DBRS Downgrades Canadian Tire to BBB (high) and R-2 (high), Stable Trends, Following the Acquisition of Forzani Group Ltd.

DBRS has today downgraded the Debentures and Medium-Term Notes ratings of Canadian Tire Corporation, Limited (Canadian Tire or the Company) to BBB (high) from A (low) and its Commercial Paper rating to R-2 (high) from R-1 (low); the trends are Stable. This action follows the Company’s acquisition of The Forzani Group Ltd. (FGL) and removes the ratings from Under Review with Negative Implications.

On May 9, 2011, DBRS placed the ratings of Canadian Tire Under Review with Negative Implications following the Company’s announcement that it had entered into a support agreement with FGL to acquire all of the outstanding shares of FGL for cash proceeds of approximately $765 million (not including assumed debt and transaction costs). Canadian Tire planned to finance the transaction with cash on hand and short-term debt (bank lines and commercial paper).

In terms of operations, Canadian Tire stated that it intended to operate FGL as a separate business unit (similar to Mark’s Work Wearhouse and Canadian Tire Financial Services) and expected significant cost synergies by leveraging the strengths of both, including supply chain, marketing and global sourcing. Specifically, the Company estimated that it could achieve full run-rate synergies of approximately $35 million per year. Canadian Tire also indicated that it intended to return to pre-acquisition leverage levels within 18 to 24 months of closing the transaction.

In its review, DBRS analysis focused on (1) the business risk profile of FGL, including the risks associated with integration and with achieving the potential synergies; (2) the immediate impact of the acquisition on the financial risk profile of Canadian Tire; and (3) the Company’s longer-term business strategy (including growth plans) and financial management intentions.

Despite a number of benefits the acquisition will have, DBRS believes Canadian Tire is best positioned in the BBB (high) rating category with a Stable trend, based on the transformational nature of the acquisition, the risks associated with integration and the realization of synergies, and the material increase in financial leverage with the inclusion of FGL’s capitalized lease expense.

DBRS ANALYSIS

(1) Business Risk Profile
The acquisition of FGL, one of Canada’s leading sports retailers, provides Canadian Tire with strong brands and market positions. FGL’s 534 stores and approximately $1.5 billion in sales will benefit Canadian Tire’s overall market share and scale and make it the largest sporting-goods retailer in Canada. FGL also complements Canadian Tire in terms of product offerings and target markets as it focuses on mid- to high-end sports apparel and footwear for a younger demographic. FGL’s locations are also reasonably complementary in nature as they are typically located in closed shopping centres in urban areas, not typical of all Canadian Tire stores.

On the other hand, DBRS considers FGL’s business to be more cyclical than Canadian Tire’s main retail lines as sports apparel and footwear are more discretionary and linked to economic cycles. The sporting-goods retail market is also very competitive and remains highly fragmented, with low barriers to entry. DBRS also considers the risks associated with integrating the acquisition and achieving ambitious synergy targets to be considerable as Canadian Tire will attempt to retain key personnel, close underperforming locations and consolidate a wide variety of banners and formats. That said, Canadian Tire has proven the ability to integrate acquisitions and achieve adequate synergies as demonstrated with the acquisition and integration of Mark’s Work Wearhouse in 2002. As such, DBRS views the impact of the acquisition on the overall business risk profile to be fairly neutral.

(2) Financial Risk Profile
In terms of Canadian Tire’s financial profile, the acquisition of FGL results in a meaningful increase in the Company’s leverage to a level that is no longer consistent with DBRS’s previous rating.

At year-end 2010 (i.e., pre-acquisition), DBRS estimates the retail operations of Canadian Tire had lease-adjusted debt of approximately $2.3 billion, based on balance-sheet debt of $870 million and a capitalized operating lease expense of approximately $1.4 billion (6.0 times (x) the operating lease expense of $240 million), and EBITDAR of approximately $918 million, resulting in lease-adjusted debt-to-EBITDAR of 2.5x. (Note that in its quantitative analysis of Canadian Tire, DBRS considers Canadian Tire’s retail operations and Canadian Tire Financial Services as separate pieces of a whole, apportioning debt, operating income and any other necessary items between the two segments in order to analyze each segment within the context of the appropriate methodology.)

Pro forma the FGL acquisition (i.e., post-acquisition), DBRS estimates the retail operations of Canadian Tire now has lease-adjusted debt of approximately $3.3 billion, based on balance-sheet debt of approximately $1.3 billion and a capitalized operating lease expense of approximately $2.0 billion (6.0x the operating lease expense of $340 million), and EBITDAR of approximately $1.1 billion, resulting in lease-adjusted debt-to-EBITDAR of approximately 3.0x. DBRS expects this metric to decline moderately over the near term but remain within the range acceptable for the BBB (high) rating category (2.5x to 3.0x).

(3) Outlook
Going forward, DBRS recognizes that Canadian Tire possesses the ability to consistently generate healthy free cash flow, which may offer the Company the opportunity to strengthen its financial profile in the medium term. That said, DBRS believes Canadian Tire will require ample financial flexibility in order to respond to an increasingly competitive Canadian retail landscape and challenging economic environment while exploring additional growth opportunities and responding to increasing shareholder expectations. As such, DBRS believes Canadian Tire is best positioned in the BBB (high) rating category with a Stable trend. DBRS also notes that Canadian Tire Financial Services should continue to complement the retail business. Recent stabilization of performance in Canadian Tire Financial Services, combined with its reduced proportion of overall operating income, also supports DBRS’s updated view of Canadian Tire’s credit risk profile.

SHORT-TERM RATING ANALYSIS

In terms of liquidity, DBRS methodology typically couples a long-term rating of BBB (high) with a short-term rating of R-2 (high). Exceptions exist where a company is capable of funding essentially all of its financing needs with internally generated cash flow. Since securitization and bank deposits are a necessary component of Canadian Tire Financial Services financing strategy, DBRS believes the appropriate short-term rating for Canadian Tire is R-2 (high). The R-2 (high) rating also reflects Canadian Tire’s positive free cash flow generation, committed bank lines, access to securitization markets and manageable debt maturity schedule.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodologies are Rating Companies in the Merchandising Industry and Rating Companies in the Services Industry, which can be found on our website under Methodologies.