Second Opinion: Zuffa's Finances Come Into Focus

October 17, 2007

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An attorney at a large Atlanta law firm with experience in the areas of bankruptcy and accounting malpractice offers the following provocative second opinion on Behind the Curtain: Zuffa’s Finances Come Into Focus:

I am not a finance expert, so please correct me if I have a flaw in my reasoning, but isn’t the gist of S&P’s report that, even though Zuffa’s revenues are growing, its margins are decreasing and it now has a highly-leveraged structure, making it a very risky business to lend money (i.e. it is likely to go bankrupt)? I usually don’t think of a potential credit downgrade as a signal that a business is “healthy,” even if it simultaneously reports revenue growth. Usually, S&P doesn’t rate the debt of healthy companies as high-risk.

EBITDA can be a very misleading thing to look at, especially given that interest on the $325 million term note is likely quite substantial. I wouldn’t equate an EBITDA margin with profit margin for a company that has such a high a debt-revenue or debt-equity ratio. On paper, the company probably now has negative equity. Cash flow that would have been profits in the past are probably now being used to pay interest on the note.

It looks to me like the Fertitas and Dana White “cashed out” and purposely switched to a very risky capital structure. Can’t say I blame them; they get to keep all the upside potential of the company while passing off the downside to their lender. This sort of thing often proceeds a bankruptcy. It signals to me that Zuffa’s owners may not be all that confident in the long-term profitability of the company. Honestly, I am surprised that a lender would make this deal, and I suspect that Zuffa is paying for it with an exorbitant interest rate. Anyway, it may be true that Zuffa will continue to be profitable long into the future, but this credit outlook downgrade and the new highly-leveraged structure certainly makes me wonder.

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