OREANDA-NEWS. S&P Global Ratings said today that it assigned a 'B' corporate credit rating to Round Rock, Texas-based Seahawk Holdings Ltd. The outlook is stable.

We assigned our 'B' issue-level rating and '3' recovery rating to SonicWALL US HoldCo.'s $1.425 billion first-lien credit facility, consisting of a $100 million five-year revolving credit facility and a $1.350 billion six-year term loan. The '3' recovery rating indicates our expectations for meaningful (upper half of the 50%-70% range) recovery in the event of payment default.

We also assigned our 'B-' issue-level rating and '5' recovery rating to SonicWALL's $275 million seven-year second-lien term loan. The '5' recovery rating indicates our expectations for modest (lower half of the 10%-30% range) recovery in the event of payment default.

Our rating is based on Seahawk's weak EBITDA margin profile and the potential for near-term operational disruption from the separation from Dell Inc. Good product and end-market diversity, and participation in a number of rapidly growing markets partially offset these risks. Although we expect trailing-12-month leverage to be in the high 7x area at the close of this acquisition, we believe that the firm has a credible path to considerably reduce expenses and that leverage will approach 7x within 12 months of the transaction.

Following its acquisition by financial sponsors, Dell Software Group will be reorganized into three operating entities under the new Seahawk Holdings parent company — Quest Software, One Identity, and SonicWALL. They will operate on a largely standalone basis, although Quest and One Identity will share some back-office functions. Quest provides systems management software with a focus on platform migration, database productivity, and data backup and recovery, serving small and midsize businesses (SMB) and enterprise clients. One Identity provides software that enables corporate information technology (IT) departments to control and manage user access to critical systems, applications, and data. SonicWALL also serves the SMB market, providing united threat management (UTM) appliances that protect corporate networks from unauthorized access and intrusion.

Dell's software business has historically been less profitable than stand-alone software peers of comparable size and maturity, largely because of a sales and marketing organization that has grown significantly faster than revenues in recent years. We estimate that EBITDA margins for fiscal 2016 would have been around 15%, incorporating our estimate of stand-alone overhead costs and standard S&P adjustments. The company expects to reduce operating expenses by approximately $90 million over 12-24 months. While we view this magnitude of expense cuts as achievable given the firm's currently weak profitability, undertaking significant restructuring while separating and reorganizing these businesses creates significant execution risk.

We also see risk in the companies' ongoing go-to-market strategy realignment, consisting of the rationalization and realignment of software-focused standalone sales organizations at Quest and One Identity as well as rebuilding distribution channel relationships at SonicWALL. Although we believe this realignment will be supportive of a return to revenue growth, we view it as an incremental source of operational complexity and potential sales disruption over the next 12-24 months.

These risks are partially offset by good product diversity. Seahawk's portfolio addresses a wide range of corporate IT needs. The largest single product category, network security, is only 30% of total revenue. Although many of Seahawks' offerings compete in mature and slower-growing markets, IT spending on identity governance and network security is growing rapidly. We believe these businesses are capable of generating consistent mid-single-digit revenue growth if the company can successfully execute its sales realignment. We also view a low level of customer or industry vertical concentration as a credit strength, although we note that the firm derives a significant amount of revenues from SMBs.

Our assessment of Seahawk's financial risk profile is primarily based on the firm's significant debt burden and weak EBITDA margin and cash flow. Although our adjusted leverage will be over 7.5x at the transaction's close, we expect leverage to decline to the mid-6x area within 18 months as planned expense reductions enable the company to grow EBITDA margins into the high teens. Significant near-term capital expenditure on stand-alone facilities will depress free cash flow over the next 12 months. We expect Seahawk to exit fiscal-year 2018 generating approximately $100 million of free cash flow annually, reflecting increased interest expense from the new credit facilities.

Our base-case scenario assumes the following:Global software industry revenues growing in the low - to mid-single-digit percentages, broadly in line with our global GDP growth forecast of 2.3% in 2016 and 2.7% in 2017.Consolidated revenues declining by 3%-4% in fiscal 2017 from ongoing organization disruption and remaining broadly flat in fiscal 2018 as revenue declines from end of life products in Quest offset low-single-digit growth in One Identity and SonicWALL. Adjusted EBITDA margins will approach 20% within 24 months of the transaction close as the firm reduces sales and marketing expense and refocuses research and development spending. No dividends and limited acquisitions for at least 12 months. Based on these assumptions, we arrive at the following credit metrics:S&P Global Ratings' adjusted leverage of 7.5x-8.0x at transaction close, declining to the low 7x area within 12 months of transaction close. EBITDA interest coverage between 2-3x going forward. Free cash flow, after interest expense, of about $100 million in fiscal 2018, potentially growing to the $150 million area depending on the pace and extent of expense reductions.

We assess liquidity to be "adequate" with sources of cash likely exceeding uses over the next 12 months by more than 1.2x. We expect that sources of cash would still exceed uses should EBITDA decline by 15%.

Principal Liquidity Sources:A pro forma cash balance of $130 million as of transaction close.$100 million availability on the five-year revolving credit facility. Over $100 million of cash flow from operations. Principal Liquidity Uses:$13.5 million of annual amortization payments on the six-year first-lien term loan. Capex of about $50 million over the next 12 months. The outlook on Seahawk Holdings is stable, reflecting our view that the firm's diversified product portfolio will support revenue stability through its separation from Dell into three largely independent operating entities. We believe that meaningful cost-reduction opportunities will enable the consolidated entity to expand adjusted EBITDA margins to the high teens and reduce leverage to the low 7x within 12 months of the acquisition closing.

Further disruption to bookings and revenues from the firm's shifting go-to-market strategy, an inability to achieve planned expense reductions, or a sustained downturn in any of Seahawk's core products that led to leverage sustained in the high 7x area could lead to a downgrade.

We view an upgrade as highly unlikely over the next 12 months because of significant near-term operational risks and high leverage. Over the longer term, however, we would consider an upgrade if Seahawk can achieve its expense reduction targets, expand EBITDA margins to the 25%-30% range, sustain revenue growth, and commit to maintaining leverage below 5x.