TEXT - S&P raises Steinway Musical Instruments to 'B+'
Overview -- A special committee of the Board of Directors of U.S.-based Steinway Musical Instruments Inc. has ended its strategic alternatives evaluation process, and will neither divest its band division nor the entire company. -- We are raising our corporate credit rating to 'B+' from 'B' reflecting improved credit metrics following better operating performance and debt reduction. -- We are also raising the issue-level rating on the company's 7% senior unsecured notes due 2014 to 'BB-' from 'B+'. The recovery rating is '2'. -- The outlook is stable, reflecting our expectation that the company will sustain its improved credit measures while maintaining adequate liquidity. Rating Action On Jan. 14, 2013, Standard & Poor's Ratings Services raised its corporate credit rating on Waltham, Mass.-based Steinway Musical Instruments Inc. to 'B+' from 'B'. The outlook is stable. At the same time, we raised the issue-level rating on the 7% senior unsecured notes due 2014 to 'BB-' from 'B+'. The recovery rating on this debt is '2', indicating our expectation for substantial (70% to 90%) recovery in the event of a payment default. Rationale The upgrade of Steinway Musical Instruments Inc. reflects Steinway's decision to end its strategic evaluation process without selling any (or all) of the company. In addition, we believe credit metrics have improved following a substantial debt prepayment in 2011. The ratio of adjusted debt to EBITDA improved to 3.3x as of June 30, 2011, following about $80 million of debt prepayment, and has since improved to 2.9x as of the 12 months ended Sept. 30, 2012. Despite these improved metrics, the potential sale of the company or its Band division and our uncertainty regarding financial policy, management, and direction of the company, had been a constraint on the rating. The ratings on Steinway reflect the company's "significant" financial risk profile and "vulnerable" business risk profile. Steinway's financial risk profile reflects the company's significant reduction in debt, as mentioned above. The company's ratio of adjusted funds from operations (FFO) to total debt remained near 20% for the 12 months ended Sept. 30, 2012, the same as the prior year. Both these ratios are near our "significant" indicative ratios of leverage of 3x-4x and FFO to total debt of 20%-30%. Key credit factors in our assessment of Steinway's business risk profile include its narrow business focus in a highly fragmented and competitive market, the discretionary nature of its products, its vulnerability to economic cycles, and weak governance. We also considered the benefits of Steinway's good market positions, its well-recognized brand names, and the geographic diversity of its sales. Steinway's product sales and profitability remain concentrated in pianos, although it has a diverse portfolio of product offerings in the band and orchestral instrument segment. Piano sales were 62% and band instruments 38% of 2011 revenues. The company holds a dominant market share of the premium grand piano market, and is the leader in certain band instrument product categories. Although the company maintains strong brand recognition through its key Steinway and related brand names, we believe sales will remain vulnerable to economic cycles because of the discretionary nature of its products. We believe the musical instruments and accessories industry is highly fragmented and very competitive, based on such factors as name recognition, sound quality, style, and price. The company has diversified its geographic reach and now has about 47% of its sales (in fiscal 2011) outside of the U.S., a large portion of which are in Europe. For the 12 months ended Sept. 30, 2012, Steinway's net sales were up about 2% compared to the prior-year period in 2011, in part reflecting a favorable recovery in the band segment, which had been weakened by a strike in its Ohio brass instrument manufacturing facility during the second half of 2011. Still, some of the company's key piano businesses remain soft, especially in the premium-priced grand pianos market. Gross margin has remained flat at about 33% as the improvement in the band segment outweighed the additional costs to increase headcount at its Hamburg facility. Adjusted EBITDA margin declined about 50 basis points to 11.1% compared to 11.6% in the prior-year period, in part because of additional sales, marketing, and promotional costs for new retail showrooms. We expect Steinway's operating results will improve modestly as sales growth in emerging markets (particularly in Asia) offset a generally weak global economy and margins remain pressured by high input costs. This should lead to moderate credit measure improvement in fiscal year 2013. Our base-case scenario assumptions include: -- Revenue growth of about 3%, reflecting continued improvement in the band segment, and sales growth in China, other emerging markets, as well as Japan, despite ongoing weakness in the piano segment, particularly in premium-priced and higher-margin pianos. -- Adjusted EBITDA margin near 12%, reflecting better fixed cost absorption thanks to a building backlog of orders, particularly in Asia. -- No dividends or share repurchases. -- We anticipate free operating cash flow (FOCF) to improve to at least $15 million in 2013. Based on the above assumptions, we expect credit measures to continue to slowly improve, including projected adjusted debt to EBITDA of 2.5x and FFO to total debt above 25% by the end of fiscal year 2013. Our projected credit measures do not consider the potential sale of the West 57st Street property. Management and governance In July 2011 the company's then-chairman, Kyle Kirkland, and CEO, Dana Messina, and certain members of management made an offer to purchase the company's band instrument division, and the board of directors formed a Special Committee to explore other strategic alternatives. Despite Dana Messina stepping down from his management role, he remains on the board, as does Kyle Kirkland, though not as Chairman. Additionally, an independent director, Michael Sweeney, became Chairman in July 2011 and was then appointed interim CEO in October, which we view as an additional constraint on governance. We believe these circumstances created additional uncertainty regarding the direction, policies, and operating strategies of the company. We view Steinway's management and governance as "weak," primarily based on the duration (18 months) of the recently concluded strategic alternatives evaluation, and the potentially limited independence of the board, given multiple management and director changes as the company transitions to a non-controlled publically traded company. Additionally, the company has been trying to sell its leasehold interest in its flagship West 57th Street property in New York City for several years. If the sale were completed, the company expects about $56 million of net proceeds; however, the company is negotiating offers with several parties and no further details on the potential use of proceeds and timing of the transaction are available at this time. Liquidity We believe Steinway's liquidity is "adequate," with sources of cash likely to exceed cash uses over the next 12 months by more than 1.2x. Our assessment of Steinway's liquidity profile incorporates the following expectations, assumptions, and factors: -- We expect liquidity sources will continue to exceed uses, even if EBITDA were to decline by 15% from current levels. -- The company is not subject to maintenance financial covenants. The asset-based revolving credit facility agreement contains a springing covenant consisting of a minimum fixed-charge coverage test of 1.1x, which only comes into effect if excess availability declines to below 15% of the total commitment. -- We believe Steinway will maintain adequate cash balances and availability on its credit facilities to fund seasonal working capital needs and its debt service requirements, including adequate availability on the revolving credit facility to meet its 2014 bond maturity, albeit possibly constraining liquidity thereafter. -- The company has sound relationships with banks in our view. As of Sept. 30, 2012, Steinway reported about $46 million in cash on its balance sheet and had about $93 million of availability on its ABL, with no borrowings outstanding on this facility. The company also has access to foreign credit facilities that provided an aggregate of about $22 million of additional borrowing capacity. Recovery analysis The issue-level rating on Steinway Musical Instruments Inc.'s 7% senior unsecured notes is 'BB-' (one notch above the corporate credit rating). The recovery rating on this debt is '2', indicating our expectation for substantial (70% to 90%) recovery in the event of a payment default. For the complete recovery analysis, see Standard & Poor's recovery report on Steinway to be published following this report on RatingsDirect. Outlook Our rating outlook on Steinway is stable. We expect the company's sales to modestly grow from increased sales in emerging markets, which should result in improved credit metrics, including debt to EBITDA near 2.5x and FFO to total debt of over 25% by fiscal year-end 2013. We could lower our ratings if business conditions weaken such that leverage rises over 4x. We estimate EBITDA would have to fall over 18% from current levels for this to occur. We believe this could occur either from a significant cancellation in sales orders (possibly stemming from a weaker-than-expected economy) or a major manufacturing disruption. Although unlikely given the company's narrow business focus, we would consider raising the rating if debt to EBITDA is reduced to and sustained near 2x or below. We estimate this could occur if EBITDA increased over 50%, possibly as a result of strong global growth in its Piano segment. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Key Credit Factors: Criteria For Rating The Global Branded Nondurable Consumer Products Industry, April 28, 2011 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Upgraded To From Steinway Musical Instruments Inc. Corporate credit rating B+/Stable/-- B/Developing/-- Senior unsecured BB- B+ Recovery rating 2 2