TEXT-S&P cuts Deluxe Entertainment to 'CCC+'

Fri Dec 14, 2012 5:16pm EST

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Overview
     -- U.S. entertainment services provider Deluxe Entertainment Services 
Group Inc.'s third-quarter performance was below our expectations as declines 
at the film processing and distribution business have accelerated. The 
company's margin of compliance with financial covenants is thin.
     -- We are lowering our corporate credit rating on the company to 'CCC+' 
from 'B-'. We are also lowering our issue-level rating on the company's senior 
secured term loan to 'B-' (one notch above the corporate credit rating) from 
'B'.
     -- The negative outlook reflects the potential for a downgrade if the 
company's performance and financial condition do not stabilize over the next 
year.
 
Rating Action
On Dec. 14, 2012, Standard & Poor's Ratings Services lowered its corporate 
credit rating on U.S. entertainment services provider Deluxe Entertainment 
Services Group Inc. to 'CCC+' from 'B-'. The outlook is negative.

We also lowered our issue-level rating on Deluxe Entertainment's senior 
secured term loan to 'B-' from 'B'. The recovery rating on this debt remains 
at '2', indicating our expectation for substantial (70% to 90%) recovery for 
lenders in the event of a payment default. The rating action reflects our 
expectation that the company's film processing and distribution segment will 
continue to decline at a steep pace, pressuring covenant compliance and 
discretionary cash flow, which could potentially strain liquidity.

Rationale
The ratings on Deluxe Entertainment reflect Standard & Poor's view that the 
company will continue to have a "vulnerable" business risk profile and a 
"highly leveraged" financial risk profile. Our view of the company's financial 
risk profile is based on its high mandatory amortization requirements relative 
to its discretionary cash flow, aggressive financial policy, and thin margin 
of compliance with financial covenants. Our opinion of Deluxe Entertainment's 
business profile is based on its exposure to the widespread adoption of 
digital projection technology by motion picture exhibitors. 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 revenue declines 
in the fourth quarter of 2012 and in 2013. We view Deluxe Entertainment's 
management and governance as "fair."

Deluxe Entertainment derives about one-quarter of its revenue from film 
processing, an industry that has been in rapid decline as theaters replace 
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. We expect film processing 
to remain under tremendous pressure going forward. Separately, the company 
provides various creative services to film, television, and advertising 
content providers, which now account for about three-quarters 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. Its 
revenues 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 40% 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 mid-single-digit percent rate, with the 
film processing and distribution segment declining at a similar or slightly 
faster rate, and that the EBITDA margin will remain under pressure.

During the third quarter of 2012, revenue at the creative services segment 
grew 5%, while revenue at the film labs and distribution segment dropped 53%. 
Total revenue declined 18%. EBITDA, according to our calculations, which 
differs from covenant EBITDA (we include restructuring charges), grew over 30% 
during the quarter, with the improvement due to lower restructuring charges. 
Leverage and interest coverage, adjusted primarily for operating leases and 
including restructuring charges, were 5.2x and 2.3x, respectively, as of Sept. 
30, 2012, compared with 5.3x and 2.1x 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 and the company's high debt amortization payments. We expect that 
leverage will be in the high-4x area throughout 2013. We expect that the 
company's conversion of EBITDA to discretionary cash flow will be 30% to 35% 
in 2013, down from around 70% during the 12 months ended Sept. 30, 2012, due 
to a much lower benefit from working capital and from the amortization of 
contract advances. More importantly, the company has sizable debt amortization 
payments and we expect that the company's discretionary cash flow may not be 
sufficient to cover its mandatory amortization payments over the next 12 
months.

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 do not expect that sources of liquidity over the next 12 months 
will exceed uses by 1.2x or more.
     -- We do not expect that sources of liquidity minus uses of liquidity 
will be positive in the event of a 15% EBITDA decline over the next 12 months.
     -- We do not believe the company has sufficient covenant headroom for 
EBITDA to decline by more than 15% without breaching its covenant tests, 
taking into account covenant step-downs.
     -- We believe the company could not absorb high-impact, low-probability 
shocks, even factoring in capital spending cuts or asset sales.
 
The company has a $100 million ABL revolving credit facility, of which $63 
million was drawn at June 30, 2012. Cash balances were $8 million at June 30, 
2012. We expect the company will generate moderate discretionary cash flow for 
the full-year 2012 and in 2013. Mandatory amortization payments are $12.5 
million per quarter and we believe that discretionary cash flow may not be 
sufficient to cover this payment in 2013.

Deluxe Entertainment's margin of compliance with financial covenants was under 
10% as of Sept. 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, 
to 2.5x in the third quarter of 2013 and to 2.4x in the first quarter of 2014. 
We expect that the company's margin of compliance will remain thin as 
covenants step down.

Recovery analysis
For the recovery analysis, see Standard & Poor's recovery report on Deluxe 
Entertainment Services Group Inc., published Aug. 14, 2012, on RatingsDirect.

Outlook
The rating outlook is negative. We could lower the rating if it becomes 
apparent that the company will violate covenants or if we become convinced 
that the company faces an increasing risk of default on principal payments. 
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.

Although less likely over the near term, we could revise the outlook to 
positive or raise the rating if the company is able to manage the decline in 
the film segment, accelerate revenue growth at the creative services segment, 
generate greater than $50 million in discretionary cash flow, and maintain a 
margin of compliance above 10%.

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
     -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
 
Ratings List

Downgraded
                                           To                 From
Deluxe Entertainment Services Group Inc.
 Corporate Credit Rating                   CCC+/Negative/--   B-/Negative/--
 Senior Secured                            B-                 B
   Recovery Rating                         2                  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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