S&P: Innovation Ventures LLC 'B+' Rating Affirmed On Proposed Refinancing; Outlook Stable; New Debt Rated
At the same time, we assigned our 'BB' issue-level rating and '1' recovery rating to Innovation Ventures' proposed $75 million revolving credit facility due in 2021 and $400 million term loan due in 2021. The recovery rating is '1', indicating the prospect for very high recovery (90%-100%) of principal in the event of a payment default.
We will withdraw the ratings on the company's senior secured notes due in 2019 after the transaction closes and the notes have been fully repaid. We also have withdrawn the ratings on the proposed $525 million secured credit facilities and the $400 million senior unsecured notes from the cancelled August 2016 transaction.
We estimate that the company's pro forma reported debt will be $400 million when the transaction closes.
The rating affirmation reflects our view that, similar to the transaction the company contemplated in August, the proposed secured credit facilities provide clarity on financial policy and how the company will allocate its cash flows between owner distributions and future debt repayment. The transaction includes $475 million of new committed debt and pays a cash dividend of $24 million to shareholders. The new bank facilities include maintenance financial covenants, large mandatory debt amortization payments, and incurrence-based leverage tests before permitting additional shareholder returns. As a result, we estimate on an adjusted basis that Innovation Ventures' leverage will be about 1.4x at transaction close, compared to about 1.2x for the 12 months ended June 30, 2016. We also believe the company will meet its term-loan amortization requirements because of continued good cash flow generation, underpinned by our belief that the company's sales will continue to modestly grow, resulting in leverage declining closer to 1x over the next 18 months. Because we can now quantify the future dividend levels, which we believe will total about $250 million in the first year, there is more visibility around the timing and amount of dividends to the company's owners than before. That reflects the company's ability under its proposed bank facility agreements to pay dividends totaling 100% of net income provided that it maintains $50 million in liquidity.
Although this transaction is strictly a refinancing of debt at slightly lower leverage levels than the recently proposed transaction to sell Innovation Ventures to Renew Group Private Ltd., we believe the possibility of a future transaction either for its founder to exit or to provide a growth platform outside of the U. S. remains a possibility. Therefore, we believe the event risk associated with any future transaction constrains the current ratings from being higher than otherwise suggested by its business strength, financial strength, and still-weak governance.
Our corporate credit rating on Innovation Ventures also reflects the company's narrow product line and reliance on a single brand, the ongoing risk of legal actions, negative publicity related to its products, and a lack of governance controls. The company is a single-product business within a niche category in the U. S. Its 5-hour Energy product contributes substantially all of its revenues within the U. S. In our opinion, the product still faces the risk, albeit declining, of unfavorable actions by federal and local regulators, including the potential for product bans in certain local markets. Moreover, consumer perception and demand for 5-hour Energy could be harmed by criticism from some health-care professionals and unfavorable publicity alleging health risks related to use of the product. Although we believe the high margins could attract competition from established beverage companies, we believe these competitive threats have made little progress against 5-hour Energy, which enjoys a more than 90% share of the niche U. S. energy shot market and favorable product display at checkout counters.
Our base-case assumptions for Innovation Ventures reflect the following:U. S. real GDP growth in the low-single-digit percentages in 2016 and 2017. Slightly positive sales growth in 2016 and 2017--similar to the rate of economic growth--because of mature market demand. There are no meaningfully unfavorable regulatory developments, including significant restrictions on the sale and marketing of energy shots, or substantial unfavorable media coverage related to the product's possible impact on consumers' health. Slight EBITDA decline in 2016 because of higher new product development or legal expenses, compared to 2015 and then remaining flat annually thereafter. Free cash flow of about $260 million annually after annual maintenance capital expenditures of about $5 million. Sizeable required annual term loan amortization of $40 million. Dividends of about $250 million in fiscal-year 2017 and negligible discounted cash flow (DCF) of about $6 million. No material acquisitions. Based on these assumptions, we expect the company to maintain leverage below 2x and funds from operations (FFO) to debt of at least 50% in 2016 and 2017, the strength of which we discount in our financial assessment because its projected DCF to debt ratio of well below 20% over the next 12 months is much weaker.
We believe Innovation Ventures has adequate liquidity. We forecast that the company's liquidity sources will exceed uses by 1.6x over the next year, and that its liquidity sources will cover uses, even if forecast EBITDA declines by 30%. Although we typically view this liquidity coverage to be strong, we don't believe overall liquidity is strong because the company doesn't have a strong standing in the credit markets. There are no public bonds or other data to assess this standing. We also don't believe the company could absorb high-impact, low-probability events with limited need for refinancing, such as a product recall that leads to significant reputational damage. Furthermore, we don't consider its banking relations as particularly strong, given the proposed maintenance covenants and higher than customary annual amortization requirements on the secured facilities. There are no contractual debt maturities until 2021 when the proposed secured credit facilities mature. We assess financial risk management as generally prudent, given its good free cash flow generation and absence of near-term debt maturities.
Principal liquidity sources:Total cash and short-term investments of about $68 million expected at transaction close. Projected annual FFO of about $270 million. Full availability of Innovation's proposed $75 million revolver due in 2021.Principal liquidity uses:$24 million of proposed discretionary dividends paid at transaction close. Shareholder distributions for taxes of about $90 million annually. Based on our profit forecast, we estimate tax-related distributions of about $30 million annually. Capital expenditures of about $5 million annually. Sizeable annual amortization of $40 million until fiscal 2019, when annual amortization increases to $60 million through maturity. Other credit considerationWe lowered our 'bb' anchor two notches, based on our weak assessment for management and governance. Although the proposed governance framework includes establishing a board of advisers, this board would serve only in an advisory capacity and we continue to believe that substantially all management and governance decisions rest with the CEO.
The stable outlook reflects our view that the company's sales volume will steadily grow while its EBITDA margins remain relatively flat. This should permit the company to generate good cash flows while it funds shareholder returns and repays debt of at least $40 million resulting in debt to EBITDA well below 2x over the next year.
We could lower the rating if unfavorable regulatory or legal scrutiny, or unfavorable media coverage of the 5-Hour Energy product lead to significant double-digit volume declines pressuring the company cash flows. Such a development could cause Innovation Ventures to lose significant market share, weaken its debt to EBITDA to more than 2x, and result in a downgrade. We estimate EBITDA would need to decline by more than 40% for this to occur.
We believe a higher rating is unlikely without a more favorable assessment of the company's management and governance. Our management and governance assessments could improve if Innovation Ventures establishes a board with several independent directors and with relatively equitable voting power to the CEO.