UPDATE 2-Baidu posts bleak Q4, but sees business reshuffle driving 2017 growth
* Posts 2nd straight drop in quarterly revenue on China ad curbs
Overview -- Despite our expectation of meaningful revenue and EBITDA growth for Toronto-based advertising holding company MDC Partners in the second half of 2012, we expect fully-adjusted leverage to remain high over the next 12 to 18 months. -- We are lowering our corporate credit rating on the company to 'B' from 'B+'. -- At the same time, we are lowering our issue-level rating on the company's unsecured debt to 'B' from 'B+'. -- The stable rating outlook reflects our expectation that MDC will generate positive discretionary cash flow in the second half of 2012, and that leverage will begin to fall as EBITDA rises and spending to add top-tier talent subsides. Rating Action On Sept. 5, 2012, Standard & Poor's Ratings Services lowered its ratings on MDC Partners Inc., including its corporate credit rating to 'B' from 'B+'. At the same time, we lowered our issue-level rating on the company's unsecured debt to 'B' from 'B+', and left the recovery rating unchanged at '4', indicating our expectation for average (30% to 50%) recovery in the event of a payment default. The rating outlook is stable. Rationale With second-quarter results, MDC reiterated its full year revenue, EBITDA, and free cash flow guidance, and we are unaware of any changes to this forecast. However, despite our expectation of meaningful revenue and EBITDA growth in the second half of 2012, under our base-case scenario, we expect that leverage (including our adjustments for operating leases, earn-outs, and put obligations) could remain well above 4x through at least 2013. As a result, over the next 12 to 18 months, we expect to continue to characterize the company's financial risk profile as "highly leveraged," which includes leverage in the 4x to 5x range. This elevated financial risk, together with continued economic uncertainty and our "fair" assessment of the company's business risk profile, is inconsistent with a 'B+' rating, in our view. We consider MDC's business profile fair, given our view of the strong creative reputation of a key number of agencies, such as Crispin Porter + Bogusky, 72andSunny, and Anomaly, and its healthy digital capabilities. Key risk factors are the company's relatively small agency network, limited global presence, and its still high (but declining) concentration of revenue and EBITDA from its top five agencies. MDC is a provider of marketing services primarily in the U.S. (81% of revenue for the first six months of 2012), with a presence in Canada (15%), and other countries (4%). The company's subsidiaries provide a comprehensive range of marketing communications and consulting services. We expect that headcount reduction efforts to date will benefit the company in 2013 in terms of run-rate cost savings, but believe that it could take several years for the company to reduce its staff cost ratio to the low-60% area. The advertising industry is subject to the cyclical nature of advertising, as well as a client's ability to switch to competitors or scale back spending at short notice. MDC has been in an aggressive growth mode over the past several years, and we believe that increased staffing and facilities costs outpaced revenue growth in certain areas. Cost of sales as a percentage of revenue was 72% in for the 12 months ended June 30, 2012, compared with 65% in 2009. For larger ad agency holding companies, typical staff cost ratios run closer to 60%. MDC has taken steps to reduce this ratio, including meaningful headcount reduction that led to severance expense in the first half of 2012. Under our base-case scenario, we expect revenue to grow at a high-teen to low-20% rate in the second half of 2012, based on historical acquisitions and net new business wins. Net new business wins were strong, with estimated annual net revenue of $80 million in the first half of the year. An important element of our base case is U.S. real GDP growth of 2.1% in 2012 and 1.8% in 2013. We believe that EBITDA (including distributions from affiliates, but after minority interest expense and equity-based compensation) could more than double compared with the second half of 2011. Advertising spending visibility remains low and the economic outlook uncertain for 2013, and we believe that like larger, higher rated peers, organic revenue growth at MDC could slow compared with 2012. The company has benefited from its revenue concentration in the U.S., where advertising and marketing spending has remained stronger compared with euro currency markets. As a result, assuming only modest acquisitions, we believe revenue could grow at a mid- to high-single-digit percent rate in 2013, largely as a result of new business wins and the potential for modest acquisitions. Under our base-case scenario (excluding potential acquisitions), we believe that the company could restore the EBITDA margin (including minority interest expense and after noncash stock compensation expense) to the high-single-digit percent area in 2012. For the second quarter, revenue increased 15%, while EBITDA (including deferred acquisition consideration adjustments and distributions from affiliates) dropped 5%, which was below our expectations on account of a 24% increase in operating expenses. Organic revenue growth was healthy, at 8.3%. The company's EBITDA margin (after net minority distributions and treating stock compensation as expense) was very low, at 3.6% for the 12 months ended June 30, 2012. Despite healthy revenue growth, increases in talent and facilities spending, as well as more recent severance-related expenses, have reversed EBITDA margin improvement. MDC has publicly stated its intention to decelerate operating cost increases and focus on margin improvement. Failure to deliver the acquisition-related and new business-related revenue, and a corresponding improvement in the EBITDA margin could cause us to revise our business risk assessment downward. Lease-adjusted debt (including deferred acquisition consideration and put obligations) to EBITDA (before noncash stock compensation, including affiliate distributions and adjustments for deferred acquisition consideration, but after minority interest) was very high, at roughly 10x as of June 30, 2012, up from 7.1x in 2011. The spike in leverage was because of EBITDA declines, as well as borrowings under the revolving credit facility to fund roughly $50 million of deferred acquisition consideration payments in the second quarter. The company's acquisition strategy focuses on making upfront payments, typically at PBT (profit before tax) multiples of 3x to 4x, with additional consideration in the form of contingent deferred acquisition payments. To date, these payments have been lumpy, limiting the company's liquidity position in certain periods and causing the need for credit amendments to loosen financial covenants. As of June 30, 2012, the current portion of deferred acquisition consideration was $90.7 million. Although high, MDC should be able to address this payment with revolver borrowings and free cash flow. Under our base-case scenario, we believe that leverage could fall to the mid- to high-5x area in 2012. In 2013, assuming the company pays the current portion of earn-out obligations, we believe leverage could drop to the mid-4x area. Further leverage reduction will depend on the pace of EBITDA growth, as well as future acquisition activity and the ongoing level of acquisition-related liabilities, which we have assumed will be in the $40 million to $50 million range longer term. Discretionary cash flow (operating cash flow, less capital expenditures and after dividends and minority distributions) was negative for the 12 months ended June 30, 2012, mainly because of EBITDA declines, high dividend payments, and working capital cash usage as a result of acquisition activity. We expect this to reverse in the second half of 2012, because of EBITDA growth and working capital benefits of media-related acquisitions in the first half of the year. As a result, under our base-case scenario, we believe the company could generate discretionary cash flow in the $30 million to $40 million range in 2012. A key rating factor will be the company's ability to generate ongoing positive discretionary cash flow, despite the level of acquisition activity. Liquidity In our opinion, MDC has "adequate" liquidity to cover its needs over the next 12 months. Our assessment of the company's liquidity profile incorporates the following expectations and assumptions: -- We expect sources of liquidity (including cash and access to the revolving credit facility) to exceed its uses by more than 1.2x over the next 12 months. -- We expect net sources to remain positive, even if EBITDA declines more than 15%. -- Following the company's July 2012 credit amendment, compliance with maintenance covenants is sufficient to withstand a greater-than-15% drop in EBITDA. -- The company has flexibility to reduce acquisition and capital spending to bolster liquidity, if need be. -- We believe MDC has good relationships with its banks, based on recent credit agreement amendments, and has a satisfactory standing in the credit markets. MDC's sources of liquidity include cash balances of $72 million as of June 30, 2012, and access to its $150 million secured asset-based revolving credit facility (unrated), which had $129 million outstanding as of June 30. Over the next 12 months, assuming modest cash generated from working capital and excluding potential acquisitions, we estimate cash flow from operations could be in the $80 million to $100 million range. Uses of liquidity over the next 12 months include capital expenditures that we estimate in the $20 million area, annual dividends of about $17 million, and deferred acquisition consideration (earn-outs), the current portion of which totaled $90.7 million as of June 30, 2012. The amended credit agreement contains financial covenants, including a maximum senior leverage ratio of 2.0x, a maximum total leverage ratio of 4.25x, a minimum fixed-coverage ratio of 1.25x, and a minimum EBITDA requirement of $94.6 million. Based on the July, 2012 amendment, the company's tightest covenant, its total leverage covenant, steps down to 4.0x on Sept. 30, 2012, where it will remain over the life of the facility. As a result of the amendment, we believe headroom against the total leverage covenant will remain above 20% over the next two years, despite the potential for spikes in borrowing under the revolving credit facility to fund earn-out payments. Outlook The stable rating outlook reflects our expectation that MDC will generate positive discretionary cash flow in the second half of 2012, and that leverage will begin to decrease as EBITDA rebounds and talent-related spending subsides. Over the next year, we view both an upgrade and downgrade as equally unlikely. We could raise the rating over the long term, if leverage drops to less than 4x on a sustained basis, compliance with financial covenants remains above 20%, and the company maintains adequate liquidity and establishes a less aggressive financial policy. We believe the company could achieve these measures in 2014, assuming stronger economic trends, and barring a continuation of aggressive debt-financed acquisition activity. We expect such a scenario would entail continued mid- to high-single-digit percent organic revenue growth, and a steady reduction in deferred acquisition-related liabilities. Conversely, although less likely in our view, we could lower the rating if the company does not begin to generate sustainable positive discretionary cash flow, or if covenant headroom falls below 15% with an expectation of further narrowing stemming from operating weakness and acquisition or earn-out related payments. Related Criteria And Research -- Issuer Ranking: U.S. Media And Entertainment Companies, Strongest To Weakest, July 17, 2012 -- Industry Report Card: U.S. Media & Entertainment Subsectors Are Exhibiting Differing Trends, May 1, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Downgraded; Outlook Action To From MDC Partners Inc. Corporate Credit Rating B/Stable/-- B+/Negative/-- Downgraded; Recovery Ratings Unchanged To From MDC Partners Inc. Senior Unsecured B B+ Recovery Rating 4 4
* Posts 2nd straight drop in quarterly revenue on China ad curbs
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