TEXT-S&P assigns CyrusOne Inc 'B' rating
Overview -- U.S. data center operator CyrusOne Inc., currently a wholly-owned subsidiary of Cincinnati Bell Inc. (CBI), is planning to become an unrestricted subsidiary of CBI, and raise stand-alone debt financing and conduct an IPO. -- We are assigning our 'B' corporate credit to CyrusOne. -- At the same time, we are assigning ratings to operating subsidiary CyrusOne LP's proposed $225 million secured revolving credit facility due 2017 and proposed $500 million senior unsecured notes due 2022. -- The stable rating outlook is based on our expectation that the company will have "adequate" liquidity to fund an aggressive growth strategy and substantial cash outflows over at least the next two years. Rating Action As we previously announced on Oct. 30, 2012, Standard & Poor's Ratings Services assigned its 'B' corporate credit rating to Carrollton, Texas-based CyrusOne Inc. The rating outlook is stable. We are also assigning our 'BB-' issue-level rating and '1' recovery rating to operating subsidiary CyrusOne LP's proposed $225 million secured revolving credit facility due 2017. The '1' recovery rating indicates our expectation for very high (90% to 100%) recovery for lenders in the event of a payment default. In addition, we are assigning our 'B+' issue-level rating and '2' recovery rating to the company's proposed $500 million of senior unsecured notes due 2022. The '2' recovery rating indicates our expectation for substantial (70% to 90%) recovery for noteholders in the event of a payment default. Rationale We expect the company to use proceeds from the proposed debt financing to repay roughly $475 million of intercompany debt owed to CBI. Following the IPO, we expect CBI to own 9.8% of common shares in CyrusOne Inc., and a large majority of operating partnership shares in CyrusOne LP, which after a 12-month lockout period, could be exchanged for common shares on a one-to-one basis. In addition, CyrusOne plans to convert into a REIT in conjunction with the IPO, which could occur in the fourth quarter of 2012 or early 2013. The ratings on CyrusOne Inc. reflect the company's "highly leveraged" financial profile, including our expectation for substantial cash outflows to fund what we consider an ambitious growth strategy. Pro forma for the proposed debt financing and initial $300 million IPO, liquidity will be roughly $500 million, which we consider necessary to fund growth capital expenditures and shareholder distributions for roughly two years before CyrusOne will need to raise additional capital. Our assessment of the company's business risk as "weak" under our criteria takes into account our relatively favorable growth expectations for data center outsourcing by large business customers, but also recognizes the longer-term risks of aggressive expansion leading to pricing declines or higher customer churn. We expect CyrusOne to record healthy revenue growth (+20%) for the next several years, based on the development of new colocation space and increased demand from new and existing customers. As a result, we currently view these revenue trends as supportive of CyrusOne's aggressive growth strategy. However, we believe its ongoing capital needs expose the company to unexpected shifts in supply and demand fundamentals, or to adverse credit market conditions if it is unable to scale back capital spending in a timely manner. CyrusOne provides physical colocation space through 23 data centers in 9 markets, with a high degree of revenue and square footage concentration in Cincinnati and various Texas markets, including Dallas and Houston. The company targets large, enterprise customers, with no one customer(excluding CBI) accounting for more than 8% of annualized rent. There is a degree of revenue concentration in the energy industry, which accounts for 38% of annualized rent. However, we believe the company's enterprise customers currently outsource only a modest percentage of their datacenter needs, providing healthy growth potential in the energy sector and other verticals, such as online media and content companies. We believe the company's focus on large enterprise customers has resulted in lower revenue churn (3% for 2011 and 4% for the first nine months of 2012) compared with peers that have a greater mix of more volatile, small- to medium-sized customers (SMB) or Internet-based businesses. CyrusOne has been aggressively adding colocation space, which totaled 895,753 square feet as of Sept. 30, 2012, with 78,000 square feet of colocation space under development and 762,000 of powered shell space available for future development. To diversify revenue streams, CyrusOne also focuses on growing high-margin interconnection revenue, which currently accounts for a negligible amount of total revenue. We believe interconnections create network effects and will increase the retention of CyrusOne's existing customer base and attract new customers in underpenetrated verticals. However, in our view, it could take a number of years to meaningfully grow this revenue stream, because of the company's need to attract more telecom carriers or large Internet companies to many of its data centers. Under our base case scenario, we believe colocation space will continue to rise at current rates of about 20%, and that revenue growth per square foot will begin to benefit from increased interconnections over the next few years. We believe the utilization rate, which was 78% for the third quarter of 2012, could decline further in the fourth quarter and potentially remain below 80% in 2013 because of new colocation space added in Phoenix and Dallas. As a result, we expect total revenue growth in the low-20% area over the next few years. We believe the EBITDA margin, which was very healthy compared with the peer group at roughly 53% for the 12 months ended Sept. 30, 2012, could drop modestly to the high-40% to low-50% area over the next 12 months, because of the dip in utilization, but could grow to the mid-50% area in the longer term because of growth in high-margin interconnection revenue. We believe that EBITDA will increase at a mid-teen to low-20% rate in 2012 and 2013, which could accelerate in later years if the company is able to expand EBITDA margins and grow interconnection revenue. Pro forma debt to EBITDA (adjusted for operating leases) was high, at roughly 5.4x for the 12 months ended Sept. 30, 2012. We expect this ratio to fall to the low- to mid-4x area in 2013 because of EBITDA growth. We believe that discretionary cash flow will be in the negative $150 million to $200 million range over the next few years, because of sizeable capital expenditures and shareholder distributions. Under a REIT structure, the company will be required to payout at least 90% of taxable income in the form of shareholder distributions. We expect taxable income to be modest over the next several years, and as a result, we have estimated potential distributions as a percentage of funds from operations (FFO). Our expected FFO payout ratio is based on industry peers such as DuPont Fabros Technology Inc. and Digital Realty Trust Inc., which had payout ratios of 34% and 68%, respectively, as of the second quarter of 2012. Based on these peer payout ratios, we have estimated annual distributions of about $40 million to $50 million over the next few years, which will continue to increase with growth in EBITDA. As a result, we expect the company's total coverage ratio (including interest expense and distributions) to be in the high-1x area over the next few years. REITS such as DuPont and Digital tend to have total coverage ratios in the low-1x area; however, these companies have higher leverage, preferred dividend payments, and mandatory debt amortization. Liquidity We consider CyrusOne's liquidity as "adequate," based on our criteria. Pro forma for the proposed financing and IPO, we expect sources of liquidity to include cash of roughly $275 million and full access to the proposed $225 million revolving credit facility. We assume funds from operations will be about $90 million to $100 million in 2013. Uses of liquidity include modest working capital cash usage as the company continues to rapidly expand, and sizeable capital expenditures, which we estimate will be in the $200 million to $250 million range over the next several years. Under a REIT structure, the company will be required to payout at least 90% of taxable income in the form of shareholder distributions. Because of our expectation of negligible to modest taxable income over the next few years, we have estimated distributions based on a percentage of FFO and adjusted funds from operations (AFFO). To compute AFFO, we subtract from FFO certain recurring real estate expenses, such as maintenance capital spending and leasing costs. Based on peer payout ratios, we have estimated annual distributions of about $40 million to $50 million over the next few years, which will continue to increase with growth in EBITDA. We expect the company to maintain an adequate cushion of compliance against all its covenants. The proposed revolving credit facility contains financial covenants, including an initial 2.5x senior secured leverage covenant, which steps down to 2x in 2015. The credit agreement also contains a 2x fixed-charge covenant, with no step-downs, and an initial total debt to gross asset value covenant of 55%, which tightens to 50% in 2015. Outlook The rating outlook is stable, based on our expectation that the company will have adequate liquidity to fund growth initiatives and negative discretionary cash flow over at least the next two years. Since we expect the company to pursue aggressive capital spending over the foreseeable future, and continue to experience discretionary cash outflows, an upgrade would most likely be the result of a reassessment of the company's business risk profile to "fair" from "weak." Specifically, we could raise the rating if the company continues to successfully increase its scale, diversify its customer vertical base, and grow high-margin interconnection revenue. An upgrade scenario would also require our confidence that the company will remain well-capitalized, and maintain adequate liquidity despite capital spending and shareholder distributions. Conversely, we could lower the rating if operating performance weakens because of competitive pressure or over-expansion, causing utilization to tumble to the low-70% area and debt to EBITDA to rise to 6x or higher, with little prospect for improvement. A downgrade could also occur if we came to view liquidity as a significant risk, because of an unwillingness to scale back capital spending in conjunction with deterioration in operating trends coupled with adverse credit market conditions. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Guidelines For Recovery Ratings On Global Industrials Issuers' Speculative-Grade Debt, Aug. 10, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 -- 2008 Corporate Ratings Criteria: Ratios And Adjustments, April 15, 2008 Ratings List New Rating CyrusOne Inc. Corporate Credit Rating B/Stable/-- CyrusOne Finance Corp. $500 mil sr unsecd nts due 2022 B+ Recovery Rating 2 CyrusOne LP $225 mil revolving bank ln due 2017 BB- Recovery Rating 1 $500 mil sr unsecd nts due 2022 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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