TEXT-S&P revises Deluxe Entertainment outlook to negative

Thu Sep 20, 2012 4:23pm EDT

Sept 20 - Overview
     -- U.S. entertainment services provider Deluxe Entertainment Services 
Group Inc.'s second-quarter performance did not meet our expectations, and the 
company's margin of compliance with financial covenants is thin.
     -- We are revising the outlook on our 'B-' corporate credit rating to 
negative from stable.
     -- The negative outlook reflects the potential for a rating downgrade if 
the company's performance and financial condition do not stabilize over the 
near to intermediate term.
 
Rating Action
On Sept. 20, 2012, Standard & Poor's Ratings Services revised its rating 
outlook on Deluxe Entertainment Services Group Inc. to negative from stable. 
Existing ratings on the company, including the 'B-' corporate credit rating, 
were affirmed.

Rationale
Our rating outlook revision to negative from stable reflects our expectation 
that the company's operating performance could remain weaker than we had 
previously expected, pressuring covenant compliances and causing discretionary 
cash flow to continue to fall. 

Our 'B-' corporate credit rating on Deluxe Entertainment reflects our 
financial risk profile assessment of "highly leveraged" (based on our 
criteria) on the company, given its high debt service requirements, including 
its sizable mandatory amortization payments and its high leverage. We view 
Deluxe Entertainment's business profile as "vulnerable" because of its 
exposure to the widespread adoption of digital projection technology by motion 
picture exhibitors, particularly in North America. We expect the company's 
film processing and distribution business to continue to decline over the next 
few years. We expect the company's creative service business will grow at a 
moderate pace, but not sufficiently to prevent lower 2012 total revenue.

We regard Deluxe Entertainment's business profile as "vulnerable" because of 
unfavorable structural trends affecting its film processing and distribution 
business, which prints and distributes 35-millimeter films exhibited at movie 
theaters. Theaters have been replacing film projectors with digital 
projectors, reducing the number of film prints they need. This business is 
also vulnerable to fluctuations in the number of films slated for release by 
the studios it services. Separate from film processing, the company provides 
various creative services, which now account for over two-thirds of revenue. 
These services have healthier long-term fundamentals than film-release print 
manufacturing. This division distributes digital movie content to theaters by 
shipping hard drives, which should benefit from the rollout of digital 
projectors in movie theaters. This business also stores and distributes 
digital motion picture content to various devices or content providers and 
should be bolstered by the proliferation of new content distribution channels. 
It stands to gain from increasing demand for 2D-to-3D conversion of content 
because of the increase in 3D theatrical releases and the availability of 3D 
TVs.

In our base-case scenario for full-year 2012, we expect revenue will decline 
at a mid- to high-single-digit percent rate as declines of more than 30% in 
the film processing and distribution business outpace growth in creative 
services. We expect that the EBITDA margin will contract slightly for the year 
as lower gross margins more than offset reduced restructuring costs. In 2013, 
we expect that revenue will fall at a low-single-digit percent rate and that 
the EBITDA margin will remain under pressure.

During the second quarter of 2012, revenue at the creative services segment 
grew 9%, while revenue at the film labs and distribution segment dropped 40%. 
Total revenue declined 11%. EBITDA, according to our calculations that differ 
from covenant EBITDA (we include restructuring charges), fell 10% during the 
quarter, with the EBITDA margin improving slightly as a result of lower 
restructuring charges. Leverage and coverage, adjusted primarily for operating 
leases and including restructuring charges, were 5.4x and 2.2x, respectively, 
for the 12 months ended June 30, 2012, compared with 4.9x and 2.3x a year ago. 
Leverage is in line with the indicative debt-to-EBITDA ratio of 5x or higher, 
which, as per our criteria, characterizes a "highly leveraged" financial risk 
profile. 

We expect leverage could fall below 5x by the end of 2012 as a result of lower 
restructuring expenses in the second half of 2012 compared with the second 
half of 2011. Leverage could fall in 2013 if reduced restructuring expenses 
accompany debt repayment. We view the company's financial risk profile as 
"highly leveraged" given its high mandatory amortization requirements relative 
to its discretionary cash flow, aggressive financial policy, and thin margin 
of compliance with financial covenants. We expect that the company's 
conversion of EBITDA to discretionary cash flow will be 30% to 50% in 2012.

Liquidity
Deluxe Entertainment's liquidity is "less than adequate" (based on our 
criteria). Our assessment of the company's liquidity profile incorporates the 
following expectations and assumptions:

     -- We expect that sources of liquidity over the next 12 months will 
exceed uses by 1.2x or more.
     -- Sources minus uses should be positive, even with an unforeseen 15% 
EBITDA decline over the next 12 months.
     -- However, we do not believe the company will be able to maintain 
covenant compliance with a 15% decrease in EBITDA.

The company has a $100 million ABL revolving credit facility, of which $39.9 
million was drawn at June 30, 2012. Cash balances were $3 million at June 30, 
2012. We expect the company will generate moderate discretionary cash flow in 
2012 and in 2013. We expect that the company's discretionary cash flow is 
sufficient to cover its mandatory amortization payments over the next 12 
months. 

Mandatory amortization payments are $12.5 million per quarter. Deluxe 
Entertainment's margin of compliance with financial covenants was under 10% as 
of June 30, 2012. The tightest covenant is the total leverage covenant, which 
steps down from 2.75x to 2.6x in the second quarter of 2013. We believe that 
the company's margin of compliance will remain thin as covenants step down.

Outlook
The rating outlook is negative. We could lower the rating if we become 
convinced that the company could violate its financial covenants, that 
discretionary cash flow will contract below $50 million, or that the company's 
liquidity will shrink. This could occur if revenue growth at creative services 
slows and if the company is unable to adequately reduce costs as the film labs 
and distribution business declines. 

We could revise the outlook to stable if the company's operating performance 
improves based on sustainable demand trends and its margin of compliance with 
financial covenants widens to 15%, neither of which we currently regard as 
likely in the near term.

Related Criteria And Research
     -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
     -- Use Of CreditWatch And Outlooks, Sept. 14, 2009
     -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009
     -- Standard & Poor's Revises Its Approach To Rating Speculative-Grade 
Credits, May 13, 2008
     -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
     -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008
     -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
 
Ratings List

Ratings Affirmed; Outlook Action
                                              To                 From

Deluxe Entertainment Services Group Inc.
 Corporate Credit Rating                      B-/Negative/--     B-/Stable/--
 Senior Secured                               B             
  Recovery Rating                             2              

 

Complete ratings information is available to subscribers of RatingsDirect on 
the Global Credit Portal at www.globalcreditportal.com. All ratings affected 
by this rating action can be found on Standard & Poor's public Web site at 
www.standardandpoors.com. Use the Ratings search box located in the left 
column.
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