‘6’ recovery rating, indicating our expectation for negligible (0 to 10%) recovery.

Under the transaction by private equity owners, Argos Merger Sub Inc., the acquiring entity, will merge into PetSmart, with PetSmart continuing as the surviving entity and borrower under the term loan and unsecured notes. Our analysis assumes the transaction closes as proposed.

"The downgrade reflects our view that acquisition-related debt results in higher leverage, resulting in weaker credit protection measures. We expect thetransaction to close by mid-2015 for a total consideration of about $8.4 billion, of which $6.2 billion will be financed with debt. Pro forma for the transaction, we estimate leverage of about 6.2x (on a lease-adjusted basis at third quarter 2014)," said credit analyst Andy Sookram. "Although we believe PetSmart will use most of its of its free cash flow for debt reduction, we expect leverage in the high-5x area in the next year. We are therefore revising our assessment of its financial risk profile to "highly leveraged" from "intermediate"."

The stable outlook reflects prospects for performance gains with EBITDA margins improving to the high-18% area. We believe the company will continue to invest in e-commerce initiatives, which should help to drive customer traffic in-store and online. We forecast leverage to improve to slightly under6x by year-end 2015 on earnings improvement and modest debt reduction.

Upside Scenario

We would consider raising the rating if PetSmart were to reduce debt such that it sustains leverage under 5x and we have clarity that financial sponsor ownership would decline over time. We believe this scenario could occur if debt declines by about $1.5 billion or EBTIDA increases by nearly 25%. We would also need to see financial sponsor ownership decline or be convinced that the potential to add debt for shareholder remuneration was less likely. If PetSmart’s financial sponsor ownership declined or financial policy clearly shifted from the possibility of further releveraging, we could view financial policy more favorably and could revise our financial policy modifier to ‘FS-5’ from ‘FS-6’.

Downside scenario

We could consider lowering the rating if operating performance worsens from poor execution of its e-commerce initiatives, or if competition increases, especially from large discounters and online retailers. Such a scenario could lead us to revise the business risk profile to "fair" or lower. A negative rating action could also result from material debt-funded dividends to the sponsors that would allow leverage to remain over 6x on a sustained basis. Under this situation, we would reassess financial policy to ‘FS-6 minus’.

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