TEXT-S&P cuts MDC Partners rating to 'B'

Wed Sep 5, 2012 2:48pm EDT

Overview
     -- Despite our expectation of meaningful revenue and EBITDA growth for 
Toronto-based advertising holding company MDC Partners in the second
half of 2012, we expect fully-adjusted leverage to remain high over the next 12
to 18 months.
     -- We are lowering our corporate credit rating on the company to 'B' from 
'B+'.
     -- At the same time, we are lowering our issue-level rating on the 
company's unsecured debt to 'B' from 'B+'.
     -- The stable rating outlook reflects our expectation that MDC will 
generate positive discretionary cash flow in the second half of 2012, and that 
leverage will begin to fall as EBITDA rises and spending to add top-tier 
talent subsides. 

Rating Action
On Sept. 5, 2012, Standard & Poor's Ratings Services lowered its ratings on 
MDC Partners Inc., including its corporate credit rating to 'B' from 'B+'. At 
the same time, we lowered our issue-level rating on the company's unsecured 
debt to 'B' from 'B+', and left the recovery rating unchanged at '4', 
indicating our expectation for average (30% to 50%) recovery in the event of a 
payment default. The rating outlook is stable.

Rationale
With second-quarter results, MDC reiterated its full year revenue, EBITDA, and 
free cash flow guidance, and we are unaware of any changes to this forecast. 
However, despite our expectation of meaningful revenue and EBITDA growth in 
the second half of 2012, under our base-case scenario, we expect that leverage 
(including our adjustments for operating leases, earn-outs, and put 
obligations) could remain well above 4x through at least 2013. As a result, 
over the next 12 to 18 months, we expect to continue to characterize the 
company's financial risk profile as "highly leveraged," which includes 
leverage in the 4x to 5x range. This elevated financial risk, together with 
continued economic uncertainty and our "fair" assessment of the company's 
business risk profile, is inconsistent with a 'B+' rating, in our view.

We consider MDC's business profile fair, given our view of the strong creative 
reputation of a key number of agencies, such as Crispin Porter + Bogusky, 
72andSunny, and Anomaly, and its healthy digital capabilities. Key risk 
factors are the company's relatively small agency network, limited global 
presence, and its still high (but declining) concentration of revenue and 
EBITDA from its top five agencies. MDC is a provider of marketing services 
primarily in the U.S. (81% of revenue for the first six months of 2012), with 
a presence in Canada (15%), and other countries (4%). The company's 
subsidiaries provide a comprehensive range of marketing communications and 
consulting services. 

We expect that headcount reduction efforts to date will benefit the company in 
2013 in terms of run-rate cost savings, but believe that it could take several 
years for the company to reduce its staff cost ratio to the low-60% area. The 
advertising industry is subject to the cyclical nature of advertising, as well 
as a client's ability to switch to competitors or scale back spending at short 
notice. MDC has been in an aggressive growth mode over the past several years, 
and we believe that increased staffing and facilities costs outpaced revenue 
growth in certain areas. Cost of sales as a percentage of revenue was 72% in 
for the 12 months ended June 30, 2012, compared with 65% in 2009. For larger 
ad agency holding companies, typical staff cost ratios run closer to 60%. MDC 
has taken steps to reduce this ratio, including meaningful headcount reduction 
that led to severance expense in the first half of 2012. 

Under our base-case scenario, we expect revenue to grow at a high-teen to 
low-20% rate in the second half of 2012, based on historical acquisitions and 
net new business wins. Net new business wins were strong, with estimated 
annual net revenue of $80 million in the first half of the year. An important 
element of our base case is U.S. real GDP growth of 2.1% in 2012 and 1.8% in 
2013. We believe that EBITDA (including distributions from affiliates, but 
after minority interest expense and equity-based compensation) could more than 
double compared with the second half of 2011. Advertising spending visibility 
remains low and the economic outlook uncertain for 2013, and we believe that 
like larger, higher rated peers, organic revenue growth at MDC could slow 
compared with 2012. The company has benefited from its revenue concentration 
in the U.S., where advertising and marketing spending has remained stronger 
compared with euro currency markets. As a result, assuming only modest 
acquisitions, we believe revenue could grow at a mid- to high-single-digit 
percent rate in 2013, largely as a result of new business wins and the 
potential for modest acquisitions. 

Under our base-case scenario (excluding potential acquisitions), we believe 
that the company could restore the EBITDA margin (including minority interest 
expense and after noncash stock compensation expense) to the high-single-digit 
percent area in 2012. For the second quarter, revenue increased 15%, while 
EBITDA (including deferred acquisition consideration adjustments and 
distributions from affiliates) dropped 5%, which was below our expectations on 
account of a 24% increase in operating expenses. Organic revenue growth was 
healthy, at 8.3%. The company's EBITDA margin (after net minority 
distributions and treating stock compensation as expense) was very low, at 
3.6% for the 12 months ended June 30, 2012. Despite healthy revenue growth, 
increases in talent and facilities spending, as well as more recent 
severance-related expenses, have reversed EBITDA margin improvement. MDC has 
publicly stated its intention to decelerate operating cost increases and focus 
on margin improvement. Failure to deliver the acquisition-related and new 
business-related revenue, and a corresponding improvement in the EBITDA margin 
could cause us to revise our business risk assessment downward.

Lease-adjusted debt (including deferred acquisition consideration and put 
obligations) to EBITDA (before noncash stock compensation, including affiliate 
distributions and adjustments for deferred acquisition consideration, but 
after minority interest) was very high, at roughly 10x as of June 30, 2012, up 
from 7.1x in 2011. The spike in leverage was because of EBITDA declines, as 
well as borrowings under the revolving credit facility to fund roughly $50 
million of deferred acquisition consideration payments in the second quarter. 
The company's acquisition strategy focuses on making upfront payments, 
typically at PBT (profit before tax) multiples of 3x to 4x, with additional 
consideration in the form of contingent deferred acquisition payments. To 
date, these payments have been lumpy, limiting the company's liquidity 
position in certain periods and causing the need for credit amendments to 
loosen financial covenants. As of June 30, 2012, the current portion of 
deferred acquisition consideration was $90.7 million. Although high, MDC 
should be able to address this payment with revolver borrowings and free cash 
flow. 

Under our base-case scenario, we believe that leverage could fall to the mid- 
to high-5x area in 2012. In 2013, assuming the company pays the current 
portion of earn-out obligations, we believe leverage could drop to the mid-4x 
area. Further leverage reduction will depend on the pace of EBITDA growth, as 
well as future acquisition activity and the ongoing level of 
acquisition-related liabilities, which we have assumed will be in the $40 
million to $50 million range longer term. Discretionary cash flow (operating 
cash flow, less capital expenditures and after dividends and minority 
distributions) was negative for the 12 months ended June 30, 2012, mainly 
because of EBITDA declines, high dividend payments, and working capital cash 
usage as a result of acquisition activity. We expect this to reverse in the 
second half of 2012, because of EBITDA growth and working capital benefits of 
media-related acquisitions in the first half of the year. As a result, under 
our base-case scenario, we believe the company could generate discretionary 
cash flow in the $30 million to $40 million range in 2012. A key rating factor 
will be the company's ability to generate ongoing positive discretionary cash 
flow, despite the level of acquisition activity. 

Liquidity
In our opinion, MDC has "adequate" liquidity to cover its needs over the next 
12 months. Our assessment of the company's liquidity profile incorporates the 
following expectations and assumptions:
     -- We expect sources of liquidity (including cash and access to the 
revolving credit facility) to exceed its uses by more than 1.2x over the next 
12 months.
     -- We expect net sources to remain positive, even if EBITDA declines more 
than 15%.
     -- Following the company's July 2012 credit amendment, compliance with 
maintenance covenants is sufficient to withstand a greater-than-15% drop in 
EBITDA.
     -- The company has flexibility to reduce acquisition and capital spending 
to bolster liquidity, if need be.
     -- We believe MDC has good relationships with its banks, based on recent 
credit agreement amendments, and has a satisfactory standing in the credit 
markets.

MDC's sources of liquidity include cash balances of $72 million as of June 30, 
2012, and access to its $150 million secured asset-based revolving credit 
facility (unrated), which had $129 million outstanding as of June 30. Over the 
next 12 months, assuming modest cash generated from working capital and 
excluding potential acquisitions, we estimate cash flow from operations could 
be in the $80 million to $100 million range. Uses of liquidity over the next 
12 months include capital expenditures that we estimate in the $20 million 
area, annual dividends of about $17 million, and deferred acquisition 
consideration (earn-outs), the current portion of which totaled $90.7 million 
as of June 30, 2012. 

The amended credit agreement contains financial covenants, including a maximum 
senior leverage ratio of 2.0x, a maximum total leverage ratio of 4.25x, a 
minimum fixed-coverage ratio of 1.25x, and a minimum EBITDA requirement of 
$94.6 million. Based on the July, 2012 amendment, the company's tightest 
covenant, its total leverage covenant, steps down to 4.0x on Sept. 30, 2012, 
where it will remain over the life of the facility. As a result of the 
amendment, we believe headroom against the total leverage covenant will remain 
above 20% over the next two years, despite the potential for spikes in 
borrowing under the revolving credit facility to fund earn-out payments. 

Outlook
The stable rating outlook reflects our expectation that MDC will generate 
positive discretionary cash flow in the second half of 2012, and that leverage 
will begin to decrease as EBITDA rebounds and talent-related spending 
subsides. Over the next year, we view both an upgrade and downgrade as equally 
unlikely. We could raise the rating over the long term, if leverage drops to 
less than 4x on a sustained basis, compliance with financial covenants remains 
above 20%, and the company maintains adequate liquidity and establishes a less 
aggressive financial policy. We believe the company could achieve these 
measures in 2014, assuming stronger economic trends, and barring a 
continuation of aggressive debt-financed acquisition activity. We expect such 
a scenario would entail continued mid- to high-single-digit percent organic 
revenue growth, and a steady reduction in deferred acquisition-related 
liabilities. 

Conversely, although less likely in our view, we could lower the rating if the 
company does not begin to generate sustainable positive discretionary cash 
flow, or if covenant headroom falls below 15% with an expectation of further 
narrowing stemming from operating weakness and acquisition or earn-out related 
payments. 

Related Criteria And Research
     -- Issuer Ranking: U.S. Media And Entertainment Companies, Strongest To 
Weakest, July 17, 2012
     -- Industry Report Card: U.S. Media & Entertainment Subsectors Are 
Exhibiting Differing Trends, May 1, 2012
     -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
     -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009
     -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

Ratings List

Downgraded; Outlook Action
                                        To                 From
MDC Partners Inc.
 Corporate Credit Rating                B/Stable/--        B+/Negative/--

Downgraded; Recovery Ratings Unchanged
                                        To                 From
MDC Partners Inc.
 Senior Unsecured                       B                  B+
   Recovery Rating                      4                  4
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