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Rating Action:

Moody's affirms Deluxe Entertainment's B3 CFR and revises outlook to stable on deleveraging plans following Creative Services spin-off announcement

02 May 2019

Approximately $429 million of new debt rated

New York, May 02, 2019 -- Moody's Investors Service ("Moody's") has affirmed Deluxe Entertainment Services Group, Inc.'s ("Deluxe" or the "company") B3 Corporate Family Rating (CFR) and B3-PD Probability of Default Rating (PDR). Concurrent with this rating action, Moody's assigned a B3 rating to the proposed $429 million senior secured term loan maturing February 2022. The rating outlook was changed to stable from negative.

Deluxe recently announced plans to spin-off its Deluxe Creative Services division ("DCS", comprising the Post-Production and Visual Effects units) for a valuation of roughly $900 million enterprise value. DCS will become a standalone entity and capitalized initially with debt and new cash equity sufficient to fund a shareholder distribution to Deluxe of $500 million, which, in turn, will use the funds, plus equitization of certain debts owed to the sponsor, to reduce existing debt by $572 million (net, including $360 million of $789 million outstanding senior secured term loans and $59 million of $69 million outstanding ABL facility borrowings), pay fees and expenses, and add to cash balances. The company will also seek to amend the existing credit agreements to downsize the ABL facility, tighten certain provisions and extend debt maturities by two years. Following the DCS carve-out, Deluxe's remaining businesses will include Localization, Delivery Operations, Digital Cinema and Deluxe One. Deluxe will retain 50% ownership in DCS following the planned equity raise.

Assignments:

..Issuer: Deluxe Entertainment Services Group, Inc.

....Senior Secured Term Loan due February 2022, Assigned B3 (LGD3)

Affirmations:

..Issuer: Deluxe Entertainment Services Group, Inc.

.... Corporate Family Rating, Affirmed B3

.... Probability of Default Rating, Affirmed B3-PD

Outlook Actions:

..Issuer: Deluxe Entertainment Services Group, Inc.

....Outlook, Changed To Stable From Negative

Ratings and outlook actions are subject to review of final documentation and no material change in the size, terms and conditions of the proposed transaction as advised to Moody's. Upon transaction close, Moody's will withdraw the ratings and LGD assessments on the existing $789 million term loans due February 2020 (includes the 2016 incremental term loan).

RATINGS RATIONALE

The rating outlook change to stable from negative reflects the elimination of near-term refinancing risk via the extension of debt maturities, Moody's expectation that Deluxe will repay debt with proceeds from the planned equity/debt raise for its Creative Services unit and sustain adequate liquidity over the next twelve months. It also reflects our expectation that by 2020 Deluxe's rationalization plan will be mostly complete, leading to improved GAAP EBITDA, GAAP financial leverage below 5x (Moody's adjusted) and positive free cash flow generation as severance and restructuring costs subside, substantial cost savings are realized and capital expenditures normalize.

Deluxe's B3 CFR reflects the elevated pro forma GAAP financial leverage after the DCS disposal and limited prospects for meaningful deleveraging over the coming year given the lack of positive free cash flow generation and ongoing need to fund restructuring actions and higher-than-usual capital expenditures, mainly for the Deluxe One platform buildout. The rating also recognizes the proposed recapitalization of the balance sheet designed to reduce leverage by repaying a sizable amount of outstanding debt via the DCS spin-off/capital raise, as well as the proposed two-year extension of debt maturities and amendments to tighten provisions in the credit agreements.

While pro forma gross debt is reduced by nearly 55% from capital raise proceeds, the company's pro forma GAAP EBITDA decreases disproportionately due to the loss of sizable EBITDA from DCS following its spin-off. Consequently, the rating is constrained by a smaller scale as well as a reduced business focus, concentrated customer base and revenue linked to the cyclical North American movie slate.

Deluxe is restructuring its business through efficiency enhancements and increased automation by developing a cloud-based B2B self-service technology platform called Deluxe One. Notwithstanding the improved capital structure, Moody's expects the restructuring and Deluxe One investments will pressure debt protection measures this year. Moody's estimates adjusted GAAP financial leverage will remain high, increasing to around 8.2x total debt to EBITDA at year end 2019 from 7.1x at LTM 3/31/19 before declining to under 5x in 2020. This leverage metric is Moody's adjusted, incorporating standard operating lease adjustments and the expected cumulative realized cost savings through 2019, however excluding one-time severance and restructuring costs that will flow through the P&L to achieve future savings. The rating acknowledges the equity sponsor's financial support for Deluxe through a $110 million total commitment to reduce the term loan within 12-18 months after transaction close. Consequently, by 2020, as the rationalization program nears completion and nearly 20% of the term loan is repaid, Moody's expects earnings quality to meaningfully improve leading to higher GAAP EBITDA, lower GAAP financial leverage in the 4x-5x area and positive free cash flow generation.

The B3 rating is supported by Deluxe's position as a leading global provider offering a broad range of outsourced media supply chain services including Localization (e.g., subtitling, dubbing and audio services), Delivery Operations (e.g., physical/digital fulfillment, media cloud and delivery for other LOBs) and Digital Cinema (e.g., distribution, mastering, keys and content protection services) to feature film studios and direct-to-consumer OTT content creators. Its long-term customer relationships are buttressed by 3-5 year contracts, principally with major accounts. Deluxe benefits from somewhat high switching costs given its technical expertise, preferred vendor status and global asset base. The company also benefits from geographic diversity with 66% of pro forma revenue from North America, 26% from EMEA and 8% from Australia. With implementation of the Deluxe One SaaS platform, Moody's believes there will be opportunities to expand and extend its services to existing and new clients as the media industry undergoes transformation.

Moody's expects Deluxe to maintain adequate liquidity supported by at least $24 million pro forma cash balances at transaction close offset by negative free cash flow generation over the next 12-15 months. Liquidity is buttressed by the proposed $60 million extended ABL facility (downsized from $115 million) and new $70 million subordinated line of credit provided by the equity sponsor. Moody's expects Deluxe will draw under both facilities on a $1 for $1 basis simultaneously over the coming year to help fund restructuring costs and higher-then-normal investments and capital expenditures.

Factors That Could Lead to an Upgrade

Upward ratings pressure is contingent upon Moody's expectation that Deluxe will sustain total debt to GAAP EBITDA below 5x (Moody's adjusted), positive free cash flow to debt at or greater than 3% (Moody's adjusted) and cash balances at or better than forecasted levels. An upgrade would also require evidence of: (i) profitable revenue growth in core segments; (ii) growth in film release volumes; (iii) meeting or exceeding management's financial projections; (iv) limited pricing pressure; and (v) margin expansion. Management would also need to demonstrate a commitment to balance debtholder returns with those of its shareholders and exhibit operating performance and financial policies consistent with a higher rating.

Factors That Could Lead to a Downgrade

Ratings could be downgraded if Deluxe's market share in its core markets were to erode and operating performance were to weaken. Moody's expectation that management intends to sustain leverage above 7.5x total debt to GAAP EBITDA (Moody's adjusted), negative free cash flow generation and diminished liquidity 18 months after closing the DCS spin-off transaction could result in a downgrade. Ratings pressure could also occur as a result of cash distributions to private equity shareholders that weaken liquidity or increase leverage.

The principal methodology used in these ratings was Business and Consumer Service Industry published in October 2016. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

Headquartered in Burbank, CA, Deluxe Entertainment Services Group, Inc. is a leading global provider offering a broad range of outsourced media supply chain services including Localization, Delivery Operations, Digital Cinema and Deluxe One to feature film studios and direct-to-consumer OTT content creators. Deluxe will retain 50% ownership in its Creative Services business following the unit's carve-out. The company is privately-owned and an indirect wholly-owned subsidiary of MacAndrews & Forbes Holdings Inc. Revenue totaled approximately $937 million in fiscal 2018. Pro forma for the Creative Services disposal, revenue totaled $483 million last year.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Gregory A. Fraser, CFA
Vice President - Senior Analyst
Corporate Finance Group
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 1 212 553 0376
Client Service: 1 212 553 1653

Lenny J. Ajzenman
Associate Managing Director
Corporate Finance Group
JOURNALISTS: 1 212 553 0376
Client Service: 1 212 553 1653

Releasing Office:
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 1 212 553 0376
Client Service: 1 212 553 1653

No Related Data.
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