OREANDA-NEWS. June 23, 2015. Fitch Ratings has revised French media group Solocal Group SA's (SLG) Outlook to Negative from Stable and affirmed its Long-term Issuer Default Rating (IDR) at 'B-'. At the same time the agency has downgraded the senior secured bonds issued by PagesJaunes Finance to 'B'/'RR3' from 'B+'/'RR2'.

The revision of the Outlook to Negative reflects Fitch's view of the increased volatility of earnings and vulnerability of cash flows that SLG faces in a challenging sales environment. The business continues to adapt to a digital world where operating expenses and investment needs are significantly higher than in the past.

SLG's recent downgrade of revenue guidance, along with targeted restructuring plans, highlights the challenges of increasing online revenues, while also seeking to deliver improving cash flow. Fitch expects that covenant headroom by end-2015 will be very limited.

Management are guiding to EBITDA margin recovery and stabilisation and believe a target in the region of 29%-30% to be sustainable. Fitch believes management understands well the importance of stabilising operating performance, reducing pressure on its bank covenant and ultimately reducing leverage. The agency nonetheless considers the drive for online growth, high associated staff and technology costs and other cash flow pressures, will lead to continued near-term margin and cash flow volatility - pressures which are better reflected in a Negative Outlook.

The downgrade of the bond rating reflects Fitch's view that enterprise value multiples, both on a performing and distressed basis, for the type of risk inherent in Solocal's business, have been lowered. The material deterioration of trading performance, combined with an analysis that applies a lower post-distress multiple and valuation, results in recoveries of 'RR3' for the senior secured bonds.

KEY RATING DRIVERS
Digital Transformation
SLG's business model has undergone fundamental change. Although its listing service still forms an element of its activities, the business model is now underpinned by driving search and display traffic, partnering with large third-party search engines and helping clients develop their own online presence.

Monetisation of traffic is driven by audience-created - impressions, clicks and leads - and by the economic model built around improving average revenue per advertiser (ARPA), increasing client numbers and improving penetration of the client base to which digital marketing services are sold. This is an inherently more complex and lower-margin business than the print business of the past. Fitch considers the transformation has been successful so far; while challenges remain if digital growth targets are to be achieved and group margin performance to stabilise.

Digital Revenues
Digital revenue growth was just 0.3% in 2014 with two quarters in the year delivering digital declines, evidence of the volatility that remains in the business. With low but improving single- digit online growth reported in each of the past two quarters an ongoing recovery and strong improvements in margins will be important if 2015 guidance is to be met.

Increased operating investment and changes to compensation structures have depressed margin performance materially but management believe a turning point has been reached. Fitch considers volatility remains, in particular challenges in balancing digital growth, commercial investment and managing working capital cash flows.

Free Cash Flow
Fitch estimates SLG will have spent a cumulative EUR45m to EUR50m in cash restructuring relating to the transformation between 2014 and 2015, with further restructuring costs expected in 2016. Publicly the company has stated it has invested EUR200m between 2011 and 2014 on the transformation, including repositioning (ie. substantially increasing) operating expenses and capex; changes that will remain within the cost base on an ongoing basis.

SLG is, in Fitch's view, an inherently lower-margin and more capital-intensive business today - both at the earnings and cash flow level. Free cash flow (FCF) may have bottomed out at EUR38m in 2014. However, appreciable FCF growth is unlikely until 2016 when lower restructuring costs and the improved working capital flows that management are targeting might be expected.

Limited Covenant Headroom
SLG's bank covenants were reset in 2014, with a net debt-to-adjusted EBITDA covenant falling progressively to 4.0x by end-2015. Delivery of management guidance on a consistent basis will be important if management are to avoid a covenant breach as Fitch expects headroom to be very limited by the end of this year. Revenue stability and/or growth, combined with a stable to improving margin, will be important if covenant headroom is to improve beyond 2015.

Bond Recoveries and Instrument Ratings
As a 'B' category issuer Fitch has applied a bespoke approach to the recovery analysis of SLG. Applying a going-concern rather than a liquidation approach results in higher recoveries and a 'RR3' Recovery Rating. This is lower than the previous 'RR2', reflecting the deterioration in Solocal's financial performance and our view that an EV in distress would be lower than previously assumed in Fitch's analysis. The bonds therefore now benefit from only a one-notch uplift from the IDR and have been downgraded to 'B' from 'B+'.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for SLG include:-
-Modest revenue declines in 2015 and continued pressure in 2016, reflecting single-digit digital growth and print declines, in line with current trends
-EBITDA margin to stabilise in the high 20% range
-Cash restructuring costs to remain high in 2015 before slowing in 2016
-Working capital cash flows to remain negative in 2015, albeit at a slower pace of deterioration relative to 2014. This trend to continue in 2016
-Capex to remain in the EUR65m - EUR70m range
-The company pays no dividends and uses FCF to maintain liquidity and repay debt. FCF is not expected to improve materially from 2014 levels before 2016

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to negative rating action include:
- Ongoing deterioration in revenue and margins, failure of turnaround strategy, or neutral or negative FCF
- Impending covenant breach and absence of signs that this will be cured or otherwise resolved without incurring a standstill
- Deterioration of FCF generation with expectations of leverage increasing to more than 4.5x net debt-to-recurring EBITDA.

Future developments that may, individually or collectively, lead to a change of the Outlook to Stable, include:

-Sound and sustainable digital revenue growth, successful completion of restructuring, combined with a stabilisation of operating expenses and an improvement in the working capital trends
-Sustainable EBITDA with positive FCF and evidence of de-leveraging capacity

LIQUIDITY
Liquidity remains healthy. At end-1Q15 SLG reported unrestricted cash and cash equivalents of EUR43.7m and availability of EUR57m under the revolving credit facility due March 2018. Fitch's base case continues to forecast positive FCF which will also provide ongoing liquidity.