TEXT-S&P summary: Rotech Healthcare Inc.
The ratings on Orlando, Fla.-based Rotech Healthcare Inc. reflect its weak business risk profile primarily due to its narrow operating focus and exposure to Medicare reimbursement reductions for its products and services. The rating also reflects the company's highly leveraged financial risk profile that factors Rotech's overall sensitivity of is credit metrics to the uncertain reimbursement environment.
Our revenue growth assumptions in 2012 incorporate low single-digit revenue growth. We believe the 2011 growth decline of over 2% along with contracted margins in the fourth quarter will be reversed because of added patient volume from Round 1 Competitive Bidding Areas (CBAs), gains from 2011 asset acquisitions, 2012 asset acquisitions and a decline in negative adjustments to revenue. Our growth assumptions is somewhat tempered by a cut in Medicare reimbursement for the generic drug budesonide. Decline in rates for the drug contributed to a decline in revenues for the fourth quarter in 2011. We expect there to be continued opportunity for asset purchases, as lower competitive bidding rates drive competitors from the market.
We expect EBITDA margins to be largely maintained at 22% by mid-2012. We do not expect higher bad debt expense that was reflected in 2011 fourth quarter results to persist. We expect free cash flow to turn positive in 2012, from negative $14 million in 2011. We expect an improvement in working capital and Rotech to pursue less asset purchases than in 2011. The company reported a $20 million investment in working capital in 2011 but we are incorporating a gradual improvement in Days Sales Outstanding ranging at or below 55 days from close to 59 days.
Rotech's credit metrics are better than metrics associated with a "highly leveraged" financial risk profile, however we factor in the company's overall sensitivity of its credit metrics to the uncertain reimbursement environment and its existing negative free operating cash flow. In fact, adjusted leverage was 5.2x at Dec. 31, 2011, higher than our expectation of 4.5x. We expect leverage to improve to the mid 4x area and funds from operations (FFO) to debt at around 13% in 2012, still better than a "highly leveraged" financial risk profile.
Rotech's weak business risk profile reflects its concentration in the highly fragmented home respiratory care services (87% of revenues) and durable medical equipment market (13% of revenues) which is experiencing pricing pressures. The company's dependence on Medicare, Medicaid and other government payors for about three-fifths of revenues exposes them to the uncertainty of reimbursement. This risk further extends to commercial payors as they seek to control costs and may follow Medicare's lead in cutting prices for respiratory care and durable medical equipment. In addition to reimbursement risk, Rotech's future growth is dependent upon Medicare Competitive Bidding, which is likely to lower contract rates but added volume.
These risks are somewhat offset by the company's position as the No. 3 provider in its niche industry segment. Although Rotech serves patients in 48 states through 425 centers, it is primarily in non-urban areas, which are less competitive.
We view Rotech's liquidity as adequate, with sources of cash exceeding mandatory uses over the next two years. Relevant aspects of the company's liquidity profile based on our criteria are as follows:
-- We expect sources of liquidity over the next 12 months to exceed uses by 1.2x or more. This partly relies on Rotech's ability to manage working-capital requirements. Net uses of liquidity factors in considerable capital spending needs (10% to 15% of revenues).
-- We expect, in the event of a 15% decline in EBITDA, liquidity sources will exceed uses.
-- We believe Rotech will have limited ability to absorb high-impact, low-probability events.
-- Rotech had ample cushion on its debt covenants that is only applicable to incremental borrowings on its revolver; the company has full availability on its $10 million 364-day revolving credit facility.
-- Sources of liquidity are supported by approximately $31 million of unrestricted cash. Rotech has about $7 million of restricted cash that serves as collateral for outstanding letters of credit.
-- There are no near-term maturities until 2015. This excludes the expiration of its unused revolver in 2013.
The issue rating on the $230 million senior first-lien notes is 'BB-'. We expect very high (90% to 100%) recovery in the event of payment default. The issue rating on the company's $290 million second-lien senior secured notes due 2018 is 'B' with a recovery rating of '4'. We expect average (30% to 50%) recovery for the second-lien notes in the event of payment default. (For the complete recovery analysis, please see the recovery report on Rotech Healthcare Inc., published March 7, 2011 on RatingsDirect.)
Our stable outlook on Rotech Healthcare Inc. reflects our view that improved operating margins will be sustained in 2012 and that leverage will decline. We view a ratings upgrade in the near term is unlikely, because of the potential for ongoing reimbursement pressures. Rotech would need to expect EBITDA margins to improve by over 200 basis points, reducing leverage to below 4x on a sustained basis to warrant a higher rating. Our ratings on Rotech could be lowered if the company is unable to offset future reimbursement pressures with increased volumes and cost reductions, resulting in lower EBITDA and persistent negative cash flow.
Related Criteria And Research
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Business Risk/Financial Risk Matrix Expanded, May 27, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
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