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.