S&P Affirms Playboy Ratings

The ratings agency says the adult-entertainment outfit's planned stock sale will improve debt leverage ratios -- and cash flow

On March 9, 2004, Standard & Poor's Ratings Services affirmed its ratings on Playboy Enterprises (PLA ), including the 'B' corporate credit rating. The rating outlook is stable.

Total debt outstanding on Sept. 30, 2003, was $156 million, including $41 million in Califa Entertainment Group Inc. and Playboy TV International LLC acquisition liabilities (payable in cash and stock), but excluding $16.7 million in Series A preferred stock owned by company founder Hugh Hefner. The company has not released its balance sheet information for 2003.

Playboy plans to issue 3.2 million shares in Class B common stock in the second quarter of 2004. Proceeds will be used to buy back a portion of outstanding secured notes. In conjunction, Hefner will convert his $16.7 million in Series A preferred stock into Class B common stock, eliminating all preferred securities from Playboy's balance sheet.

These two transactions, when completed, will improve interest coverage and debt leverage ratios as well as cash flow. Upon completion of the two transactions, Standard & Poor's expects to revise its rating outlook to positive from stable, reflecting the improvement in credit measures and the additional financial flexibility.

The rating on Chicago, Ill.-based Playboy reflects the niche audience for paid adult content, the company's relatively smaller cable TV distribution compared to top 10 broadcast networks, the abundance of free adult materials online, and high financial risk. These factors are only partly offset by the company's significant presence in the non-cyclical adult entertainment industry, strong brand recognition, and good satellite direct-to-home (DTH) TV coverage.

Founded in 1953, Playboy is a major creator and distributor of adult programming. The company invests heavily in original programming and has exclusive licensing arrangements with adult-oriented, independent production studios to supplement its proprietary content.

Playboy's programming is distributed through cable/DTH TV, print publications, Internet, and home video. The company's multiple domestic TV networks are carried by all major cable multiple system operators and DTH providers. The main distinctions between Playboy and other TV networks are distribution, pay-per-view (PPV) revenue, and programming. PPV accounts for the majority of Playboy's TV network revenue as the company's channels are usually not available on a subscription basis, except on DirecTV. As a result, the company relies on individual paid viewing and does not have the same quality of recurring revenue stream as other cable network providers.

Playboy magazine remains the best-selling men's monthly magazine. In 2003, the magazine was able to stem the decline in advertisers and newsstand sales. However, these developments could be the one-time benefit from Playboy's 50th Anniversary issue in the second half of 2003 and the marketing buzz surrounding the event. The sustainability of these improvements is not assured.

The company's online group consists of the Playboy and Spice branded websites, which generate revenues mainly through subscriptions, product sales, and e-commerce. The company continues to gain and retain subscribers, partially through the introduction of new online clubs. The probability of a near-term return to operating losses is low; nevertheless the track record of positive EBITDA for this segment is still very short.

Although sales are generated from several revenue streams, the company exhibits significant cash flow concentration. Playboy's pay TV networks contribute over 40% of consolidated revenue, but more importantly, the vast majority of the company's free cash flow. Print publications generate a similar percentage of overall revenue but their cash flow contribution is minimal, reflecting both a high-cost structure and the general competitiveness of the magazine industry.

Playboy's online group was in investment mode over the past several years. Since the fourth quarter of 2002, the online group has become profitable and cash flow positive due to a combination of rate increases, subscriber growth, and the addition of new online clubs. This is a significant turn- around. However, given the competition from free online content, the online group may not be a major contributor to cash flow for some time.

For the 12 months ended December 31, 2003, Playboy's earnings before interest, taxes, depreciation,andamortization (EBITDA) margin was 11%, compared with 9.5% a year ago. For the same period, EBITDA coverage of interest rose to 2.1 times from 1.8 times, pro forma for the debt issuance in March 2003. Total debt to EBITDA was about 4.5 times at September 30, 2003 (balance sheet data for December 31, 2003, is not yet available), from 6.2 times at December 31, 2002. The completion of the two proposed transactions will further enhance interest coverage and total debt leverage ratios. The company converted about 44% of EBITDA to discretionary cash flow off a small EBITDA base.

Liquidity: Playboy has sufficient near-term liquidity with full availability under its $20 million revolving credit facility and about $31 million in cash on the balance sheet. Furthermore, the company was able to generate positive discretionary cash flow over the past two years. Capital expenditure requirements are low -- between $4 million and $5 million per year--and should not hamper discretionary cash flow generation. A return to discretionary cash flow deficits, especially in the context of the company's small EBITDA base, could quickly strain liquidity. Remaining 2004 maturities are moderate at $7 million but could be met with existing cash balances.

Outlook: The rating outlook is stable. While the company's operating performance improved in 2003, some of the improvement could be attributed to the Playboy's 50th Anniversary, a special one-time event, and to sales of art and memorabilia. The sustainability of this level of earnings is uncertain. Furthermore, the company's relatively small EBITDA base means that credit measures are more sensitive to fluctuations in its business environment.

The equity issuance and the conversion of Series A preferred stock to common stock would increase Playboy's financial flexibility. Therefore, upon completion of the two transactions, Standard & Poor's expects to revise its rating outlook to positive from stable.

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