Overview -- U.S.-based pet food company Blue Buffalo Co. Ltd. has entered into a new senior secured credit facility with the intent of using term loan proceeds to fund a special shareholder dividend. -- We are assigning a 'B' corporate credit rating to Blue Buffalo, and a 'B+' issue-level rating to the company's $390 million senior secured credit facility. -- The outlook is positive, reflecting our expectation that Blue Buffalo will maintain adequate liquidity while continuing to improve its operating performance and strengthening its credit measures over the near term. Rating Action On Aug. 20, 2012, Standard & Poor's Ratings Services assigned its 'B' corporate credit rating to Wilton, Conn.-based Blue Buffalo Co. Ltd., a manufacturer and marketer of pet food. The outlook is positive. We also assigned our 'B+' issue-level rating to Blue Buffalo's $390 million senior secured credit facilities, which consist of a $40 million revolving credit facility due 2017 and a $350 million term loan B due 2019. The recovery rating on these facilities is '2', reflecting our expectation that lenders would receive substantial recovery (70%-90%) in the event of a default. We understand that the company will use all of the gross proceeds from the term loan to fund a special dividend to its shareholders. Pro forma for the transaction, we estimate Blue Buffalo will have about $350 million in total debt outstanding. Rationale The ratings on Blue Buffalo reflect our view that the company's financial risk profile is "highly leveraged" and its business risk profile is "vulnerable" under our criteria. Key credit factors in our assessment of Blue Buffalo's business risk profile include its narrow product focus; customer, supplier, and geographic concentration; and the company's small size relative to its financially stronger and larger competitors. We also considered the benefits of Blue Buffalo's good market position and participation in the faster growing natural segment of the U.S. pet food industry, as well as the somewhat nondiscretionary and recession-resistant nature of pet food. Blue Buffalo has a narrow product focus as a manufacturer and marketer of pet food. Primary products include dry and wet types of dog and cat food, and all products are sold under the Blue Buffalo brand name with several formulations. The company believes it has the leading position in the "natural" pet food segment (defined based on ingredients), which it believes represents 40% of the faster growing $6 billion "pet specialty" segment of U.S. pet food sales. However, Blue Buffalo competes against larger, financially stronger competitors offering premium brands such as Colgate-Palmolive (Science Diet brand), Mars (Nutro and Royal Canin), Nestle (Pro Plan), and Procter & Gamble (Iams and Eukanuba). Blue Buffalo has been able to increase its sales and market share through successful innovation in its products and marketing. Significant customer concentration exists, with pet specialty retailers PetSmart and Petco combined accounting for the majority of Blue Buffalo's sales during 2011. Although there is also some supplier concentration, we believe this will diminish as the company moves from its current 100% co-packer manufacturing to a hybrid model given plans to bring its first owned plant on-line in 2015. The company also lacks geographic diversity, with about 95% of sales in the U.S. and the remainder in Canada. However, pet food is not a very discretionary product, and sales, including premium items, tend to remain fairly stable even during economic downturns. We believe Blue Buffalo is exposed to commodity cost volatility, which it has largely addressed through supply contracts and product price increases, given the relatively low price elasticity of natural pet foods as a premium product. Blue Buffalo has maintained its trend of rapid, yet diminishing, growth rates off of an initial relatively small base. Sales of about $352 million in 2011 grew 83% relative to 2010. For the same period, EBITDA increased by more than 150% as the company realized operating leverage benefits relating to its increasing scale. This trend continued into the first half of 2012 as sales increased more than 60% compared with the first half of 2011. Blue Buffalo's highly leveraged financial risk profile reflects the company's substantial increase in debt and aggressive financial policy following its proposed debt-financed special dividend to shareholders. Pro forma for this transaction, we estimate the company's credit measures will be close to indicative ratios for an "aggressive" financial risk descriptor, which includes a ratio of lease-adjusted total debt to EBITDA of 4x to 5x and a ratio of adjusted funds from operations (FFO) to total debt of 12% to 20%. Key assumptions in our forecast include: -- Blue Buffalo's volumes continue to grow, albeit at a declining pace. We expect continued rapid sales growth in excess of 40% for all of 2012, with significant declines in the growth rate thereafter, including 20% growth in 2013. -- The company will be able to manage raw material cost inflation largely with pass-through pricing. -- Overhead costs will decline with increasing volumes. Continued operating leverage improvement will result in EBITDA margins improving to more than 20%. -- Elevated capital expenditures will average about $25 million annually over the next three years as the company constructs a manufacturing plant and warehouse. -- We anticipate cash flow from operations (excluding more than $7 million of fees and expenses relating to the financing transaction), before capital expenditures, will increase to more than $30 million for the year 2012. Liquidity We believe Blue Buffalo's liquidity is "adequate," with sources of cash likely to exceed cash uses for the next 12 months. Our assessment of Blue Buffalo's liquidity profile incorporates the following expectations, assumptions, and factors: -- We expect cash flow sources to cover uses in excess of 1.2x for the next 12 months. -- We expect liquidity sources to continue exceeding uses, even if EBITDA declines by 15% from current levels. -- We expect a single financial covenant consisting of a maximum net secured leverage ratio, with an initial cushion of at least 30%, and that covenant cushion will remain at least 15%. -- The company has moderate debt maturities over the near term. -- The company has sound relationships with banks. Cash sources include availability under the company's new $40 million revolving credit facility and cash flow from operations. As of June 30, 2012, Blue Buffalo reported about $42 million in cash on its balance sheet, some of which we expect will be used to fund expenses related to implementing the new credit facility. Management does not expect to draw on its revolving credit facility. We believe Blue Buffalo will maintain adequate cash balances and availability on its credit facility to fund working capital needs, its debt service requirements at about $3.5 million annually, and capital expenditures that we expect to average about $25 million annually over the next three years as the company constructs a new manufacturing plant. Recovery analysis For the complete recovery analysis, see Standard & Poor's recovery report on Blue Buffalo to be published on RatingsDirect following the release of this report. Outlook Our positive rating outlook on Blue Buffalo reflects our expectation that it will maintain adequate liquidity while continuing to improve operating performance and strengthening credit measures over the near term. We could raise the ratings if the company is able to achieve and sustain adjusted leverage close to 4x and adjusted FFO to debt approaching 20%, and the covenant cushion remains at or above 15%. We estimate this would require little moderation in recent sales growth rates and EBITDA margins in the low- to mid-20% area. We would consider revising the outlook to stable if the company's adjusted leverage remains between 4x and 5x, its ratio of FFO to debt is near 12%, and the covenant cushion remains at or above 15%. We estimate this could occur if the sales growth rate declined to about 20% over the next year and EBITDA margin remained unchanged. Related Criteria And Research -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Key Credit Factors: Criteria For Rating The Global Branded Nondurable Consumer Products Industry, April 28, 2011 -- Criteria Guidelines for Recovery Ratings, Aug. 10, 2009 -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Our Rating Process, April 15, 2008 Ratings List New Rating; Outlook Action Blue Buffalo Co. Ltd. Corporate Credit Rating B/Positive/-- New Rating Blue Buffalo Co. Ltd. Senior Secured US$40 mil revolver bank ln due 2017 B+ Recovery Rating 2 US$350 mil term loan B bank ln due 2019 B+ Recovery Rating 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. 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