TEXT-S&P revises Deluxe Entertainment outlook to negative
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.