CSC’s credit metrics remain in line with our indicative ratios for a “highly leveraged” descriptor, which include adjusted leverage greater than 5x and a ratio of funds from operations (FFO) to total debt less than 12%. We expect the company’s credit metrics to remain very weak: Over the next two years, we expect adjusted leverage of around 8x and FFO to total debt in the high-single-digit percent area, despite some slight improvement because of a continued increase in revenues from the addition of contracts and some vend price increases.
We believe weak conditions in the U.S. and low growth prospects for the outsourced laundry facilities management industry will constrain Coinmach’s organic revenue growth. Our expectation that credit protection measures will be fairly consistent with current levels over the next 12 months assumes the following:
-- In fiscal 2013 (ending March 31, 2013), we anticipate low-single-digit revenue growth, fueled primarily through the securing of contracts and acquisitions.
-- Taking into consideration the interplay of macroeconomic factors of unemployment, vacancy rates, and usage, we project a solid mid-20% adjusted EBITDA margin in the next 12 months, in line with the company’s consistent performance within a tight bandwidth for this measure. Given the capital expenditure requirements of new contracts and the related transition period before achieving stabilization, we expect the full-year $1 million-$4 million of EBITDA benefit to be realized in fiscal 2013.
-- Given the possibility of tuck-in acquisitions (financed largely through cash flow), we forecast 2013 capital expenditures of roughly $90 million, around the same as the previous year.
-- The company remains very highly leveraged, and we believe growth in debt levels from payment-in-kind (PIK) accretion of principal on the company’s $186 million 10.125% senior unsecured notes due in 2015 will outpace modest reductions in revolver borrowings and term loan amortization. We do not anticipate meaningful voluntary debt repayment beyond required amortization of 1% annually, and the required 50% excess cash flow sweep.
CSC’s current credit agreement limits its financial flexibility, particularly with respect to acquisition activity. While the company’s strategy continues to include acquisition of small players in the market, in the absence of an amendment to its revolver credit agreement, CSC’s ability to conduct a large-scale acquisition remains heavily constrained. Furthermore, particularly with respect to the tightening cushion on the total leverage ratio covenant, which becomes more restrictive with step-downs that began in the fourth fiscal quarter (ending March 31, 2012), CSC’s liquidity, in our view, is less than adequate.
Our assessment of the company’s business profile as “weak” is based on our expectation that its business focus will remain narrow within the highly competitive outsourced approximately $2.5 billion U.S. laundry facilities management industry. Although the company maintains the No. 1 market position, it competes in a highly fragmented market, in which the top three players capture approximately 40% of market share and smaller owner-operators and local players compete for the remainder. Competition is intense; laundry service providers vie for contracts based primarily on price and, increasingly, differentiation in customer service delivery. As smaller players come under pressure to compete, they become acquisition targets for larger players seeking a greater footprint and higher route density. We expect industry consolidation in the next year or two across the competitive landscape.
The company’s primary business segment provides installation and operation of laundry machines along certain contracted “routes” for multifamily housing properties in return for a commission. We do not expect CSC to expand meaningfully into new businesses. Management’s modest diversification into equipment rental and distribution, in our view, will remain the only noncore businesses.
CSC’s geographic diversity continues to be strong; the company’s highest geographic concentration is only approximately 10% of revenues from the Mid-Atlantic region of the U.S. The top 10 customers account for less than 10% of revenues. This distribution has remained consistent over the last several years with no single customer accounting for more than 2% of revenues. Moreover, CSC’s cost structure continues to benefit from route density by leveraging existing assets over a greater number of contracts: the company is able to take advantage of the large number of customers per route to keep labor and fuel costs low.
Unemployment and vacancy rates also affect laundry service providers’ ability to secure new contracts. In our view, with respect to these indicators, progress in 2013 will be extremely slight given the ongoing weakness in the economy and the housing market. However, we believe the long-term, renewable nature of route lease contracts creates a barrier to market entry, which benefits CSC given its large size and scale. Further, laundry machine usage--and thus demand--remain relatively constant despite economic conditions, and the recent trend of successful vend price increases supports this observation. (For Standard & Poor’s most recent U.S. economic forecast, please see “U.S. Economic Forecast: Keeping The Ball In Play,” published Aug. 17, 2012, on RatingsDirect.) In our view, these factors contribute to CSC’s relatively stable (albeit somewhat tempered) revenue stream and predictable operating earnings.
We assess the company’s liquidity as “less than adequate,” per our criteria (see “Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers,” published on Sept. 28, 2011, on RatingsDirect). Our assessment reflects the leverage covenant that remains below our 15% threshold, and our belief that the cushion could tighten further as the leverage covenant continues to become more restrictive because of step-downs in the credit agreement. We believe the company would need to seek an amendment in order to achieve adequate liquidity.
Key liquidity sources include cash on hand, cash flow generation, and the company’s $50 million revolving credit facility expiring in November 2013. As of June 30, 2012, the company had approximately $39 million in cash and cash equivalents and approximately $31 million of availability on its revolver. The company holds a portion of the cash balance in route machines. The company’s $50 million delayed draw term loan and $725 million term loan are both due in November 2014.
Relevant aspects of CSC’s liquidity, in our view, include the following:
-- We expect tighter covenant headroom over the next 12 months under the sole financial covenant required by the credit facilities: maximum consolidated total leverage. As of June 30, 2012, the company was in compliance with about 12.5% EBITDA cushion. However, we forecast significant tightening to below 10% by the fourth fiscal quarter of 2013.
-- We expect capital expenditures to total between $80 million and $90 million annually. These would, in our view, be used primarily to invest in new laundry equipment contracts and maintenance, and to fund upfront commission payments to property managers in order to secure and/or renew laundry-route contracts.
-- Required debt amortization is minimal at approximately $7 million annually, with the nearest debt maturity in November 2013.
-- We believe the company would not be able to absorb high-impact, low-probability stress events given the limitations of its current credit agreement.
Our issue-level rating on the company’s senior secured debt facilities is ‘B’ (one notch higher than the corporate credit rating). The recovery rating of ‘2’ indicates our expectation of substantial (70% to 90%) recovery in the event of a payment default. (For the complete recovery analysis, please see our recovery report on Coinmach Service Corp., to be published shortly following this report, on RatingsDirect.)
Our stable outlook assumes that the impact of economic conditions on CSC’s operating performance and credit protection measures will remain relatively consistent over the next year. We expect the company to generate adjusted EBITDA of greater than $140 million over the next year, in line with its history of steady EBITDA generation in this area. Because of step-downs in the credit agreement, the covenants continue to tighten throughout fiscal 2013. We believe the covenant cushion will fall below 10% in fiscal 2013.
We could consider lowering the rating to ‘CCC+’ within the next year if the company does not amend its current credit agreement and attain flexibility on its covenant.
Since we believe it is unlikely the company will be able to meaningfully reduce leverage because of the weak economy, an upgrade to a ‘B’ corporate credit rating is not likely over the next year.