Michaels is set to tighten covenants for its bond deal and price wide of initial expectations, as the arts and crafts retailer confronts a shifting retail landscape and an earnings hit from the latest round of US/China trade tariffs, according to six sources familiar with the deal.

Led by BofA, the company earlier this week began marketing USD 500m of B1/B rated senior unsecured notes due 2027, with initial whispers in the low 7% area. The roadshow ended yesterday and, after buyside pushback, the deal is set to undergo covenant changes, with buysiders pushing for pricing in the region of 8%, the sources said.

Proceeds from the deal, along with cash on hand, will refinance the company’s existing USD 510m 5.875% senior subordinated notes due 2020. The notes last traded today at 100.25 to yield 5.696%, in line with recent levels, according to MarketAxess.

Although seen as one of the brighter retail credits, Michaels is still subject to competition from e-commerce disruption. The potential covenant amendments–which include tighter restrictions on changes of control, debt capacity and restricted payments–aim to improve protections against, for example, potential M&A involving Michaels.

The originally proposed documents contained a double-trigger for the change-of-control put option at 101%. As noted in Debtwire affiliate Xtract Research‘s covenant report on the deal, both a ratings decline and either a 50% sale or a complete sale of the company are required to trigger the put option.

Under those docs, the sale requirement excludes permitted holders such as former owners Blackstone and Bain.

In addition to those concerns, buysider pushback has centered around the impact of the latest escalations in US/China trade tariffs, which is set to put a dampener on earnings, the sources added.

Pro forma the transaction, the company is 3.3x levered, based on USD 807m of LTM adjusted EBITDA as of 4 May and USD 2.7bn of total debt.

Liquidity totals USD 904m through USD 227m of cash and USD 677m of availability on an undrawn USD 850m ABL revolver due 2021.

Tariff impact

During an investor call for the deal, Michaels executives said roughly USD 400m the company’s product costs are set to be impacted by an increased 25% tariff on “List 3” Chinese imports, announced last month. Furthermore, the company could be impacted by further tariff increases, the sources noted.

Management estimated the cost of the tariffs at USD 100m, forecasting that two-thirds of that would hit this year, with the remainder coming in 2020. “They’re trying to mitigate the impact, but that will take time,” said one of the sources.

The 25% List 3 tariff announcement prompted Michaels to adjust FY19 guidance earlier this month, reducing its forecast for adjusted operating income to USD 625m-USD 650m from USD 640m-USD 665m as of 4Q18.

Recent store closures are another drag on earnings. Michaels is split into three divisions: retail, wholesale and e-commerce, and operates 1,260 physical Michaels stores in 49 US states and Canada as of 4 May, according to company documents.

Last year, the company closed its standalone Pat Catan’s and Aaron Brothers stores, and is now trying to boost earnings without expanding its physical presence.

“They said they are geographically saturated so they can’t grow their store footprint – so they’re trying to boost e-commerce, right-size costs and increase promotional activity,” said a source who attended the roadshow.

Building in the impact of tariffs and store closures – a 7% decrease from 2018 EBITDA – sources projected EBITDA in the region of USD 750m for 2019. Accounting for USD 135m of capex and USD 145m of pro forma interest costs, that implies free cash flow of USD 470m (16% of total debt).

If tariffs increase in a potential List 4, Michaels could face additional costs impacted by the tariff rates, the sources said.

The strong free cash flow provides a buffer from earnings pressure that could stem from tariffs or broader disruption in the retail space – but the company has recently been using free cash flow to buy back stock, the sources noted.

Michaels was taken public by Bain Capital and Blackstone in 2014 at USD 17 per share. Bain and Blackstone currently own 33% and 13% of the company’s equity, respectively, according to two of the sources.

The stock has been on a downward trend in recent years—it last traded at USD 8.90 a share for a market cap of USD 1.4bn, down 67% over the last year and a half, from USD 27.78 in January 2018. That prompted some sources to question the potential influence of large shareholders on the company’s strategy.

“You have to wonder what a shareholder like Bain might do to improve the valuation,” said one of the sources.

Among potential retail comps, the 4x-levered Party City provides a reference point, though Party City has been facing its own pressures lately amid a global helium shortage. Party City’s USD 500m 6.625% senior notes due 2026, which are rated B1/B-, are trading around par today, down from trades around 101 earlier this month, according to Markit.

Against that benchmark, similarly rated Michaels offers an attractive premium—but the underperformance of its stock, the impact of tariffs and store closures and the wild card of Bain and Blackstone’s substantial stakes warrants the wider pricing, the source said.

Another potential comp is specialty crafts and fabrics retailer Jo-Ann Stores, which as of 3Q18 carried several more turns of leverage at 5.6x. Jo-Ann posted a year-over-year EBITDA decline for 1Q19 and mentioned that tariffs would be a headwind for the company in the near-term, as reported by Debtwire.

Jo-Ann’s USD 725m Libor+ 500bps TLB due 2023, which is rated B1/B and through which the issuer was levered 3.1x as of 3Q18, is quoted in the 90.6/93 context today, according to Markit. Based on current quotes, the loan has a yield to three year call of 10.23%.

Michaels’ USD 2.2bn L+ 250bps TLB due 2023, rated BB+/Ba2, is quoted in the 96.625/97.5 context, up slightly from recent quotes in the 95/96 context. Based on current quotes, the loan has a yield to three year call of 5.98%.

BofA declined to comment. Michaels declined to comment.

2019 Debtwire