TEXT-S&P cuts Cengage Learning Holdings II LP

Mon Nov 19, 2012 5:49pm EST

Nov 19 (Reuters) - Standard & Poor's Ratings Services lowered its corporate credit rating on Stamford, Conn.-based Cengage Learning Holdings II L.P. to 'CCC' from 'B-'. The outlook is negative.

We have lowered our issue-level ratings on the company's debt by two notches in conjunction with the downgrade. Our recovery ratings on the company's debt issues remain unchanged.

Rationale

The downgrade reflects weak operating performance in the fiscal first quarter ended Sept. 30, 2012, which we expect will continue over the near term. The company's senior leverage ratio, as defined in its credit agreement, increased to 6.72x at Sept. 30, 2012, from 4.78x at June 30, 2012, precipitously narrowing the EBITDA margin of compliance to 13% from 38%. We believe Cengage will need to amend covenants to maintain compliance, based on our expectation that EBITDA will decline for the remainder of its fiscal year ending June 30, 2013, and into fiscal 2014. Also, the company has $2.08 billion of low-cost term loans due July 2014, as well as $654 million of long-term public debt due 2015, which are trading at what we regard as a distressed yield. We believe that the costs of refinancing would be prohibitive and result in interest coverage below 1x and negative discretionary cash flow.

Our corporate credit rating on Cengage reflects our expectation that the company will face difficulty maintaining compliance with its senior leverage covenant and refinancing its 2014 and 2015 debt maturities. We consider the company's business risk profile as "weak" (according to our criteria), based on its eroding business position in U.S. higher education and professional training publishing, and competitive obstacles facing this business. We assess Cengage's financial risk profile as "highly leveraged," reflecting thin interest coverage and low discretionary cash flow compared with its debt burden, as well as its hurdles to refinancing.

Cengage is the second largest U.S. college textbook publisher and lacks the breadth and financial resources of Pearson PLC, the market leader. However, Cengage has been adversely affected by the growth of the rental textbook market, which has increased the availability of discounted used books. Cengage's sales to for-profit educational institutions are declining, because these buyers are experiencing enrollment pressures as a result of regulation that significantly tightens their marketing practices. In addition, lower funding from state and local governments is hurting the company's library reference and supplemental publishing businesses.

Under our base-case scenario, we expect revenues to decline at a low-double-digit percent rate in fiscal 2013 while EBITDA will likely decline over 20% due to competition from the growing volume of used textbook rentals, declining volume to for-profit institutions, which are shifting to lower-priced ebooks, and pricing competition. In the key first fiscal quarter ended Sept. 30, 2012, revenue and EBITDA declined 22% and 38%, respectively. The EBITDA drop was impacted by retailer just-in-time inventory management practices, sharply reduced sales to a major customer, and lower sales of higher-margined digital products. The EBITDA margin declined to 28% for the 12 months ended Sept. 30, 2012, from 34% over the prior 12 months; we expect it to decline to 27% in fiscal 2013.

Cengage's debt leverage is considerably higher than that of its peers, which we view as a disadvantage in light of the potential for increased competitive pressure. Lease-adjusted debt to EBITDA (after amortization of prepublication costs) increased to 10.8x in the 12 months ended Sept. 30, 2012, from 8.6x over the same period last year, due to weak operating performance. This ratio is consistent with our indicative financial risk threshold of more than 5x that we associate with a "highly leveraged" financial profile. We expect that debt leverage will remain over 10x in fiscal 2013 and 2014 due to weak operating performance and minimal discretionary cash flow.

We expect interest coverage to remain extremely thin, and that discretionary cash flow and EBITDA conversion to discretionary cash flow will decline in the next two years. We expect total interest coverage to decline to about 1x at best, in fiscal 2013 and potentially lower in fiscal 2014 because of weak operating performance and the higher average cost of debt. EBITDA coverage of interest expense declined to 1.1x over the 12 months ended Sept. 30, 2012, from 1.4x over the prior 12 months, because of weak operating performance and higher interest expense resulting from recent refinancings. The company generated discretionary cash flow of slightly over $100 million in the 12 months ended Sept. 30, 2012, as working capital was a source of funds due to the large sales decline. EBITDA conversion to discretionary cash flow increased to roughly 20% from 10% in the prior year period. We expect that EBITDA conversion to discretionary cash flow will decline to roughly 10% in fiscal 2013. We believe the benefit of unfavorable interest rate swaps expiring in July 2013 could be more than offset by higher interest costs from additional refinancing.

Liquidity

Cengage has "weak" sources of liquidity to more than cover its needs over the next 12 to 18 months, based on our assumption that future refinancing costs may be prohibitive. Relevant expectations and assumptions in our assessment of Cengage's liquidity profile are as follows:

-- Because of Cengage's high debt burden and low discretionary cash flow to total debt, we do not believe it can absorb high-impact, low probability shocks.

-- The thin cushion of covenant compliance could be at significant risk over the next year, based on our expectation of EBITDA declines.

-- In light of debt trading levels of the company's debt issues, we have little confidence in the company's standing in the credit markets. We view low trading levels as posing an incentive for the company to consider a subpar buyback or exchange.

Liquidity sources include cash balances of $57 million as of Sept. 30, 2012, a $225 million non-extended revolving credit facility due July 2013, and a $300 million extended revolving credit facility due 2017, of which the company had drawn a total of $57 million as of Sept. 30, 2012. Cash balances supplement seasonal working capital borrowings, which occur during the first half of the calendar year. We expect that discretionary cash flow will decline to roughly $50 million in fiscal 2013 and be minimal in fiscal 2014, excluding potentially higher interest costs resulting from additional refinancing.

Near-term debt maturities consist of $1.5 billion of the low-cost, non-extended term loan due July 2014, $550 million add-on term loan due July 2014, and $654 million of long-term public debt due 2015. However, based on recent trading levels of the company's debt, we believe that the costs of refinancing could be prohibitive. Also, the maturity dates of both the extended term loan due 2017 and the extended revolving credit facility due 2017 will revert to October 2014 if more than $350 million of $402 million 10.5% senior notes due January 2015 remain outstanding as of that date.

The company has a thin 13% cushion of compliance with the senior secured leverage covenant of 7.75x--the only financial test, which does not step down over the life of the agreement. We believe Cengage will need to amend covenants to maintain compliance with them, based on our expectation that EBITDA will keep declining.

Recovery analysis

For our complete recovery analysis, see the recovery report on Cengage, published June 21, 2012, on RatingsDirect.

Outlook

The negative outlook reflects our view that the company will need an amendment over the next year to avoid a covenant violation. We could lower the rating if it becomes apparent that a covenant default will occur, or if discretionary cash flow becomes negative, raising the specter of a default on interest. This could occur if enrollments decline or pressure increases from textbook rentals, and weakness in the library reference business continues. Specifically, an EBITDA decline of 10% over the next year would reduce pro forma EBITDA coverage of total interest (after prepublication costs) to only 1x. We will also continue to monitor low trading levels of the company's debt. An increasing discount to par might suggest that a subpar exchange offer would be among alternatives that management could consider. We would view such a transaction as a selective default.

We regard an upgrade or even a near-term revision of the outlook to stable as a remote scenario, involving consistent improvement in operating performance, a reduction in leverage, and restoring a healthy margin of compliance with financial covenants, none of which appear probable.

Related Criteria And Research

-- Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings, Oct. 1, 2012

-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012

-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011

-- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009

-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

-- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008

Ratings List Downgraded To From Cengage Learning Holdings II L.P. Corporate Credit Rating CCC/Negative/-- B-/Negative/-- Cengage Learning Acquisitions Inc. Senior secured credit facilities CCC+ B Recovery Rating 2 2 Senior secured notes CC CCC Recovery Rating 6 6 Senior unsecured CC CCC Recovery Rating 6 6 Subordinated CC CCC Recovery Rating 6 6 Cengage Learning Holdco Inc. Senior unsecured CC CCC Recovery Rating 6 6

Ratings List Downgraded

To From Cengage Learning Holdings II L.P. Corporate Credit Rating CCC/Negative/-- B-/Negative/-- Cengage Learning Acquisitions Inc. Senior secured credit facs CCC+ B Recovery Rating 2 2 Senior secured notes CC CCC Recovery Rating 6 6 Senior unsecured CC CCC Recovery Rating 6 6 Subordinated CC CCC Recovery Rating 6 6 Cengage Learning Holdco Inc. Senior unsecured CC CCC Recovery Rating 6 6

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