DBRS Assigns Golf Town/Golfsmith Issuer Rating of B (high) and Provisional Notes Rating of B (low)

DBRS has today assigned an Issuer Rating of B (high) and a provisional rating of B (low), both with Stable trends, on the proposed new Senior Secured Second Lien Notes to be jointly issued by Golf Town Canada Inc. (Golf Town) and Golfsmith International Holdings, Inc. (Golfsmith). The Senior Secured Second Lien Notes have a recovery rating of RR6. On May 14, 2012, Golf Town USA Holdings Inc. (Golf Town USA), Golfsmith and Major Merger Sub, Inc. (Merger Sub) (which will merge with Golfsmith, with Golfsmith continuing as surviving entity) announced that they had signed a merger agreement, pursuant to which Golf Town would acquire Golfsmith, which trades publicly on the NASDAQ, for approximately US$109 million in cash plus assumed liabilities. Combined, Golf Town and Golfsmith (the Company) benefit from well-established market positions, a differentiating store format, enhanced geographic diversification, and strong sponsorship from OMERS Administration Corporation (OMERS). The Company will be managed by OMERS Private Equity Inc., which is the entity responsible for identifying and managing the private equity investments of OMERS. The ratings also reflect the cyclical and competitive nature of the golf retail business, and risks surrounding longer-term profitability and growth.

Golf Town has grown organically since its inception in 1999, developing a very strong brand and market position with approximately 35% market share in Canada. Despite a relatively large market share, Golf Town’s earnings profile nevertheless reflects the highly discretionary product offering and cyclical nature of the business. Golf Town’s revenues have grown considerably along with the store base since being founded, rising to $384.1 million for the last twelve months ended Q1 2012. Operating margins have benefited over time from increasing operating leverage as the store base has grown, but are susceptible to economic cycles, abnormal weather, and in recent years have been affected by additional costs associated with the inaugural U.S. expansion in 2011. As a result, EBITDA peaked in 2008 and has remained relatively flat through 2011, when it declined.

Golfsmith’s earnings profile has historically benefited from its well-established market position and adequate market share (approximately 10%) in a very fragmented U.S. market. The golf retail market in the United States is considerably more competitive than in Canada, but Golfsmith has benefited from the recent rationalization of the number of golf retail stores which took place through the economic downturn. Golfsmith’s revenues reached a peak in 2007 and subsequently declined through 2009, due primarily to the economic downturn, leading negative same-store sales. Most recently, Golfsmith’s revenues have almost fully recovered, reaching US$387 million in 2011. Operating margins reflect the more competitive nature of the U.S. market and the discretionary nature of the product offering, as EBITDA margins declined from 3.9% in 2007 to 1.7% in 2010, before recovering to 3.5% in 2011. As a result, EBITDA declined from US$15.3 million in 2007 to a low of US$6.1 million in 2010, before beginning to recover to US$13.4 million in 2011.

In terms of financial profile, Golf Town and Golfsmith have historically required a combination of cash flow from operations and either external capital for Golfsmith or the use of a revolving credit facility for Golf Town to sufficiently fund capex and working capital requirements through high growth phases.

Going forward, DBRS believes the Company’s earnings profile will strengthen on a through-the-cycle basis as it begins to benefit from its newfound scale, improved geographic diversification, and sharing of best practices. Revenues are expected to increase with new store openings, and positive same-store sales growth as the economy continues to stabilize. Operating margins should benefit from increased scale and operating leverage but will remain somewhat volatile through economic cycles. DBRS therefore expects pro forma EBITDA to be in the $50 million to $55 million range in 2012, with the possibility of reaching the $70 million to $75 million range by 2015.

DBRS believes that the Company’s financial profile will improve over time subsequent to the acquisition of Golfsmith and the recapitalization of the business. The expected improvement should result from a combination of growth in earnings, positive-trending free cash flow generation, and the repayment of debt. Cash flow from operations is expected to continue to track operating income, while working capital and capex requirements are expected to be fairly stable but substantial as the Company grows in the United States. Free cash flow generation is expected to improve from a modestly negative position in 2012 toward breakeven in 2013 and then rise steadily to nearly $25 million in 2015. DBRS expects that the Company will use free cash flow to repay the asset-backed loan revolver debt in the near to medium term, which, combined with growth in EBITDA, will result in improved credit metrics (i.e., lease-adjusted debt-to-EBITDAR toward the 4.25 times (x) to 4.5x range by 2015 from the current 5.4x).

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodologies are Rating Companies in the Merchandising Industry and DBRS Criteria: Rating Leveraged Finance, which can be found on our website under Methodologies