Zuffa Maintains “BB” Credit Rating After $50M Add-On

Standard and Poor’s February report states that it has maintained Zuffa’s credit rating at “BB” following a $50 million add-on proposed to it’s senior secured term loan, which now has a sum of $525 million.

The issue-level rating on the term loan in ‘BB’, which is the same as the corporate credit rating, with a ‘4’ recovery rating (in case of a payment default).  The $50M add-on brings the total size of the senior secured credit facility, which includes a $50M revolving credit facility, to $525M. The intent of the additional debt is for Zuffa to use the proceeds in order to repay the outstanding balance on its revolving credit facility.

As always, the ‘BB’ credit rating from Standard & Poor’s reflects the assessment of Zuffa’s business risk profile (‘fair’) and the company’s financial risk profile (“aggressive”).

The following S&P concerns kept Zuffa’s credit rating from being upgraded:

• Risk of revenue and EBITDA volatility given the company’s primarily event-driven business model
• Vulnerability to changing consumer preferences and susceptibility to variability in discretionary spending
• Management’s aggressive financial policy (high level of distributions in recent years & high debt leverage)
• Although the UFC has a strong fan-base, in order to maintain their advantage, they need to continue to develop fighters that appeal to the 18-34 demographic.
• Preserve current regulatory acceptance of the sport. Fatal injury or change to the rules and regulations governing the sport and legal status could have meaningful impact to the company’s business model and long-term viability.

The concerns stated above are mostly offset by S&P’s belief that Zuffa’s strong EBITDA margin and healthy cash flow conversion rate are sustainable over the near to intermediate term.

 

Report Summary

• Revenue and EBITDA decreased in full-year 2011 compared with 2010, as key fighter injuries likely contributed to lower PPV buys along with weakness in merchandise sales.
• Despite Zuffa’s weaker performance in 2011 compared to 2010, S&P is expecting Zuffa’s 2012 EBITDA to rebound back to a similar level seen in 2010, which will be driven by increased PPV & event revenues, as well as by it’s recent television contract with FOX Sports Media Group.
• The FOX television deal is expected to yield more favorable economics for the Zuffa, as it replaces it’s previous Spike TV and Versus TV deals, over the term of the agreement as it reduces the risk on the more volatile event based revenue.  The belief is also that Zuffa should be able to deliver more content and be able to expand it’s audience due to FOX’s distribution capabilities.
• S&P believes that Zuffa’s total debt to EBITDA and EBITDA interest coverage looks to remain in line with the rating over the intermediate term.
• S&P will be expecting the owners to to continue pursuing moderate distributions over time as Zuffa continues to grow, which will most likely preclude any meaningful sustained improvement to the financial risk profile.
• S&P is approximating 55% of total revenue is event-based (majority which depends on PPV buys and ticket sales).  The remaining 45% of total revenue is estimated to be sourced from live and taped TV broadcasts, sponsorship, merchandising, licensing, and content distribution agreements.
• The expectation is that over the life of the new FOX TV deal, TV broadcasting may become a larger source of revenue, which is a positive considering the volatility of event based revenue.
• The report points out that Zuffa has successfully expanded the sponsorship and merchandising portion of the business in recent periods, which also improves the stability of the revenue and strengthens the business model.
• Zuffa’s plan of international expansion is seen as a positive due to growing the diversification of it’s ban base and broadening the acceptance of the sport worldwide.
• Zuffa is now taking a more measured approach in expanding into new markets, where the acceptance of the sport and profitability are ensured.  The UK expansion was noted as a market which  resulted in extremely volatile EBITDA  margins.
• The report once again points out that Zuffa could face increased labor costs in the future if fighters organize (union) and seek a higher share of revenue, which is the case for most major sports in the U.S.
• The acquisition of Strikeforce (along with the WEC) is believed to have strengthened the UFCs already dominant market position, as it continues to increase the number of fighters and title fights under the promotion.

LIQUIDITY:

• Zuffa has an “adequate” liquidity profile to cover its needs over the next 12 to 18 months. Sources of liquidity are expected to exceed uses by at least 1.2x and remain positive, even if EBITDA declines by 20%.  Sources include cash flow generated from strong operations,  and it’s revolving credit. This assessment is despite  Zuffa only having $1M of availability under it’s $50M revolving credit facility as of Sept. 30, 2011.
• Borrowing under the revolving credit facility are subject to compliance with a max 5X senior secured leverage ratio covenant. There was a meaningful cushion at the end of Sept. 2011 quarter. Zuffa’s revolver expires in 2012, however the report expects it will successfully extend the revolver maturity to early 2015 based on the terms of it’s recently proposed amendment, followed by the term loan maturity in mid-2015.
• Zuffa’s payments for taxes are primarily distributed directly to the owners and additional dividend payments are limited by a restricted payment basket under the credit facilities.
• Expectations are that the owners will continue to pursue max distributions allowable under the credit agreement.

Zuffa Credit History

November 2007 – S&P Cuts Zuffa Rating, BB to BB-
July 2008 – Zuffa Rating Goes Negative to Stable
July 2009 – Cuban Now a Zuffa Bond Holder
October 2009 – S&P Re-Affirm BB-, Slide Recovery Rating Down
December 2010 – S&P Raises Zuffa Rating, BB- to BB
August 2011 – Zuffa Maintains “BB” Credit Rating
February 2012 – Zuffa Maintains “BB” Credit Rating After $50M Add-On

 

Payout Perspective

Typically, a rating of “BB” implies that Zuffa is less vulnerable in the near term, although it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions, which can result in failure to meet its financial commitments. On the other hand, it’s a credit rating of “stable”, which is not a bad place to be for a company who’s core business model is volatile and can be affected by many market variables. The rating holds with the belief that Zuffa’s ability to successfully market UFC events will continue to drive strong revenue and cash flow.  Due to the business model being so volatile, a negative rating by S&P is always a possibility due to declining PPV sales (economic weakness and/or declining consumer interest) and the result of weaker profitability due to expansion efforts. Another interesting note is that, just as before, it mentions that given Zuffa’s aggressive posture towards dividends, tarting upside potential is limited over the intermediate term, despite potential improving measures in 2012 based on expectations for revenue and EBITDA growth.

A focal point of the report should be S&P’s assessment that Zuffa’s total revenue now has a 55-45 split. This is notable considering that previous assessments have placed Zuffa in a 75-25 split, where 75% of total revenue was expected to be event based (PPV buys and ticket sales).  An expected 55-45 split would be great for Zuffa, as it shows a more diversified and stable business model. The international expansion efforts and the seven-year $100 million FOX TV deal help tremendously in bringing more stability to the UFC. The hope with the new FOX TV deal at the time was that more mainstream exposure would come to the brand by creating more PPV draws, and opening the door for more stable revenue opportunities which can help offset the volatile nature of having a PPV based core business model.  At this time, the TV deal expectations haven’t fully matured yet and the numbers don’t quite show it either, so it will be interesting to find out if this new assessed 55-45 split ratio has to do with the expectations of what the FOX TV deal is supposed to do for Zuffa, rather than what it has actually done in terms of performance over the last 7 months. We get into more details regarding the TV deal’s performance a little later.

The report points out that revenue and EBITDA for 2011 is down compared to 2010. The main reason given for the decline was injuries to UFC stars. The problem with solely blaming injuries and correlating it to revenue is that you hope next year won’t be as bad but as we are starting to see on a year-to-year basis, injuries are part of the sport.We made this assessment last time around, and since then, two of the UFC’s biggest draws, have either left the UFC (Brock Lesnar) or sidelines for meaningful amount of time (Georges St. Pierre has only fought once since 2010 and is not expected back until the end of 2012).  Injuries is an unknown that cannot be controlled or correctly estimated beforehand, so injuries will always be a hot topic again in 2012, as it has been for the past 2 years.  As example, the upcoming UFC 149 event in Calgary has had every main event match-up changed since the official lineup was announced due to injuries.  Fans pay a premium up front to see a UFC event, but may get a completely different card by the time the actual event takes place. Another factor we will keep our eyes on is fighter suspensions by the State Athletic Commissions due to failed drug and banned substance tests.  A failed test can draw a fighter suspension of around 1 year on average, so in addition to injuries, the combination of both really impacts the UFC’s bottom line due the volatile nature  of fighter availability in combat sports.

If injuries and suspensions are the main component of declining PPV buys, then that brings up another issue. It means that fans are only willing to pay to see fighters that they deem worthy of their hard-earned money. It also shifts the drawing power to the fighters instead of the UFC brand and product they offer. It means MMA may not be enough anymore to get anyone outside of the MMA hardcore fanbase to tune in, and I’m sure that’s something the UFC hopes to address with the exposure the FOX TV deal brings along with its vast distribution platforms.

There has also been a lot of talk this year about the UFC or MMA peaking or plateauing, and pointing out declining PPV buys and TV ratings as a quick and easy measuring stick. So far, looking at the UFC/FOX TV Deal performance in Q1 2012, the numbers in general are trending down from what they were doing in Spike TV and Versus.  In fact, one of the biggest selling points of the TV deal was that the UFC would attract mainstream sponsors (which has not been the case so far) and that TUF would be featured on FX by switching to a LIVE format on Friday nights.  UFC President Dana White even went on record and was quoted as predicting 3 million viewers on average tuning in to catch the show, which is a main staple in developing talent and future stars.  The TUF Live debut on FX resulted in being the lowest rated season in TUF history (averaged less than 1 million for the season), and it was recently announced that the show will now switch back to being taped.  In terms of PPV’s, the FOX deal appears to have increased the popularity of a few featured fighters such as Cain Velasquez and Junior Dos Santos, but overall the effect appears to be minimal at this point.  FOX is a great platform for the product, but with only four contracted events on Primetime, the product does not have enough frequency to make a meaningful impact up to now and in fact, each event has produced less viewership since it’s debut (UFC on FOX 1: 5.7M, UFC on FOX 2: 4.7M, UFC on FOX 3: 2.4M).  FX has placed UFC content on Friday nights, which is one of the lowest rated nights in TV for the M18-34 demo.  The real winner has been Fuel TV, who has increased their ratings and households since the deal was announced, but is still one of the lowest rated ad supported networks in cable TV and is only in 36.2M homes.

In terms of competitors, Zuffa owns the MMA market domestically and worldwide if they chose to go to that market.  The key factor we will be observing and analyzing in 2013 is what type of effect Spike TV and Bellator will have on the market space.  Spike TV has been itching to get back to televising live MMA fights since UFC left the network and signed with FOX.  Spike has shown signs that they will be heavily investing in MMA (Bellator) and Pro Wrestling (TNA) starting in late 2012 as they prepare for a big 2013. Mentioned plans include cross promotion and fighter tie ins with both brands, as they have done before with Bellator champions on TNA events and Spike TV exclusive programming such as the Video Game Awards, and reality TV.

Media groups believe MMA still has potential, but at this point, it makes more sense for these media groups to either own or sign a very intimate contract with a promotion rather than having a licensing fee agreement for MMA programming such as networks have done in the past. Is more mainstream MMA content what we need for ratings and PPV buys to kick back up again or will it just add to the ever-growing free MMA content readily accessible from various TV and media channels? Will an adverse effect shift UFC’s business core to be more TV dependent in the next few years? Can you really sustain a PPV core model in the long run? These questions will continue to be asked as the FOX and Spike TV deals run their course.

It’s not realistic to expect that the UFC will outdo itself year-after-year, but it will be interesting to see how it can push itself off a potential stagnant stage and onto that next level as they have shown in the past with the Spike TV deal (TUF), the acquisition of PRIDE/WFA/WEC, and now signing the major FOX TV deal.  Focusing on stable revenue streams such as the FOX TV deal and international expansion (Brazil, Australia, South Africa, Asia, and India) are great ways to alleviate a stagnant domestic market and a great way to diversify your product’s fanbase.

MMAPAYOUT THOUGHTS:

– Zuffa has significantly drained their revolver, which makes you wonder what kind of burn rate/overhead they have.

-The other interesting tidbit is Zuffa’s dividend distribution policy. On one hand, some people think its smart/prudent to protect your gains/investment. On the other hand, some people say if you really believe in this company long term and its a business your going to keep, why would you cash out all the money instead of putting it back into the company.