March 14 - Overview -- New York-based global marketing services company MDC Partner's fourth-quarter 2011 EBITDA was below our expectations. -- Covenant headroom could narrow in the second quarter of 2012 because of revolving credit facility borrowings to fund deferred acquisition consideration payments. -- We are revising our rating outlook on MDC to negative from stable. -- The negative rating outlook reflects our view of increasing potential for a covenant violation barring an amendment or alternative sources of cash. Rating Action On March 14, 2012, Standard & Poor's Ratings Services revised its rating outlook on New York-based MDC Partners Inc., a holding company for a portfolio of marketing services firms, to negative from stable. We affirmed our 'B+' corporate credit rating on the company, as well as the 'B+' issue-level rating on the company's senior unsecured debt. The recovery rating on the company's senior unsecured debt also remain unchanged at '4', indicating our expectation of average (30% to 50%) recovery for noteholders in the event of a payment default. Rationale The rating outlook revision reflects a steeper EBITDA decline in the fourth quarter of 2011 than we had previously expected. We estimate this will result in fully adjusted leverage (including operating leases and acquisition-related liabilities) in the low-6x area at year-end. As a result, according to our criteria, we are revising our assessment of the company's financial risk profile to "highly leveraged" from "aggressive." In addition, we believe that covenant headroom could narrow in the second quarter of 2012, when a large portion of the company's $51.8 million of near-term deferred acquisition consideration (earn-out) obligations become due. We believe the company will have to meet a large portion of these obligations with borrowings under its revolving credit facility. The total leverage covenant under the company's credit facility agreement steps down to 3.75x at June 30, 2012, from 4.6x, which, in conjunction with more difficult first half year-over-year comparisons, could lead to a slim margin of compliance. We currently consider MDC's business profile as "fair," given our view of the strong creative reputation of its key agency, Crispin Porter + Bogusky, and its growing digital capabilities. We believe this despite the company's relatively small agency network, limited global presence, and its still high (but declining) concentration of revenue and EBITDA from two key agencies. However, further EBITDA margin compression could cause us to revise our assessment. MDC is a global provider of marketing services, with revenue concentration in the U.S. (80% of revenue), Canada (16%), and other (4%). The company's subsidiaries provide a comprehensive range of marketing communications and consulting services. The advertising industry is subject to the cyclical nature of advertising, as well as a client's ability to switch to competitors or scale back spending at short notice. MDC has been in an aggressive growth mode over the past two years, spending over $150 million on acquisitions and over $60 million in key talent additions and office expansion. We believe that increased staffing and facilities costs outpaced revenue growth in certain areas. Cost of sales as a percentage of revenue was 72% in 2011, compared to 65% in 2009. As a result, the company plans to reduce headcount by roughly 300 employees across various agencies, which will most likely lead to modest severance expense in the first half of 2012. An important industry trend is the shift of advertising and marketing services to online distribution. Digital business now accounts for over 50% of revenue at MDC, and the company's increased capabilities have led to increased market share and net new business wins being up 33% in 2011. We believe acquisition activity will slow in 2012, but we anticipate that the company will continue to explore opportunities in digital and social media, and integrated agencies, in addition to expanding capabilities in media buying and international markets. Advertising spending visibility remains low in 2012, and we believe that like larger, higher-rated peers, organic revenue growth at MDC will slow compared to 2011. Key industry risk factors include the performance of certain euro-currency markets, as well as anything that stalls the modest momentum in the U.S. economy, such as rising oil prices or deterioration in consumer confidence. Revenue concentration in the U.S., where advertising and marketing spending was stronger, together with recent business wins totaling $104 million, supported revenues in 2011.Under our base case scenario (not including the impact of potential acquisitions), we expect revenue to increase at a mid- to high-single-digit percentage rate in 2012. As a result, based on our expectation of higher salary and facilities costs, we believe EBITDA (including distributions from affiliates, but after minority interest expense and equity-based compensation) could increase at a mid-teens rate. For the fourth quarter, revenue jumped 20.5%, led by organic revenue growth of 6.7% and acquisition-related growth of 14%. However, EBITDA (including distributions from affiliates, but after minority interest expense, acquisition deal costs, and equity-based compensation) dropped 40%, primarily the result of a roughly 29% increase in costs of services sold and 81% increase in office and general expenses. The company's EBITDA margin (after net minority distributions and treating stock compensation as expense) declined to roughly 6.2% in 2011, down from 8.6% in 2010 because of expense increases. Despite healthy revenue growth, increases in talent and facilities spending have constrained EBITDA margin improvement. MDC has publicly stated its intention to decelerate operating cost increases in 2012 and focus on margin improvement. Under our base case scenario (excluding potential acquisitions), we believe that the company could restore the EBITDA margin to the mid- to high-6% area in 2012. Lease-adjusted debt (including earn-outs and put obligations) to EBITDA (after net distributions to noncontrolling interests, but before noncash stock compensation) was high, at 5.5x as of Sept. 30, 2011. For full-year 2011, we estimate that fully adjusted leverage was slightly higher, in the low-6x area. Under our base case scenario, assuming a constant level of acquisition-related liabilities and excluding the impact of potential acquisitions, we believe that fully adjusted leverage could decline to the low- to mid-5x area in 2012. Discretionary cash flow (operating cash flow, less capital expenditures and after dividends and minority distributions) was negative for the 12 months ended Sept. 30, 2011, mainly because of working capital cash usage as a result of acquisition activity. We estimate that discretionary cash flow was also negative for the full year, in the $35 million to $40 million area, owing to working capital cash usage. A key rating factor will be the company's ability to generate positive discretionary cash flow in 2012, which will partly depend on acquisition activity. Liquidity In our opinion, MDC has "adequate" liquidity to cover its needs over the next 12 months, despite covenant headroom that suggests "less than adequate" liquidity according to our criteria. We believe the company's credit metrics and bank relationships provide a degree of financial flexibility if the company were to need another amendment. Our assessment of the company's liquidity profile incorporates the following expectations and assumptions: -- We expect sources of liquidity (including cash and access to the revolving credit facility) to exceed its uses by more than 1.2x over the next 12 months. -- We expect net sources to remain positive, even if EBITDA declines more than 15%. -- Compliance with maintenance covenants would not survive a 15% drop in EBITDA from levels as of Dec. 31, 2011, and compliance could fall below 5% in the second quarter barring an amendment. -- The company has flexibility to reduce acquisition and capital spending in order to bolster liquidity, if need be. -- We believe MDC has good relationships with its banks, based on recent credit agreement amendments, and has a satisfactory standing in the credit markets. MDC's sources of liquidity include cash balances of $8.1 million as of Dec. 31, 2011, and access to its $150 million secured asset-based revolving credit facility (unrated). Based on covenant limitations in the senior note indentures, the company was able to borrow an incremental $41.2 million under the revolver as of Dec. 31, 2011. In 2012, assuming a neutral impact from working capital and excluding potential acquisitions, we estimate cash flow from operations could be in the $35 million to $40 million range. Uses of liquidity over the next 12 months include capital expenditures that we estimate in the $20 million area, annual dividends of about $16.5 million, and the deferred acquisition consideration (earn-outs), the current portion of which totaled $51.8 million as of Dec. 31, 2011. The credit agreement contains financial covenants, including a maximum senior leverage ratio of 2.0x, a maximum total leverage ratio of 4.15x, a minimum fixed-coverage ratio of 1.25x, and a minimum EBITDA requirement of $90 million. As of Dec. 31, 2011, we estimate the company had less than 10% cushion against the 4.15x maximum leverage ratio, which, based on its February 2012 amendment, loosens to 4.6x on March 31, 2012 to accommodate more difficult first-quarter comparisons. The covenant steps down to 3.75x in the second quarter of 2012, where it will remain over the life of the facility. Barring an amendment or alternative sources of cash, we believe the company could have difficulty meeting the second quarter step-down. However, based on the company's recent credit amendments in September 2011 and February 2012, when MDC was able to loosen covenants and not incur additional interest costs, we believe the company has good relationships with its banks. Recovery analysis See Standard & Poor's recovery report on MDC Partners published Oct. 28, 2011 on RatingsDirect. Outlook Our negative rating outlook reflects our expectation that headroom against financial covenants will narrow in the second quarter of 2012, potentially requiring an amendment. In addition, the outlook reflects the company's negative discretionary cash flow in 2011 and low visibility into 2012. We could lower the rating over the near term if it becomes apparent that a covenant violation is likely in the second quarter, which we believe could happen if EBITDA doesn't grow at a mid-single digit percentage rate or faster in the first half of 2012. We could also lower the rating because of further sizable debt-financed acquisitions or EBITDA deterioration that precludes the company from building a 15% to 20% cushion against financial covenants and generating positive discretionary cash flow in 2012. We believe such a scenario would entail higher-than-expected operating cost increases, due to international expansion and talent acquisition. We could revise the outlook to stable if the company begins to build a more substantial cushion against financial covenants and we see a clear indication of its financial policy moving toward lower leverage through decelerating operating cost growth and acquisition activity. Related Criteria And Research -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Use Of CreditWatch And Outlooks, Sept. 14, 2009 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Standard & Poor's Revises Its Approach To Rating Speculative-Grade Credits, May 13, 2008 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Ratings Affirmed; Outlook Action To From MDC Partners Inc. Corporate Credit Rating B+/Negative/-- B+/Stable/-- Senior Unsecured B+ Recovery Rating 4 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.