S&P Affirms Fender Music ‘B’ Rating

As Fender announced its intent to refinance its existing term loan this Monday, Standard & Poor’s Ratings Services affirmed its ‘B’ corporate credit rating for the MI giant, as well as additional ratings that indicate confidence in Fender’s relative stability and debt repayment in the coming year.

Read the full report, below…

Nov. 5, 2012–Standard & Poor’s Ratings Services today affirmed its ratings on Fender Musical Instruments Corp., including its corporate credit rating at ‘B’. The affirmation follows Fender’s announcement that it will refinance its existing term loan.

At the same time, we assigned our ‘B’ issue-level rating to Fender’s proposed $245 million term loan due 2018. The recovery rating is ’3′, indicating our expectation for meaningful (50% to 70%) recovery for lenders in the event of a payment default. The new issue-level rating for the proposed term loan is subject to a review of final documentation by Standard & Poor’s. We understand that Fender will use the net proceeds from the notes offering to repay the existing balances on its $200 million term loan and $100 million delayed draw facility, both due 2014. We will withdraw the issue-level ratings on the company’s existing senior secured term loan upon completion of this transaction and after the existing balances have been repaid.

The outlook is stable. Pro forma for this transaction, we estimate the company will have about $255 million reported debt outstanding, a $4 million increase from current balances.

We continue to view Fender’s financial risk profile as “highly leveraged” given its significant debt obligations. Key credit factors in our assessment of Fender’s “weak” business risk profile include its narrow business focus, customer concentration, the discretionary nature of its products, and the highly competitive musical instruments industry in which it operates.

Additionally, we considered the company’s good market positions, its well-recognized brand names, and the geographic diversity of its sales.

We estimate that following this refinancing, Fender’s credit protection measures will remain unchanged. We continue to view Fender’s financial risk profile as highly leveraged. Pro forma for this transaction, Fender’s estimated ratio of adjusted debt to EBITDA is about 5.4x for the 12 months ended July 1, 2012, which remains near the indicative leverage ratio for a highly leveraged financial risk profile of greater than 5x. We also estimate that the pro forma ratio of adjusted funds from operations (FFO) to total debt is about 15% and slightly better than the indicative ratio of less than 12% for a highly leveraged financial risk profile.

Operating performance has modestly improved during the past year. Revenues grew 3.4% for the 12 months ended July 1, 2012, over the prior-year period. Performance improvement resulted from Fender’s ability to resolve its backlog and supply disruption issues. EBITDA improved by almost 10%, and we estimate adjusted EBITDA margins have remained flat near 8%, reflecting pricing actions and improved operating efficiencies as production normalized, partly offset by elevated raw material costs. Free operating cash flow has also improved, primarily owing to improved working capital levels as the company recovered from its backlog issues, offset by raw material cost pressures, and increased capital expenditures over the last year.

We believe Fender’s credit metrics will continue to improve but remain constrained by the weak economy, particularly in Europe, and continuing margin pressure from high input costs. Key assumptions in Standard & Poor’s 2013 forecast include:

• Revenue growth in 2013 in the low single-digits and adjusted EBITDA margin near 8%, reflecting a greater portion of sales coming from higher-margin products, offset by continued input cost pressures, including raw material costs such as hardwoods, and rising labor costs.
• We estimate about $12 million of capital expenditures in 2013.
• We anticipate free operating cash flow for the year will approach $20 million in 2013 as working capital levels normalize.

Based on our forecast, we expect Fender’s adjusted leverage will remain near 5x through the remainder of 2012, but to improve closer to below 5x in 2013 from debt prepayment on the term loan. We expect the ratio of FFO to total debt to remain near 15% over the next 12 months.

Fender’s sales are concentrated in guitars, with 72% of its fiscal 2011 gross sales represented by fretted instruments and guitar amplifiers. The company also has some sales concentration with its largest customer, Guitar Center Inc., accounting for an estimated 16% of 2011 sales. Although Fender maintains strong brand recognition through its key Fender and related brand names, we believe sales will remain vulnerable to economic cycles because of the discretionary nature of its products. We believe the musical instruments and accessories industry is highly fragmented and very competitive, based on such factors as name recognition, sound quality, style, and price. Fender’s primary competitors include Gibson Guitar Corp., Yamaha Corp. and Marshall Amplification PLC. Fender believes it had the leading market share by revenue in the U.S. in 2011 in electric, acoustic, and bass guitars and amplifiers (as measured by MI Sales Trak), as well as being one of the largest independent distributors of musical instrument accessories in the U.S. The company has diversified its geographic reach through acquisitions, and now has about 47% of its sales outside of the U.S., a large portion of which are in Europe.

We believe liquidity is adequate to cover Fender’s needs for the next 12 months. This is based on the following information and assumptions:

• We estimate liquidity sources will exceed uses in excess of 1.2x for the next 12 months.
• We estimate net sources would continue to be positive, even with a 15% decline in EBITDA from current levels.
• The company’s existing term loan credit agreements does not contain financial covenants. However, the proposed term loan credit agreement contains a maximum senior secured leverage covenant. We expect cushion under this covenant test to remain above 15% in order to maintain adequate liquidity.
• The company is also required to maintain a fixed-charge coverage test of 1.0x in the event availability of funds under its $100 million asset-backed revolving credit facility (ABL) due 2016 declines below $12.5 million, which we do not expect to occur over the next 12 to 24 months.
• The company has manageable debt maturities, and annual amortization on the proposed term loan is at about $2.5 million.
• As of July 1, 2012, Fender reported about $13 million of cash on hand and $85 million of availability under its ABL, net of outstanding letters of credit.
• We believe Fender will generate sufficient cash flow from operations to fund its capital expenditures that we expect to be about $12 million over the near term.

The company’s proposed $245 million term loan due 2018 is rated ‘B’, the same as the corporate credit rating, with a recovery of ’3′, indicating our expectation for meaningful (50% to 70%) recovery for lenders in the event of a payment default. For a complete recovery analysis, see Standard & Poor’s recovery report, to be published following this report on RatingsDirect.

The stable outlook reflects our expectation that the company will maintain adequate liquidity and will continue to reduce leverage over the next 12 months.

We could consider an upgrade if Fender sustains operating performance at improved levels and applies excess cash flow toward debt reduction, resulting in credit measures in line with indicative ratios for an aggressive financial risk profile, including an adjusted total debt to EBITDA ratio between 4x and 5x, and a ratio of FFO to total debt in the range of 12% to 20%. We estimate Fender could achieve these metrics in a scenario of mid-single-digit revenue growth and an upper-single-digit EBITDA margin.

We could consider a downgrade if the company’s operating performance deteriorates significantly or its financial policies become more aggressive (including a large debt-financed acquisition or dividend), causing covenant cushion on the proposed term loan to fall below 10%.

RELATED CRITERIA AND RESEARCH

• Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
• 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
• 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

RATINGS LIST

Ratings Affirmed

Corporate credit rating B/Stable/–

Senior secured: B

Recovery rating: 3

Ratings Assigned

Senior secured

$245 mil. term loan due 2018: 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.