March 14, 2012 / 7:08 PM / in 6 years

TEXT-S&P revises Fender Musical Instruments outlook

Overview	
    -- Scottsdale, Ariz.-based Fender Musical Instruments Corp. has 	
demonstrated improved operating performance during 2011.	
    -- We are affirming our 'B' corporate credit rating on Fender and 	
revising the outlook to stable from negative.	
    -- The stable outlook reflects our anticipation that the company will 	
maintain adequate liquidity and leverage close to current levels. 	
 	
Rating Action	
On March 14, 2012, Standard & Poor's Ratings Services revised its rating 	
outlook on Fender Musical Instruments Corp. to stable from negative. At the 	
same time, we affirmed our 'B' corporate credit rating and 'B' senor secured 	
rating on the company.  	
 	
Rationale	
The outlook revision follows Scottsdale, Ariz.-based Fender Musical 	
Instruments Corp.'s announcement of its fourth-quarter 2011 results and 	
improved operating performance and credit measures in 2011. We estimate 	
Fender's adjusted debt to EBITDA (including our standard adjustments) was 	
about 5.1x at the end of its fiscal year 2011, down from about 11.3x the prior 	
year. 	
	
Fender also recently announced its intention to conduct an IPO and to use 	
approximately $100 million of the proceeds to reduce its term loan; however we 	
do not incorporate this into our outlook revision or current ratings because 	
of the uncertainty regarding the potential IPO transaction's timing and final 	
terms. If Fender successfully completes the proposed IPO transaction, 	
resulting in a reduction of Fender's outstanding debt and corresponding 	
improvement in credit metrics, we will evaluate the effect on Fender's ratings 	
at that time. About $246 million of total debt was outstanding on Jan. 1, 	
2012. 	
	
The ratings on Fender reflect Standard & Poor's view that the company's 	
financial risk profile is "highly leveraged" and its business risk profile is 	
"weak," as defined in our criteria. Key credit factors we considered in our 	
assessment of Fender's business risk profile include its narrow business 	
focus, 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.	
	
Although Fender maintains strong brand recognition, we believe sales will 	
remain vulnerable to economic cycles because of the discretionary nature of 	
its products. Fender's sales remain concentrated in guitars, with 72% of its 	
fiscal year 2011 gross sales represented by fretted instruments and guitar 	
amplifiers, although the company has diversified its product portfolio and 	
geographic reach through acquisitions. We estimate Fender generates about 47% 	
of its sales outside of the U.S. A large portion of its international sales 	
are in Europe. The company also has some sales concentration with its largest 	
customer, Guitar Center Inc. Operating within the highly fragmented musical 	
instruments and accessories industry, Fender competed in retail musical 	
products categories that generated an estimated total $4.7 billion in U.S. 	
retail sales in 2010.	
	
Fender's highly leveraged financial risk profile reflects the company's 	
significant debt obligations. Although operating results and credit metrics 	
have improved during 2011, Fender's adjusted debt to EBITDA of about 5.1x at 	
year end, although down considerably from over 11x the prior year, remains 	
near the indicative leverage ratio for a highly leveraged financial risk 	
profile of greater than 5x. We also estimate that for the 12 months ended Jan. 	
1, 2012, the ratio of adjusted funds from operations (FFO) to total debt was 	
about 16.1%, up from about 6.3% the prior year, and slightly better than the 	
indicative ratio of less than 12x for a highly leveraged financial risk 	
profile. We estimate the ratio of adjusted EBITDA to interest expense also 	
improved over this period, rising to 3.2x from 1.8x in the prior-year period. 	
	
During the year ended Jan. 1, 2012, revenues grew 13.4% relative to the 	
prior-year period. Performance improvement resulted from Fender's ability to 	
resolve its backlog and supply disruption issues and achieve significantly 	
improved EBITDA levels. We estimate adjusted EBITDA increased to $58.9 	
million, compared with $27.3 million for the year ended Jan. 2, 2011. In 	
addition, we estimate adjusted EBITDA margins increased to 8.4%, compared with 	
4.4% for the prior-year period, reflecting pricing actions and improved 	
operating efficiencies as production normalized. This was partly offset by 	
elevated raw material costs. However, free operating cash flow remained weak, 	
primarily owing to elevated working capital levels as the company recovered 	
from its backlog issues, faced raw material cost pressures, and increased 	
capital expenditures over the last year. 	
	
We believe Fender's operating results 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 2012 	
forecast include:	
     -- Revenue growth of about 5% and reported EBITDA margin near 7%, 	
reflecting a greater portion of sales coming from higher-margin products.	
     -- Continued input cost pressures, including raw material costs such as 	
hardwoods and rising labor costs.	
     -- Capital expenditures of about $10 million. 	
     -- We anticipate free operating cash flow for the year will approach $15 	
million as working capital requirements return to more normal levels.	
     -- Based on our forecast, we expect Fender's adjusted leverage will 	
remain near 5x and its ratio of FFO to total debt will remain near 15% during 	
2012. 	
 	
Liquidity	
We believe Fender's liquidity is "adequate," as defined in our criteria, with 	
sources of cash likely to exceed cash uses for the next 12 months. Our 	
assessment of Fender's liquidity profile incorporates 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 credit agreements do not contain financial covenants. 	
The company is required to maintain a fixed-charge coverage test of 1.0x in 	
the event availability of funds under its asset-backed revolving credit 	
facility declines below $12.5 million, which we do not expect to occur over 	
the next 12 months.	
     -- The company has no substantial debt maturities over the near term.	
     -- In our view, the company has well-established relationships with 	
banks. 	
 	
As of Jan. 1, 2012, Fender reported about $13 million of cash on hand and had 	
no amount drawn under its $100 million asset-backed revolving credit facility, 	
which had availability of $92.9 million, net of outstanding letters of credit. 	
We believe Fender will generate sufficient cash flow from operations to fund 	
its required debt amortization of $3 million annually and capital expenditures 	
that we expect to be about $10 million over the near term. At the end of 	
fiscal year 2011, Fender also had a $3.6 million excess cash flow sweep 	
payment payable under its credit agreement.	
 	
Recovery analysis	
For the complete recovery analysis, please see Standard & Poor's recovery 	
report on Fender Musical Instruments Corp., published on Sept. 15, 2011, on 	
RatingsDirect. 	
 	
Outlook	
The stable outlook reflects our anticipation that the company will maintain 	
adequate liquidity and credit measures near current levels. We could consider 	
an upgrade if Fender's operating cash flow increases and it achieves and 	
sustains strengthened 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. 	
Fender may also achieve an improved credit profile if it completes its 	
proposed IPO on terms that include a substantial reduction of the company's 	
outstanding debt. We could consider a downgrade if the company's financial 	
policies become more aggressive, if leverage increases significantly, if 	
operating performance and cash flow deteriorate substantially, or if liquidity 	
becomes constrained. 	
	
Ratings List	
	
Ratings Affirmed; Outlook Action	
                                        To                 From	
Fender Musical Instruments Corp.	
 Corporate Credit Rating                B/Stable/--        B/Negative/--	
	
Ratings Affirmed	
	
Fender Musical Instruments Corp.	
 Senior Secured                         B                  	
   Recovery Rating                      3

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