High financial risk remains DJO's dominant credit feature, as it has been since it merged with ReAble Therapeutics Inc. in 2007. As of Sept. 29, 2012, total lease-adjusted debt (including accrued interest) was 9x trailing-12-months' EBITDA. We expect this debt leverage measure to remain above 8x for the next two years, declining gradually mainly as a result of EBITDA growth. DJO had free operating cash flow (FOCF; after capital spending and working capital requirements) in only one of the past six years. We believe it could continue to need incremental external financing over the next few years.
Uncertain third-party reimbursement and coverage for DJO's products overshadow relatively stable demand for them, contributing to our "fair" assessment of its business risk profile. Its activities are concentrated in the fairly narrow niche of orthopedic and pain management devices. We believe DJO's recognizable brands, long-standing customer relationships, and its respectable record of new product development and enhancements have fostered a leading market position in most product categories.
In a series of transactions during 2012, DJO refinanced most of its debt. As a result, debt maturity dates were pushed out, the leverage limit in its credit agreements was loosened and revolver availability was restored, improving DJO's liquidity. The amount of debt increased about $35 million and DJO incurred significant cash and non-cash transaction costs, but we expect minimal changes in its projected interest expense.
We view DJO's liquidity as "adequate." Our liquidity analysis is based on the following assumptions and expectations:
-- For 2013 and 2014, we expect capital spending of about $35 million to $40 million annually and working capital growth of about $10 million per year to be financed internally. Mandatory debt amortization is less than $10 million per year through 2015. We assume DJO will not make any acquisitions over the next few years.
-- As of Sept. 29, 2012, DJO had $38 million of cash and $62 million of funds available from its $100 million revolving credit facility. We believe all revolver borrowing was repaid in October with some of the proceeds from the issuance of new notes.
-- Over the next 12 to 24 months, we estimate sources of liquidity, including the revolver, will cover uses by more than 1.2x. Even if EBITDA is 15% below our expectations, sources would still cover uses, based on our estimates.
-- We expect DJO to maintain adequate headroom under its loan agreement covenant, even when the covenant begins to tighten in the fourth quarter of 2013. As of Sept. 29, 2012, leverage (as defined) was 29% below the maximum permitted.
-- We believe DJO has sound relationships with its banks, but lacks the ability to absorb a high-impact, low-probability event, such as an onerous product liability settlement, without refinancing.
-- We have ratings on the debt of DJO Finance LLC (DJOFL), a subsidiary of DJO Global Inc.
-- Our rating on DJOFL's first-lien secured debt is 'B+', two notches above the corporate credit rating on DJO Global, and our recovery rating on this debt is '1', indicating our expectation for very high (90% to 100%) recovery of principal in the event of payment default.
-- Our rating on DJOFL's second-lien secured debt is 'B-', the same as the corporate credit rating on DJO Global, and our recovery rating on this debt is '3', indicating our expectation for meaningful (50% to 70%) recovery of principal in the event of payment default.
-- Our rating on DJOFL's senior unsecured debt is 'CCC+', one notch below the DJO Global corporate credit rating, and our recovery rating on this debt is '5', indicating our expectation for modest (10% to 30%) recovery of principal in the event of payment default.
-- Our rating on DJOFL's subordinated debt is 'CCC', two notches below the corporate credit rating on DJO Global, and the recovery rating on this debt is '6', indicating our expectation for negligible (0 to 10%) recovery of principal in the event of payment default.
Our rating outlook on DJO is stable, reflecting our expectation of continued high leverage, low-single-digit annual revenue growth over the medium term broadly in line with volume growth for the markets DJO serves, and relatively stable profit margins. We also assume that DJO will need, at most, moderate borrowing if cash flow is below our base-case expectation.
We could raise our rating if a combination of wider EBITDA margins, accelerated growth, or other factors enables DJO to consistently generate meaningful FOCF and sustain adjusted debt to EBITDA below 7.5x. We could consider a downgrade if we expect the covenant cushion to fall below 10% or availability of the revolver is substantially reduced, resulting in impaired liquidity. This could occur if weaker-than-expected economic conditions in the U.S. or Europe significantly slow DJO's growth and depress its margins. There is also potential for intensified price pressure, which we believe could erode profitability.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- 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