DBRS Confirms Cogeco Communications Inc. Ratings Post–MetroCast Acquisition Announcement

DBRS Limited (DBRS) has today confirmed Cogeco Communications Inc.’s (Cogeco or the Company) Issuer Rating at BB (high), Senior Secured Notes & Debentures rating at BBB (low) with a Recovery Rating of RR1 and Senior Unsecured Notes rating at BB with a Recovery Rating of RR5. All trends are Stable. The confirmation follows Cogeco’s announcement that its subsidiary, Atlantic Broadband (ABB), has entered into a definitive agreement with Harron Communications, L.P. to purchase the remaining assets of the cable systems operating under the MetroCast Cablevision (MetroCast) brand name (the Acquisition) that it did not already own.

The transaction is valued at USD 1.4 billion and is expected to be financed through a combination of (1) committed secured debt at ABB, which is non-recourse to Cogeco, and (2) a USD 315 million equity investment by Caisse de dépôt et placement du Québec (rated AAA with a Stable trend by DBRS) for a 21% interest in ABB’s holding company. Cogeco forecasts that MetroCast’s calendar-year 2017 EBITDA will be USD 121 million ($158 million). The transaction is expected to close in January 2018.

In December 2016, DBRS confirmed Cogeco’s Issuer Rating at BB (high) with a Stable trend. The Issuer Rating is predicated on Cogeco’s consolidated indebtedness and reflects the probability of default within the consolidated entity. At that time, DBRS noted that it could accept financial leverage of up to 3.5 times (x) as a result of a debt-financed acquisition(s), if coupled with a credible deleveraging plan. DBRS is confirming Cogeco’s ratings despite the fact that the Company’s consolidated gross debt-to-EBITDA will increase to ~3.75x at the time of close. Today’s rating action is based on several factors, including (1) the attractiveness of the acquisition target, which provides a highly complementary operating footprint and material revenue growth potential; (2) a relatively low level of integration risk given it is an asset purchase and ABB is familiar with MetroCast’s network and back-office operations after having acquired its Connecticut cable system in 2015; (3) an acceptable transaction valuation, the attractiveness of which is enhanced by the present value of tax benefits created by the Acquisition; and (4) management’s intention to use free cash flow (FCF) to aggressively reduce leverage post–transaction close.

In its analysis, DBRS focused on (1) the business risk profile of the combined entity, including the benefits and risks associated with integration and realization of operating synergies; (2) the financial risk profile, including assessing the cash-generating capacity of the combined entity; and (3) the Company’s longer-term business strategy and financial management intentions.

DBRS ANALYSIS

(1) Business Risk
DBRS believes that the Acquisition’s primary benefit to Cogeco’s business risk profile is the material enhancement of its scale and geographic revenue diversification in the U.S. market and future growth potential. MetroCast is the incumbent provider of video, Internet and telephony services in five states: New Hampshire, Maine, Pennsylvania, Maryland and Virginia. Pro forma the Acquisition, ABB will increase its geographic footprint from eight states to 11. Further, the Acquisition will increase ABB’s primary service units (PSUs) by ~230,000, increasing ABB’s total PSUs to an estimated 835,000, of which 95% of MetroCast’s homes passed feature 860 megahertz or fibre-to-the-home digital connectivity. The fragmented communications landscape in MetroCast’s operating footprint is a competitive advantage. ABB faces minimal wireline triple-play competition and should be able to offer Internet data speeds that are similar to or faster than other communication providers.

That said, industry headwinds persist for Cogeco (and the cable industry) as the competitive environment intensifies. Cogeco competes with numerous (and, in some cases, much larger) players for telephony, broadband and, more recently, video in the form of Internet protocol television (IPTV) services. Cogeco, along with other cable operators, may continue to lose market share to IPTV providers in the future, given IPTV’s competitive speeds and integration capabilities. While Cogeco’s feature-rich TiVo digital video platform may mitigate this pressure somewhat, broader trends of cord shaving and, to a lesser extent, cord cutting in favour of over-the-top services pose mounting challenges as more consumers view content through broadband connections rather than through cable television.

Overall, DBRS believes the Acquisition is a net positive for Cogeco’s business risk profile because of (1) the addition of adjacent markets without operating overlap, (2) common network technology that should allow capital intensity to remain below ABB’s current rate, (3) familiarity with back-office and financial controls that should facilitate integration and (4) a demographic profile that should provide significant opportunity to drive revenue growth through bundled plans, the launch of additional features (TiVo), access to higher Internet speeds, increased data packages and an enhanced commercial product platform.

For the year ending December 31, 2017, MetroCast is expected to generate revenue of USD 230 million ($304 million) and EBITDA of USD 121 million ($158 million). On a pro forma consolidated basis, Cogeco’s revenue and EBITDA for the year ending December 31, 2017, are expected to be approximately $2,500 million to $2,600 million and $1,100 million to $1,200 million, respectively. ABB will represent approximately 36% of Cogeco’s consolidated pro forma revenue, up from ~26% prior to the Acquisition.

(2) Financial Risk Profile
In terms of financial profile, the Acquisition is expected to result in an increase in Cogeco’s consolidated debt balance to approximately $4.31 billion at close, up from $2.72 billion as at Q2 F2017 (ended February 28, 2017). Pro forma gross debt-to-EBITDA is expected to peak at roughly 3.75x at the time of close compared with 2.88x for the 12-month period ended February 28, 2017. EBITDA coverage is forecast to decrease to ~6.5x at close compared with 7.46x for the 12-month period ended February 28, 2017.

Post-close, DBRS forecasts that FCF after capital expenditures (capex) and dividends and before changes in working capital as a percent of debt will be at a reasonably sound level at just below 10%, despite the increase in debt. The Company intends to deleverage toward 3.0x within 18 months of the close primarily by applying the majority of FCF (after dividend payments) to debt repayment.

(3) Business Strategy and Financial Management Intentions
The positive impact of the Acquisition on the business risk profile reflects the added scale and revenue growth potential in the ABB services division. While the overall U.S. cable market is highly competitive, the non-metropolitan markets in which ABB operates feature a more fragmented competitive environment and an attractive demographic profile.

ABB plans to leverage the acquired assets to drive revenue growth rather than reduce operating expenses in an effort to gain margin expansion. DBRS believes that ABB’s experience in integrating and growing MetroCast’s Connecticut assets over the last 15 months should largely mitigate integration and operational risks. DBRS estimates that Cogeco could generate up to $1,300 million in annual consolidated EBITDA within three years post-close of the Acquisition if the Company is effective at integrating and launching ABB bundled products, rolling out new video features (such as TiVo), accelerating enterprise customer growth and enhancing Internet speeds and WiFi access in a timely manner.

DBRS believes that Cogeco has the ability and willingness to deleverage after the close of the Acquisition. DBRS estimates Cogeco will generate almost $1,000 million of consolidated cash flow from operations per annum over the next couple of years. With higher capex spending and a modest dividend increase over the next few years, DBRS estimates that pro forma annual FCF after capex and dividends and before changes in working capital should be $325 million to $350 million, of which $120 million to $140 million is expected to be generated by ABB. This magnitude of consolidated FCF (if sufficiently applied to debt reduction) combined with modest EBITDA growth should result in the Company achieving its 18-month deleveraging target. In terms of willingness, Cogeco has completed four acquisitions over the last ten years and has a history of effective leverage reduction after each of these transactions.

DBRS’s confirmation of the Issuer Rating reflects its view that financial deleveraging toward 3.0x over the 18 months following the close of the transaction is reasonable in both magnitude and time frame for the BB (high) rating category. Should Cogeco’s gross debt-to-EBITDA not trend toward 3.0x over the 18-month deleveraging period, a negative rating action could result.

The Recovery Rating remains RR1 for Cogeco’s Senior Secured Notes & Debentures. While DBRS examines recovery scenarios through an enterprise-valuation approach, because ABB’s debt is non-recourse to Cogeco, the Recovery Rating on Cogeco’s senior debt is based only on a valuation of its Canadian operations. Therefore, the increase in debt at ABB as a result of the Acquisition does not affect the Recovery Rating of Cogeco’s debt. In accordance with “DBRS Criteria: Recovery Ratings for Non-Investment Grade Corporate Issuers,” DBRS has confirmed the security rating of BBB (low) with a Recovery Rating of RR1 for Cogeco’s Senior Secured Notes & Debentures, which is one notch above the Company’s Issuer Rating of BB (high). DBRS has also concluded that the holders of the Senior Unsecured Notes could likely recover 10% to 30% of their value in a default scenario, a level that corresponds with a Recovery Rating of RR5. In accordance with the above, DBRS has confirmed the security rating of BB for Cogeco’s Senior Unsecured Notes, which is one notch below the Company’s Issuer Rating of BB (high).

Cogeco’s ratings continued to be supported by its established footprint in existing markets and the growth potential and diversification of the U.S. cable segment, which DBRS believes is enhanced by the Acquisition. The ratings also continue to consider intensifying competition, consumer cord cutting and/or shaving trends, the Company’s lack of a wireless offering and risks associated with technological and regulatory changes.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The principal methodologies are Rating Companies in the Communications Industry and DBRS Criteria: Recovery Ratings for Non-Investment Grade Corporate Issuers, which can be found on dbrs.com under Methodologies.

This rating is no longer endorsed by DBRS Ratings Limited for use in the European Union.

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.