S&P Report on Zuffa – Analysis

October 1, 2009

Today, Standard & Poor’s released its latest credit report on Zuffa LLC that documented the corporation’s latest financing initiatives.

Below is a summary of the report’s action:

  • Zuffa requested an additional $100 million in incremental term loans to help pay off part of the existing revolving credit line and fund a dividend to the owners of the company.
  • Standard & Poor’s reaffirmed Zuffa’s credit rating at BB- (stable).
  • S&P dropped Zuffa’s recovery rating to ‘4’ from ‘3.’

Payout Perspective:

S&P re-affirmed the BB- (stable) credit rating for Zuffa, which means the bonds will still be considered high yield and accompanied by higher interest rates. The report cited lingering concerns related to Zuffa’s heavily event-driven business model, relatively short operating history, susceptibility to changes in consumer tastes, and the weak economy for the ratings hold.

The report did acknowledge the fact that Zuffa has made tremendous strides in the past few quarters – specifically mentioning the video game and improved margins in the UK.

However, the fact of the matter remains that Zuffa is operating in a volatile, uncertain business environment. The company has really only been profitable for the last four years, and that’s not enough time to a.) build long-term creditor confidence, or b.) develop enough cushion to insulate the corporation from a severe industrial downturn (i.e., hedge against business risk).

The following caught my eye, because it raises the issue of balancing dividend policy with credit policy:

 “Given management’s relatively aggressive posture toward dividends, an outlook revision to positive or ratings upside potential is limited over the intermediate term, despite the likelihood for some improvement to credit measures over the next several quarters.”

The disbursements themselves aren’t a tremendous concern, because they are limited under loan convenants. The underlying issue that I see – albeit a small one – is that the company increased its leverage in part to fund the dividend disbursement, and that ultimately influenced S&P’s decision not to upgrade Zuffa’s credit rating.

The real, tangible difference between credit ratings like BB- and BB+ or BBB- is the interest rates paid on the debt. Not only are they paying more in interest, but through operating in Nevada, a lower percentage of those interest payments are tax deductible due to the absence of corporate tax in the state.

It’s just a small issue, though, as what matters most is Zuffa’s ability to meet those payments. Since the last report, Zuffa has increased its coverage ratios to something more in line with their current credit rating, which is an improvement from the “slightly weak” coverage of last July.

Overall, Zuffa appears to be healthy: the company has managed to stabilize its EBITDA margins, improved its profitability internationally, and has begun to diversify its revenue streams. The concerns laid out in the report are more of an indictment of the business risk involved than they are of any management issues on-going within the company.

20 Responses to “S&P Report on Zuffa – Analysis”

  1. Rob Maysey on October 1st, 2009 8:51 PM

    If the UFC is seen as a growth engine that is barely “scratching” the surface, why would you, on numerous occasions it appears, take on large amounts of debt to fund dividends?

  2. Derek Stewart on October 2nd, 2009 4:02 AM

    Zuffa borrowed money and used part of it to issue dividends for the same reason any other successful business does in any industry across the world – because they can. There are always conditions and financial ratios that Zuffa owners would have to adhere to to keep them “in check”, with bondholders like Mark Cuban keeping a close eye on the responsible use of their money. If your business is booming, why not borrow money to accelerate expansion plans and throw a little bit of cash in your jeans?

    The part that amazes me is that 75% of revenues are still event-driven, even with the success of the video game, the magazine (ok, ok, only one issue), and action figures. Maybe this revenue has yet to roll on to Zuffa’s books?

  3. Justin on October 2nd, 2009 6:10 PM

    I agree with Rob. Taking on debt to pay dividends in a bad economy is not a good idea for the longevity of any company. Sounds like the kind of financial advice that might be given to a pre-recession casino owner. Squeezing the company like a grape and then relying on the next years worth of events to stay afloat. Don’t get me wrong I love the UFC. This kind of aggressive profit taking makes me a bit nervous.

  4. Adrian on October 2nd, 2009 7:58 PM

    I would agree with Derek.

    By acquiring additional debt to restructure dividend payments could also imply a speculative, yet solid, forecast of the next two years in sales.

    If 75% of Zuffa’s revenue stream are from Events such as PPV fights and UFC Fight Night, and if the rumor of 2 1/2 to 3 UFC events per month for 2010 is scheduled, then it is no suprise to me that Zuffa would adjust their debt services to increase shareholder dividend payments. It is a solid tactic for Zuffa shareholders, in particular the principal and major investors such as the Fertittas, to pay out the surplus-income in order to recover their initial 44 million investment.

    It may sound absurd to leverage your gross-income on a single revenue source, however, if a company had the business model to support such a financial tactic, then why not?

    I imagine that the UFC has a substantial percentage of Free Cash Flow in comparison to their EBITDA.

  5. Adrian on October 2nd, 2009 8:04 PM

    If the American economy is still in turmoil, then I would imagine that Zuffa and UFC are speculating higher sales volumes of UFC events when the marketing swings on the upside.

    Plus, it would be interesting to see the percentage of PPV sales and its origin of purchase. At one time it may have been 90% from US Household and Commercial establishments, however, with market exposure into Canada, U.K. and various parts of Europe, and not including whatever small fraction of sales is contributed from Asia, Africa, South America, and Australia, I wouldn’t be suprised if the US sales per unit increased over the past two years, but however, decreased in percentage of sales volume overall because of market expansion efforts.

  6. Rob Maysey on October 2nd, 2009 9:30 PM

    Adrian,

    I don’t have much of a quibble with any of your posts–in fact, I made the same point in another thread.

    That said, this action implies a predictable cash flow like you state, and is more in line with the view that the company is matured, not in rapid growth phase.

    To put the point another way, if you believe that Dana, Lorenzo and Frank are savvy business people, and I do, doesn’t this at least suggest that they no longer see their greatest return on potential investment in Zuffa, and tha Zuffa at this point is in the cash-cow phase? Otherwise, if the greatest returns are still to be made with Zuffa, why wouldn’t they have used that cash to fund the growth, and thereby reap the rewards?

  7. Mike on October 3rd, 2009 7:49 AM

    Derek, 75% of the revenues may come from events, but the vast majority of the revenue from the video game drops right to the bottom line. It could be something like 10% of company revenue but it is a MUCH higher percentage of profit. Licensing a brand does not require much in the way of expenses.

  8. S - Sherdog Mixed Martial Arts Forums on October 3rd, 2009 9:15 AM

    [...] [...]

  9. Daniel on October 3rd, 2009 12:23 PM

    Does any one know how a person can invest in the UFC BB- rating bond? I appreciate any candid answers.

  10. Derek Stewart on October 3rd, 2009 5:35 PM

    @Mike – great point. And I would imagine that at 75%, Zuffa’s ratio is much better than its competitors. Question to Kelsey, any idea on Strikeforce’s (and the others’) event-driven revenue percentage?

  11. Chris on October 3rd, 2009 6:47 PM

    Rob,
    With regards to:
    “Otherwise, if the greatest returns are still to be made with Zuffa, why wouldn’t they have used that cash to fund the growth, and thereby reap the rewards?”

    Their expansion efforts are largely based on their human capital constraints (guys like Dana, Ratner, and Lorenzo travelling around and breaking down the regulatory resistance), rather than significant capital investments, so they may not require a ton of additional cash to continue the rapid growth – making the dividend payments a little less questionable.

  12. Rob Maysey on October 3rd, 2009 9:10 PM

    That is possible–yes, though that leads to the question, would additional talent speed the efforts, and is the talent available.

    At the very least, it raises questions. Those that say it isn’t a consideration or otherwise meaningless are not correct, in my opinion.

  13. Adrian Lee on October 5th, 2009 5:21 PM

    Hey Rob,

    Thanks for the reply. It’s great to read a response that provokes thought and discussion. Nonetheless, regarding your comment:

    “this action implies a predictable cash flow like you state, and is more in line with the view that the company is matured, not in rapid growth phase.”

    Depends on how a company wishes to define rapid growth, but more importantly fund it. I know many investors who would incur debt to increase payment dividends because it is strategic approach to raise future monies (say 6-24 months away) from equity shareholders to be. So long as the ratio of Debt incurred to Shareholder payments does not exceed their forecasted infusion of cash from future shareholders, and of course without seriously adjusting their operating business model.

    For all we know, Frank and Lorenzo own 90% while Dana owns 10%. Why not take so money off the table by inviting new investors with limited voting options and restricted management control but sizeable cash infusions? If it doesn’t disrupt the revenue and operating income, and more importantly their free cash flow, then it makes perfect sense to enact this strategy as method of attracting new investors.

    Reasonable Debt Service ratio with Increased divdend payments would truly attract more investors, and in return allow the UFC to expand the growth of the business through equity distribution rather than debt issuance (such as bonds).

    But regardlesss, difficult to speculate without seeing the books? LMAO Or seeing a similar business model. (ie Strikeforce)

    Adrian

  14. Adrian Lee on October 5th, 2009 5:25 PM

    Daniel,

    Contact your investment broker and have him/her contact a bond broker, or find out which firm performed the underwriter duties.

  15. Adrian Lee on October 5th, 2009 5:44 PM

    To Chris and Rob:

    “Their expansion efforts are largely based on their human capital constraints”

    I respectfully disagree. I believe their employment structure and strategy is partially the reason why their business model is so successful, based on the following assumptions =D LOL … Let the speculating begin.

    1. UFC may have outsourced a production team for all UFC events, and promotional material for print/media/communications. If they negotiated a long term contract with payments made on a per event basis or annual fee, they could get away with lower man power cost versus traditional employment for services.

    The UFC holds an event every 2 out of 30 days (in production terms) per month, why would I retain full time services of staff when I need them to only work so many hours of the month.

    2. I wouldn’t be suprised if the corporate or internal team of UFC was a boutique firm, say less than 25 staff members. All events are held at locations where the facility is licensed, not leased. Thus, no need for a real estate administration team to manage lease audits and management, and even a fully staffed accounting team. How much sizeable and non-liquidable equipment could the UFC possibly have?

    3. I can suspect that their legal team is perhaps the deepest. With insurance issues concerning fighters, event days (just imagine the peril coverage and CGL amounts with all those fans + alcohol), state/local/government agency compliance issues, regulatory updates, senate advocacy, etc. Hire the sharks as in-house legal counsel versus outsourcing.

    However, this all speculation, but If I were to stake my assumptions of why the UFC business model is as successful as it is today, it’s the operating model. Employment is probably below 15% of the revenue stream, maybe even 10% (Intuition tells me, and wouldn’t be suprised if Dana and Lorenzo accounted for more 80% of employment, lol).

    PPV payouts for fighers and bonuses can be added to the cost of sales. While professional services are in the range of 10-20%. Thus combining the two equates to 30% at the highest point (Employment + Professional Services), and yet professional services is a variable cost which can easily swing downwards and can be absolutely controlled in the event of an upswing — termination with ease.

    Those are just my thoughts, nothing concrete.

  16. Adrian Lee on October 5th, 2009 5:49 PM

    Just to add to the Employment structure:

    Anothe reason as to why UFC’s legal team is the largest component of their employment cost is simply due to all the intellectual property that is produced, maintaned, circulated, protected, and archived by the UFC. It’s outstanding amount and I wouldn’t be suprised that the historic value is less than 1/100 of a penny in comparison to its market value. No company comes close to the UFC in terms of intellectual property value for MMA.

  17. Rob Maysey on October 6th, 2009 12:56 PM

    Interesting comment in regards to equity stakes Adrian–and I agree, that is another possibility for sure. In that case, it would also make sense.

  18. Adrian Lee on October 7th, 2009 1:00 PM

    It’s difficult to speculate given the UFC is the only successful (stability wise) MMA promotion as of yet. With more than a decade of operations (other MMA promotions have similar operational history), they are still the only MMA company to propel from regional to trasnational market share. Thus, difficult to reconstruct and speculate their business operations.

  19. Adrian Lee on October 7th, 2009 1:01 PM

    Note* but not impossible.

    If any one from Strike Force is reading” I can be hired for professional consultation.

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