Fitch Affirms WildBrain's IDR at 'B+'; Outlook Negative

(The following statement was released by the rating agency) Fitch Ratings-New York-29 October 2020: Fitch Ratings has affirmed WildBrain, Ltd.'s Long-Term Issuer Default Rating (IDR) at 'B+'. Fitch has also affirmed the 'BB+'/'RR1' ratings on WildBrain's senior secured debt. The Rating Outlook remains Negative. The affirmation reflects Fitch's expectation for WildBrain to resume deleveraging toward Fitch's negative sensitivity as near-term coronavirus-related headwinds subside. Prior to the onset of the pandemic, WildBrain had been focusing on reducing leverage through a combination of debt repayment and EBITDA improvement. Debt had peaked at CAD1.109 billion as of June 30, 2017 following the debt-funded acquisition of an 80% interest in the 'Peanuts' brand (20% continues to be owned by members of the Charles Schulz family who maintain final strategic input) and 100% of the 'Strawberry Shortcake' brand for CAD466 million, or 12x EBITDA. Soon after completing the acquisition, weak operating performance caused by operational headwinds led to a strategic review that resulted in significant structural, operational and senior management actions with a focus on reducing debt. The primary outcome of the strategic review involved the sale of 49% of WildBrain's 80% interest in the 'Peanuts' brand to Sony Music Entertainment (Japan) Inc. (Sony) for CAD236 million, or 14x the company's interest in 'Peanuts', with CAD214 million of net proceeds repaying debt. Fitch notes WildBrain continues to maintain management control over the 'Peanuts' brand. Additional outcomes included eliminating the annual dividend (CAD10 million savings), reducing annual operational costs by approximately CAD11 million, voluntarily delisting from NASDAQ and signing a new marketing agreement in China and Asia. The company also replaced several senior executives including the CEO and CFO and added five independent board members. The new CEO completed a CAD60 million rights offering and sold a building in Toronto, with net proceeds of both used to repay debt, and completed a reorganization that reduced annual operating costs by an additional CAD10 million. The actions discussed above, combined with a reduced reliance on interim production facilities (IPF) and other operating improvements, allowed WildBrain to reduce debt by CAD499 million to CAD610 million at June 30, 2020 from CAD1.109 billion at June 30, 2017, or a 45% reduction. The combination of nominal debt reduction and EBITDA improvement drove a decline in Fitch-calculated Total Debt with Equity Credit/Operating EBITDA to 6.6x at Dec. 31, 2019, from a peak of 9.3x at June 2018, running ahead of Fitch's prior expectations. However, the combination of the coronavirus pandemic and changes in YouTube's advertising algorithm methodology increased leverage to 7.5x at June 30, 2020. Fitch notes this is only slightly ahead of its previous expectations of 7.0x at June 30, 2020. Fitch has adjusted its leverage calculations to account for the treatment of leases as required under IFRS 16. While the accounting change did not directly impact WildBrain's cash flow profile, it increased Fitch-calculated leverage at June 30, 2020 to 9.2x, from 7.5x if it were calculated as it was prior to the lease treatment change. Accordingly, Fitch has revised the sensitivities to be more consistent with Fitch's new treatment of operating leases, placing greater emphasis on cash flow-based metrics. Fitch will revisit the rating over the next 12 months to assess management's deleveraging progress in the context of the existing rating and outlook. Key Rating Drivers Coronavirus Impact: The coronavirus pandemic has had a targeted, but material, impact on WildBrain's operating performance. The pandemic primarily impacted the WildBrain Spark and Consumer Products segments. The pandemic's impact on the overall advertising market, coupled with recent changes to YouTube's Made for Kids advertising policies resulted in a 10% revenue decline in fiscal 2020. WildBrain's consumer products segment declined 4% in 2020, as widespread restrictions on movement and commerce limited consumer discretionary spending. WildBrain had minimal business continuity interruptions as the company successfully transitioned its content production capabilities to a remote work environment. Excluding the impact of IFRS 16 and the 'Peanuts'-related minority interest distributions, fiscal 2020 EBITDA only declined CAD4.5 million, or 6%. Fitch expects WildBrain to return to revenue and EBITDA growth as economic conditions normalize, driven by increasing value for children's programming and expanding viewership via AVOD and SVOD platforms. Significant Debt Repayment: WildBrain has reduced debt from a peak of CAD1.109 billion at June 30, 2017 to CAD610 million at June 30, 2020. Reductions in debt have been primarily financed by non-core asset sale net proceeds and free cash flow. Although leverage as previously defined declined to 7.3x at June 30, 2020 from a peak of 9.3x at June 30, 2018, it remains elevated above Fitch's prior 6.0x negative leverage sensitivity. Although term loan prepayments have eliminated required amortization through maturity, the company has publicly committed to using FCF to continue further debt prepayments. Vertically Integrated Platform: WildBrain develops and creates content for itself and others, delivering between 175 to 225 half hours annually to more than 500 global broadcasters and streaming services. This fresh content expands the world's largest independent children's programming library, with more than 13,000 half hours of children's programming. The company distributes programming globally to linear and digital video outlets, including WildBrain, the largest proprietary network of children's content on YouTube, and four pay-TV Canadian channels. 'WildBrain' grew total watch time by a 112% five-year CAGR through 2018. It also provides licensing and merchandising for intellectual property (IP) it both owns and represents. Strong Defensible Brand Recognition: WildBrain owns some of the industry's most iconic children's programming brands representing unique IP with global exposure that is virtually impossible to recreate. Brands include 'Strawberry Shortcake', 'Caillou', 'Yo Gabba Gabba!', and 'Inspector Gadget'. WildBrain also holds a 41% interest in 'Peanuts', the world's sixth largest character brand. WildBrain's vertically integrated platform provides diversification across a broad product and content offering, expansive geographic reach and deep customer base. Children's Programming Growth: WildBrain is well-positioned to capitalize on continued growth in spending on children's programming by linear and digital platforms. Spending on children's/family programming by U.S. linear cable networks grew at a 7.9% four-year CAGR through 2016, exceeding overall total content growth of 6.3%. Over-the-top (OTT) networks have also made significant children's programming investments as part of their destination branding efforts; the company has relationships with several, including Netflix (NASDAQ:NFLX) and Apple (NASDAQ:AAPL) TV+. Finally, children are increasingly directly accessing content on the internet with YouTube becoming a centralized destination for online children's viewing. Content Production Costs: Many competitors have deeper funding access as they are part of larger better-capitalized conglomerates. However, while WildBrain has increased content production to refresh and expand its library, the company aims to cover 85% of hard production costs with government tax credits, only available to Canadian content producers, and licensing contract receivables. To account for cash variances, the company uses IPFs to fund shortfalls until the tax credits are collected and the IPF is repaid as required. IPF's are nonrecourse subordinated loans made to special purpose vehicles (SPVs) specifically created for each show's season and are secured by tax credits associated with the season. WildBrain has reduced its overall reliance on IPFs, which has further reduced debt. As of June 30, 2020, the company had CAD66.7 million of IPFs, secured by CAD81.6 million of licensing contract and tax credit receivables, which Fitch includes in its leverage calculations. This compares to the company's historical IPF levels that have ranged from approximately CAD90 million to CAD110 million. Leverage Exceeds Sensitivities: Fitch-defined total leverage, calculated as Total Debt with Equity Credit/Operating EBITDA, at June 30, 2020 was 9.2x, which represents an increase from pro forma leverage of 7.5x as of June 30, 2019. However, Fitch notes the increase is primarily attributable to Fitch's revised treatment of leases under IFRS 16 and that Fitch-calculated leverage excluding the lease change is 7.5x, only slightly ahead of Fitch's previous expectations of 7.0x at June 30, 2020. Regardless, Fitch has revised the rating sensitivities to reflect the impact of the accounting change on Fitch-calculated credit protection metrics, adding additional cash flow-based metrics. Derivation Summary WildBrain is weakly positioned against major global peers on most comparatives given its relative lack of scale and elevated leverage. Many of its competitors have deeper access to production funding as part of larger, better capitalized diversified conglomerates. However, the company benefits from its broad collection of iconic global brands, diverse revenue sources and customer base, strong industry position within its business segments and vertically integrated platform. In addition, as a Canadian company, WildBrain uses access to Canadian incentive programs and tax credits to fund a significant portion of their content production costs. Fitch believes the company is well positioned overall to continue exploiting the ongoing positive growth characteristics of the children's programming subsector. No country-ceiling or parent/subsidiary aspects impact the rating. Key Assumptions Fitch's Key Assumptions Within Our Rating Case for the Issuer - Fitch assumes flat revenue growth in fiscal year 2021, as a recovery in digital advertising and growth from new distribution deals is offset by continued weakness in broadcasting revenue and consumer products sales. - Beyond fiscal 2021, Fitch assumes mid- to high-single digit revenue growth driven by: 1) high single digit growth in Distribution driven by focus on continued growth at WildBrain Spark; 2) owned IP Consumer Products benefitting from Sony's ownership interest in 'Peanuts'; 3) mid-single digit Production increase driven by strategic focus on premium content production for internal and external use; 4) mid-single digit declines in Broadcasting as overall softness in Cable Networks more than offsets the increased commercial load. - Margin improvement driven by cost cutting efforts and increased economies of scale. - Mid-to-high single digit FCF margins supported by a stable EBITDA margin profile and limited capital investment requirements. Fitch assumes a significant portion of FCF will be used for additional debt repayment, in line with management's strategic review and public comment - No new M&A over the rating horizon. - Fitch assumes debt is refinanced at maturities KEY RECOVERY RATING ASSUMPTIONS The recovery analysis assumes that WildBrain would be considered a going concern in bankruptcy and that the company would be reorganized rather than liquidated. Fitch has assumed a 10% administrative claim. Fitch's recovery analysis estimates a going concern enterprise value for a reorganized firm of approximately CAD504 million. Fitch assumes a mid-single-digit decline in revenues driven by the loss of a major OTT contract and a decline in consumer product sales driven by a recession. Fitch also assumes the company is unable to reduce costs fast enough leading to a 150bp margin decline to 21%. As such, EBITDA after minority interests declines to CAD63million. Fitch assumes WildBrain will receive a going concern multiple of 8x EBITDA and considered several factors. WildBrain owns some of the industry's most iconic children's programing brands representing unique intellectual property with global exposure that is virtually impossible to recreate. Brands include 'Strawberry Shortcake', 'Caillou', 'Yo Gabba Gabba!', and 'Inspector Gadget'. WildBrain also has a 41% interest in 'Peanuts', the world's sixth largest character brand. Fitch notes the company initially purchased an 80% interest in 'Peanuts' at an 11x multiple in 2017 and sold 49% of its interest in 'Peanuts' to Sony for 14x in 2018. Content creators have been acquired at lofty multiples, especially if their IP is difficult to recreate. Children's programming creators are especially valuable as spending on children's/family programming by U.S. linear cable networks grew at a 7.9% four-year CAGR through 2016, exceeding overall total content growth of 6.3%. In addition, OTT networks have made significant investments in children's programming as part of their destination branding efforts. Content acquisition examples include several by The Walt Disney Company (NYSE:DIS): 1) Pixar for USD7.4 billion (23x Fitch-calculated EBITDA) in 2006; 2) Marvel Entertainment, Inc. for USD4 billion (high teens market multiple estimates) in 2009; 3) Lucasfilm Limited for USD4.1 billion (low teens estimates) in 2012 and; 4) certain Twenty-First Century Fox assets, primarily content creation, for USD85 billion (low teens estimates) in 2018. Comcast (NASDAQ:CMCSA) acquired DreamWorks Animation SKG, Inc. for USD4.1 billion (mid-twenties estimates) in 2016 (the NBCUniversal acquisition is excluded as it included broadcast and cable channels and the NBC network along with Universal Studios' content creation arm). Finally, we include the two recent 'Peanuts' brand acquisitions: WildBrain's initial acquisition of an 80% interest for USD345 million (12x) in 2017 and Sony's acquisition of 49% of WildBrain's 80% ownership for USD185 million (14x) in 2018. The 8x multiple also incorporates the fact that children are increasingly directly accessing content on the internet with YouTube becoming a centralized destination for online children's programming viewing. To that end, 'WildBrain', the company's digital network and studio, is one of YouTube's largest children's programming networks and grew total watch time by a 112% five-year CAGR through 2018. Fitch assumes a fully drawn revolving credit facility (CAD40 million) in its recovery analysis since credit revolvers are tapped as companies are under distress. As of June 30, 2020, the company had $10 million outstanding borrowings under its revolving facility, CAD377 million in secured term loan debt, CAD140 million of unsecured debentures and CAD16.6 million of exchangeable debentures. Fitch excludes WildBrain's IPFs (CAD67 million) from the recovery analysis as they are secured by assets directly related to specific programming content. IPFs are nonrecourse subordinated loans made to SPVs specifically created for each show's season that are used to fund content creation cash shortfalls until associated tax credits are collected and the IPF is repaid as required. Each IPF is secured by assets associated with that particular season including Canadian federal and provincial tax credits and licensing contract receivables covering approximately 85% of WildBrain's content creation cash outlays, along with any restricted cash held in the SPV. The recovery analysis results in a 'BB+' and 'RR1' issue and recovery rating for the company's secured credit facilities, implying expectations for 100% recovery. Fitch does not rate the IPFs or the unsecured debentures. RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: --(Cash Flow from Operations-Capex)/Total Debt sustained near or above 7.5%; --The Negative Outlook could be stabilized if the company demonstrates significant progress in moving Fitch-calculated total leverage (Total Debt with Equity Credit/Operating EBITDA) towards 6.0x; --Favorable sector tailwinds leading to strong revenue growth and EBITDA and FCF expansion as the Company benefits from economies of scale. Factors that could, individually or collectively, lead to negative rating action/downgrade: --(Cash Flow from Operations-Capex)/Total Debt below 5%; --Fitch-calculated total leverage not moving towards 6.0x over the next 12 months; --Sustained weakness of the operating profile, particularly within the WildBrain Spark segment, evidence by continued revenue declines and limited margin expansion. Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure Adequate Liquidity: As of June 30, 2020, the company had CAD48 million of cash and CAD30 million of capacity under its CAD41 million (USD30 million) revolver. Since acquiring Peanuts in 2017, the company has prepaid CAD500 million of debt, reducing interest payments and eliminating required term loan amortization through maturity. The lower interest payments, coupled with low capex requirements of less than 2.0% of revenues and the elimination of the dividend, generates improved FCF conversion metrics. Fitch believes the company will generate enough cash over the ratings case to cover internal operating and investment needs and repay additional debt. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg. WildBrain Ltd.; Long Term Issuer Default Rating; Affirmed; B+; Rating Outlook Negative ----senior secured; Long Term Rating; Affirmed; BB+ Contacts: Primary Rating Analyst Jack Kranefuss, Senior Director +1 212 908 0791 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Rating Analyst Zachary Getelman, Senior Analyst +1 646 582 4616 Committee Chairperson David Peterson, Senior Director +1 312 368 3177 Media Relations: Elizabeth Fogerty, New York, Tel: +1 212 908 0526, Email: elizabeth.fogerty@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Criteria Corporate Hybrids Treatment and Notching Criteria (pub. 11 Nov 2019) (https://www.fitchratings.com/site/re/10100477) Corporate Rating Criteria (pub. 01 May 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10120170) Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10090792) Applicable Model Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s). 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