May 8, 2012 / 7:35 PM / 5 years ago

TEXT-S&P revises Guitar Center Holdings outlook to negative

Overview	
     -- U.S. musical instrument retailer Guitar Center is facing a $134.7 	
million applicable high-yield discount obligation (AHYDO) payment in April 	
2013 and its Holdco notes are also becoming cash interest pay in 2013.	
     -- We believe the company will have to borrow under its revolver to meet 	
its financing and operating needs during 2013 and that cushion to its senior 	
leverage covenant will likely narrow to about 10% 	
     -- We are re-assessing Guitar Center's liquidity profile to "less than 	
adequate" and revising our ratings outlook to negative from stable.	
     -- We are also affirming all existing ratings on the company, including 	
our 'B-' corporate credit rating.	
	
Rating Action	
On May 8, 2012, Standard & Poor's Ratings Services revised its ratings outlook 	
on Westlake Village, Calif.-based musical instrument retailer Guitar Center 	
Holdings Inc. to negative from stable. At the same time we affirmed all 	
existing rating on the company, including our 'B-' corporate credit rating.   	
	
We rate subsidiary Guitar Center Inc.'s $375 million revolver due 2016 'B+' 	
with a recovery rating of '1', indicating our expectation for high (90% to 	
100%) recovery in the event of a payment default. We rate the company's $650 	
million term loan due 2017 'B-' with a recovery rating of '3', indicating our 	
expectation for meaningful (50% to 70%) recovery of principal in the event of 	
a payment default. 	
	
In addition, we rate both Guitar Center Inc.'s $375 million cash 	
interest-paying senior unsecured notes due 2017 and Guitar Center Holdings' 	
$401.758 million senior unsecured notes due 2018 'CCC'. Both notes have a 	
recovery rating of '6', indicating our expectation for negligible (0% to 10%) 	
recovery in the event of a payment default.	
	
Rationale	
Our ratings on Guitar Center reflect our assessment that the company's 	
liquidity is "less than adequate" but sufficient to avoid a default within two 	
years.  	
	
The March 2011 amendment of the company's capital structure allowed it to 	
accrue 50% of interest on the Holdco notes for the next four payment periods, 	
the last being in October 2012. Subsequently, the company will have to pay 	
cash interest on these notes with the first payment due in April 2013. In 	
addition, Guitar Center must make a $134.7 million AHYDO payment in April 	
2013. This cash payment represents accrued payment-in-kind (PIK) interest of 	
$189.7 million on the company's Holdco notes that has been added to the 	
principal, minus the first payment that the company made in the amount of $55 	
million. As such, we believe the company will have to borrow under its 	
asset-based loan (ABL) revolver to meet its financing and operating needs 	
during 2013. In our view, this will result in cushion to its net senior 	
leverage covenant narrowing to about 10%.  	
	
We view Guitar Center's financial risk profile as "highly leveraged," 	
reflecting its high debt levels resulting from 2007 LBO transaction and weak 	
cash flow protection measures. Although debt leverage decreased to about 8.9x 	
at Dec. 31, 2011 from about 9.5x a year earlier, we anticipate that leverage 	
will remain elevated due to additional borrowings under the company's ABL 	
revolver. Also, we anticipate that EBITDA coverage of interest will remain 	
thin, at about 1.1x.  	
	
We view Guitar Center's business risk profile as "fair," reflecting its 	
operational weakness during the latest economic downturn, offset by recently 	
modestly improving profitability and its leading position in the highly 	
fragmented and competitive music products retail industry. Although recent 	
operational difficulties for Direct response segments were due to the 	
headquarter relocation and Web redesign, we anticipate that increasing 	
e-commerce competition will continue to challenge this segment of the 	
company's operations.  	
	
As such, our specific assumptions for Guitar Center include: 	
     -- Sales growth in the mid-single-digit percent due to modest same-store 	
sales and incremental revenues from newly opened stores offset by weaker 	
performance at the Direct Response segment;	
     -- Modest EBITDA margin improvement as incremental costs to support new 	
store growth offset benefits from sales leverage;	
     -- Increased capital expenditure to support the opening of 10 to 20 new 	
stores; 	
     -- Exercise of the PIK feature on the Holdco notes during the October 	
2012 payment period; 	
     -- The company makes the $134.7 million AHYDO payment in April 2013; and	
     -- The company will be free operating cash flow (FOCF) negative during 	
2012 and 2013.  	
	
Liquidity	
Liquidity is less than adequate in our view. Our assessment incorporates the 	
following factors:	
     -- The likelihood that Guitar Center will not be able to absorb 	
low-probability adversities;	
     -- We expect the ratio of the company's sources of liquidity to its uses 	
to be less than 1.2x during 2013; and	
     -- We also expect that cushion to the company's net senior leverage 	
covenant will narrow to about 10% during 2013 	
	
Liquidity sources at Dec. 31, 2011 consisted of $106 million of cash and about 	
$289 million available under its $373 million ABL facility. During September 	
2011 and subsequent to the Dec. 31, 2011 fiscal year-end, Guitar Center 	
obtained a commitment to extend till February 2016 about $70 million of its 	
$120 million non-extended portion of the ABL revolver. The remaining $50 	
million matures at the original date in October 2013.   	
	
The company's term loan matures in April 2017, the senior notes in October 	
2017, and the Holdco notes in April 2018.	
	
We anticipate the company to be FOCF negative during 2012 and 2013. 	
	
Recovery analysis	
For the complete recovery analysis, see the recovery report on Guitar Center, 	
to be published following the release of this report on RatingsDirect. 	
	
Outlook	
Our rating outlook is negative and reflects our less-than-adequate liquidity 	
assessment. We anticipate the company will have to borrow under its revolver 	
to meet its financing and operating needs during 2013. We therefore believe 	
that cushion to the company's senior secured leverage will narrow to about 	
10%. 	
	
A downgrade could occur if lower-than-expected EBITDA growth leads us to 	
believe that the company could breach its financial covenants.  	
	
Although unlikely in the near term, a positive rating action would entail our 	
reassessment of liquidity back to "adequate" and leverage decreasing toward 	
6x. 	
	
Related Criteria And Research	
     -- 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	
     -- 2008 Corporate Ratings Criteria: Ratios And Adjustments, April 15, 	
2008 	
	
Ratings List	
	
Ratings Affirmed; CreditWatch/Outlook Action	
                                        To                 From	
Guitar Center Holdings Inc.	
 Corporate Credit Rating                B-/Negative/--     B-/Stable/--	
	
Ratings Affirmed; Recovery Ratings Unchanged	
	
Guitar Center Holdings Inc.	
Guitar Center Inc.	
 Senior Unsecured                       CCC                	
   Recovery Rating                      6                  	
	
Guitar Center Inc.	
 Senior Secured revolver                B+                 	
   Recovery Rating                      1                  	
 Senior Secured term loan               B-                 	
   Recovery Rating                      3                  	
	
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.

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