July 6 - Overview -- In our view, recent Argentine government policies and actions could hinder the operations of Spain-based gaming company Codere S.A. in Argentina. -- Codere relies heavily on its earnings from Argentina, which represent about 55% of group consolidated EBITDA. -- We are lowering our long-term rating on Codere to 'B-' from 'B' and assigning a negative outlook. -- The negative outlook mainly reflects our view that any significant macroeconomic and political deterioration in Argentina over the next 12 to 24 months could adversely affect Codere's earnings and liquidity during the period. Rating Action On July 6, 2012, Standard & Poor's Ratings Services lowered its long-term corporate credit rating on Spain-based gaming company Codere S.A. (Codere) to 'B-' from 'B'. The outlook is negative. At the same time, we revised the recovery rating on the senior unsecured notes issued by subsidiary Codere Finance (Luxembourg) S.A. to '4' from '3', indicating our expectations of average (30%-50%) recovery for noteholders in the event of payment default. We also lowered our issue rating on these notes to 'B-' from 'B', in line with the corporate credit rating on Codere. Rationale The downgrade reflects our view that Argentina's deteriorating economy and government policies enacted since October 2011, including tightening control and limitations on cash flow repatriation for foreign companies, as well as rising restrictions to international trade, could affect Codere's liquidity and, ultimately, its credit quality. We believe that the increasing risks to Argentina's economy, including high inflation (which has appreciated the real exchange rate), import restrictions, and other actions that have also contributed to the emergence of a parallel foreign exchange market, could cause a decrease in Codere's earnings. The group relies heavily on its earnings from Argentina, which totaled about 55% of group consolidated EBITDA in 2011. The downgrade also takes into account our concerns about Codere's ability to refinance its EUR120 million senior credit facility maturing in June 2013, if the group faced a pronounced worsening in the economic and political conditions in Argentina over the next 12 months. We would view Codere's continuous access to its facility, which is subject to financial covenants, as critical under such a scenario. In our base-case scenario, we don't factor in the risk of expropriation of foreign owned gaming operations in Argentina. In our view, Codere's financial risk profile is highly leveraged. The main constraint is the consolidation of its principal shareholder payment-in-kind (PIK) loan and its dependence on continued access to cash flows from Latin America given its increasing reliance on that region. Under our scenario of deterioration in Argentina's economy and restraints on capital movement, we think the group's Standard & Poor's adjusted debt to EBITDA ratio (including the PIK loan) could rise to about 6x by Dec. 31, 2012, up from 5x in 2011. In addition, Codere's financial risk profile reflects the group's vulnerability to foreign exchange movements, which are only partially hedged for this year (a total of $90 million of hedges against the Argentine peso as of March 31, 2012), but unhedged for 2013. Our assessment of Codere's business risk profile as "weak" reflects the group's substantial exposure to Latin America, particularly to Argentina and Mexico, which we regard as generally subject to greater regulatory, foreign exchange, and labor relations risks than European countries. At the same time, we acknowledge the current economic weakness in Spain and Italy, where Codere also operates. However, the two markets combined represent less than 15% of group consolidated EBITDA. These weaknesses are offset to a degree by our view of the company's cash generative characteristics, its leading market positions, and limited maintenance capital expenditure (capex) requirements. We also remain mindful of the growing importance of the Mexican business to Codere, particularly following its recent increase of its stake in ICELA. This year, Codere expects to upstream a dividend of about EUR50 million and a contribution of about 30% of group consolidated EBITDA from its Mexican operations. Liquidity We view Codere's liquidity as "less than adequate" under our criteria. We believe that Codere's liquidity sources are likely to exceed its liquidity uses by more than 1.0x in both 2012 and 2013, under our base-case scenario. Our assessment of the group's liquidity mainly reflects our view that access to its senior credit facility maturing in June 2013 would be critical if its Argentine operations were to be significantly affected by deteriorating economic and political conditions. This is because Codere already faces growing restrictions on cash flow repatriation from Argentina, as well as large investments linked to the renewal of five of its Argentine gaming licenses. The group's liquidity sources benefit from: -- EUR186.4 million of cash and short-term investments on March 31, 2012. However, we are mindful that non-European subsidiaries hold about 55% of the company's cash (including about 25% in Argentina), so some cash might not be immediately available to the parent company. We understand that Codere's cash position in Argentina has recently decreased to about EUR25 million; -- EUR60 million that's fully available under the RCF tranche of the EUR120 million senior credit facility maturing June 2013, as of March 31, 2012. On the same date, the group also had about EUR7 million available out of the EUR60 million tranche dedicated to letters of credits and surety bonds; -- Positive funds from operations (FFO) of about EUR170 million for both 2012 and 2013; and -- Adequate headroom under its financial covenants. However, we note that the continued availability of the senior credit facility is subject to covenants, which could be tested in the event that conditions in Argentina worsen more than currently anticipated. At the same time, the group's liquidity uses include: -- EUR46 million and EUR16 million of debt maturities in 2012 and 2013, respectively; -- EUR150 million of estimated annual capex in 2012 and 2013, excluding Codere's recent acquisition of the additional stake in ICELA; -- Total license renewal fees that we estimate between EUR100 million and EUR150 million, assuming they are calculated in a manner similar to previous renewals. These include upfront fees, which will likely represent the largest portion of the outlay, plus a cannon tax surcharge payable over the next five years; and -- About EUR45 million of short-term liabilities relating to gaming tax payables. Given Codere's growing business in Argentina and the weak economic environment in Spain and Italy, we think that Codere's liquidity depends increasingly on continued access to cash flows from Latin America. We understand that management doesn't intend to further upstream significant amounts of cash from Argentina in the remainder of 2012. It has announced its intention to use local cash sources to partly fund the upcoming license renewal fees. In addition, Codere holds some flexibility in its projected capex investments, since most of these are discretionary and not committed. We note that in the 2001-2002 Argentine financial crisis, Codere was directly affected by restrictions on cash transfers abroad (as well as by negative currency effects). Recovery analysis The issue rating on the EUR760 million senior notes and $300 million senior notes issued by Codere Finance (Luxembourg) S.A. is 'B-', in line with the long-term corporate credit rating on Codere. The recovery rating on these notes is '4', indicating our expectation of average (30%-50%) recovery for noteholders in the event of a payment default. The notes are guaranteed on a senior basis by Codere and on a senior subordinated basis by subsidiary guarantors. We have revised our recovery rating on the senior notes in light of Codere's exposure to Argentina's deteriorating economy and our view of its weak medium-term growth prospects. We believe that the increasing risks to Argentina's economy, including high inflation, import restrictions, and the risk of devaluation of the Argentine peso could cause Codere's earnings to decline. In turn, we believe the potentially worsening conditions could lead us to lower our valuation of the company's Argentine business in our hypothetical default scenario. Our recovery and issue ratings are supported by our valuation of Codere as a going concern, underpinned by its leading market positions and strong barriers to entry in the highly regulated gaming sector. At the same time, the issue and recovery ratings are limited by our view of the security package and noteholder protection as weak. This is because the company could raise up to EUR200 million of senior bank debt according to the euro notes' documentation (compared with $400 million permitted in the dollar notes' documentation), including the EUR120 million credit facility that would rank ahead of the notes. The ratings also reflect the uncertainties related to Codere's operations in Latin American jurisdictions, and the company's exposure to the Spanish insolvency regime, which we view as unfavorable for creditors (see "Update: Jurisdiction-Specific Adjustments To Recovery And Issue Ratings," published June 20, 2008). As part of our revised recovery analysis, we have simulated a hypothetical default scenario with a default in 2014, versus 2015 previously, triggered by declines in revenues and margins, primarily following potential regulatory actions in Latin America and Europe. In addition, our scenario assumes that the difficult political and economic conditions in Argentina would accelerate margin contraction in Codere's Argentine business. We project that the group will be able to refinance its EUR120 million credit facilities due in 2013. Our valuation on Codere is based on a combination of discounted cash flow and market multiple approaches, and a blended enterprise value to EBITDA multiple that we have revised to 4.5x from 5.5x mostly owing to our anticipation of a lower valuation of the group's Argentinean operations at the point of default. In 2014, the hypothetical year of default, we forecast EBITDA down to about EUR165 million and a stressed enterprise value of about EUR740 million (down from EUR920 million). From the stressed enterprise value, we deduct priority liabilities of about EUR106 million, comprising enforcement costs and finance leases. We also deduct EUR237 million of debt ranking ahead of the euro and U.S. dollar senior notes, including the debt of Codere's various subsidiaries and the EUR120 million senior facility that we assume would be fully drawn by the point of default. The residual value is sufficient for average recovery in the 30%-50% range for senior noteholders, comprising about EUR1,040 million in the year of default, although we see some volatility in the recovery prospects for the following reasons. First, according to the proposed notes' documentation, Codere can increase the amount of debt ranking above the notes, which would reduce recovery prospects for noteholders. Second, we believe that if the group were to push down the proposed U.S. dollar notes to a Latin American holding entity, recovery prospects for both the euro and U.S. dollar notes could be affected by potential changes in the overall capital structure and in our valuation assumptions. Third, we consider that a more severe depreciation of the currencies in Argentina or Mexico could lead to materially lower recovery prospects for the senior noteholders, given that this debt is denominated in euros and U.S. dollars. Outlook The negative outlook mainly reflects our view that any further significant macroeconomic and political deterioration in Argentina over the next 12 to 24 months could adversely affect Codere's earnings and liquidity during the period. Given the current conditions in Argentina, we think it's particularly critical that Codere keeps a tight rein on investment spending. We could lower the ratings on Codere if we perceived marked weakening in its liquidity from current levels, either owing to the inability to satisfactorily refinance its upcoming senior credit facility maturity, further restrictions on cash flow repatriation from Argentina, increased foreign exchange controls, or if covenant headroom were to materially tighten. We could further lower the ratings if our adjusted ratio of Codere's EBITDA interest cover were to go below 2.0x. We could also consider a downgrade if we were to anticipate a material risk of nationalization of gaming businesses in Argentina. A revision of the outlook to stable depends largely on Codere's successful refinancing of its senior credit facility and the maintenance of adequate covenant headroom over the next 12 to 24 months. Related Criteria And Research -- Spanish Gaming Company Codere Proposed $250 Million Senior Notes Assigned 'B' Issue Rating; '3' Recovery Rating, Jan. 26, 2012 -- Principles Of Credit Ratings, Feb. 16, 2011 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Hybrid Capital Handbook: September 2008 Edition, Sept. 15, 2008 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Downgraded; Outlook Action To From Codere S.A. Corporate Credit Rating B-/Negative/-- B/Stable/-- Downgraded To From Codere Finance (Luxembourg) S.A. Senior Unsecured* EUR100 mil 8.25% bnds due 06/15/2015 B- B Recovery Rating 4 3 EUR660 mil bnds due 06/15/2015 B- B Recovery Rating 4 3 US$300 mil 9.25% bnds due 02/15/2019 B- B Recovery Rating 4 3 *Guaranteed by Codere S.A. 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