TEXT-S&P affirms Hill-Rom rating after Aspen Surgical deal
Overview -- We believe U.S.-based patient bed maker Hill-Rom Holdings' prospects for sustained mid-single-digit sales growth and modest expansion in EBITDA now will rely on the contribution of acquisitions, given weak organic demand for its hospital beds. -- The acquisition of Aspen Surgical Products does not meaningfully diversify Hill-Rom's exposure to variable capital equipment sales. -- We are affirming our ratings on the company, including our 'BBB' corporate credit rating. The outlook is stable. -- Our stable rating outlook reflects our expectation that credit metrics will remain consistent with a "modest" financial risk profile. Rating Action On July 27, 2012, Standard & Poor's Rating Services affirmed its corporate credit and issue-level ratings on Batesville, Ind.-based Hill-Rom Holdings Inc. at 'BBB.' The rating outlook is stable. These actions follow earnings weakness that we already considered in our base-case expectations, given the company's exposure to variable hospital customer demand for its high-ticket equipment. The acquisition of Aspen Surgical Products, a maker of consumable surgical products, will not meaningfully diversify operations, but neither does it require more financial leverage than is factored into the ratings. Rationale The ratings on Hill-Rom incorporate Standard & Poor's assessment that the patient bed maker has a "fair" business risk profile that features a well-established, but narrow, market position. Its "modest" financial risk profile reflects cash generation ample to sustain debt leverage of under 2x on an ongoing basis, even with a moderate pace of share repurchases and acquisitions. The company's reliance on its beds and surfaces operations and, consequently, its exposure to variable U.S. hospital capital spending, is a key element in our assessment of its fair business risk. Revenue rebounds of both 8% and 6%, in fiscal 2011 and fiscal 2010, respectively, as recessionary fears subsided, demonstrated this variation. Fiscal 2009 revenues had declined 8%. However, the 5% year-over-year decline in North American revenues in the June quarter shows the readiness of hospitals to postpone capital purchases amid sluggish in-patient activity in the U.S. Total constant-currency revenues for Hill-Rom through the nine months of fiscal 2012 were up 4.9%, year over year, aided by international operations (which account for about one-quarter of revenues). We believe that the relatively high margins of the North America Acute Care segment (62% of total revenues) will continue to benefit from manufacturing and distribution economies of scale tied to its market-leading positions. Hill-Rom's long history in the design and manufacture of patient beds and surfaces, and its well-established customer relationships provide competitive advantages. We anticipate that acquisitions, such as the just-completed purchase of Aspen (some $120 million in revenues), and the early 2012 purchase of Germany-based Volker group (some $100 million in annual revenues), will leverage its marketing presence with hospitals. While these respective acquisitions enhance the company's distribution capability and increase participation in consumable surgical products, they will not soon provide significant customer diversity suggestive of a business risk profile better than "fair." We believe prospects for sustained mid-single-digit sales growth through 2013 and modest expansion in EBITDA now will rely on the contribution of acquisitions, given weak organic demand for its hospital beds. Variations in discretionary capital spending by customers could lead to an uneven organic revenue performance, but one that exceeds the 2% rise in 2012 and 2013 GDP expected by our economists in their base case. Acquisitions, such as the February 2012 purchase of Volker group, and the just-completed acquisition of Aspen, will supplement the company's product offering to health care institutions. We continue to assess Hill-Rom's financial risk profile as "modest." We believe soft North America customer demand could contribute to a decline in consolidated average adjusted EBITDA margins through 2013 of some 200 basis points (bps), from the 21.3% fiscal 2011 level. Dimmed prospects for 2012 EBITDA, reflecting a downshift in momentum for the second half of the fiscal year, we believe, will be followed by EBITDA improvement in 2013, supported by the inclusion of Aspen. Accordingly, we expect that, even with incremental debt used for the transaction, debt leverage will continue to remain low relative to our modest financial risk profile guidelines, which includes leverage of 1.5x to 2.0x. Hill-Rom's distribution agreement (part of the spin-off) limits certain discretionary expenditures once debt to EBITDA hits 1.8x. This distribution agreement will remain in place until Hillenbrand Inc. settles legal issues regarding alleged restraint of trade in the casket business. When the distribution agreement expires, Hill-Rom will be held to a 3.5x debt to EBITDA covenant and 3.5x EBITDA to interest coverage ratio covenant in its credit agreement. While we expect Hill-Rom could then become more acquisitive, its generation of substantial discretionary cash flow should give it room to make niche-filling acquisitions and share repurchases without compromising its record of operating with relatively low leverage. Liquidity We view Hill-Rom's liquidity as "strong," with sources of cash well exceeding mandatory uses of cash over the next 12 to 24 months. Relevant aspects of the company's liquidity are: -- Sources of liquidity will exceed uses by at least 2x; -- Annual funds from operations (FFO) of some $250 million; -- Cash and cash equivalents, totaled $220 million at June 30, 2012, a portion of which funded the Aspen acquisition; -- A substantial portion of the revolver, of which $449 million was available at June 30, 2012, was also used in the transaction. The planned renewal of the revolver within the next couple of months is an important liquidity consideration, since it expires in March 2013; -- We expect annual capital expenditures to be manageable, at roughly $75 million; -- We believe that any debt-financed share repurchases will supplement acquisition spending within a 2x leverage figure. Share repurchases, which totaled $115 million in fiscal 2011, have been minimal in fiscal 2012 with the increase in acquisition activity; and -- Dividends should be manageable ($27 million in fiscal 2011). The company is exposed to potential settlements or adverse rulings related to the outstanding legal issues of Hillenbrand. However, Hill-Rom is responsible for payments for legal settlements or rulings only after Hillenbrand has exhausted its financial resources. Outlook Our stable rating outlook on Hill-Rom reflects our expectation that credit metrics will remain consistent with a modest financial risk profile. This view incorporates the possibility of approximately 200-bp margin decline over the next two years, reflecting customer cost-containment efforts and the imposition of a U.S. medical device tax in 2013. We expect debt-financed acquisition activity to occur at a measured pace, supplemented with share repurchases. We also believe, however, that FF0 to debt will remain above 45% and debt to EBITDA will stay below 2x. A lower rating is possible in the next few years if there is a combination of sustained organic revenue declines tied to slackened demand and pricing pressure from customers under third-party payor reimbursement reductions. Such a scenario could involve margin declines in excess of 300 bps. Surprisingly large borrowing that takes leverage above 2x, without an early prospect that it would subside to more historically conservative levels, also could lead to a downgrade. A higher rating is unlikely, given clouded business prospects and the increased use of the company's debt capacity for acquisitions. Related Criteria And Research -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Ratings Affirmed Hill-Rom Holdings Inc. Corporate Credit Rating BBB/Stable/-- Senior Unsecured BBB Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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