TEXT-S&P affirms FirstGroup 'BBB-/A-3' ratings, outlook negative
Overview -- On Oct. 3, 2012, the U.K. Department for Transport cancelled the competition for the West Coast rail franchise, overturning its decision to award the franchise to FirstGroup PLC. -- This followed FirstGroup's interim update, which confirmed that the group's bus earnings will likely experience a moderate decline in financial year 2013, and the payment of a dividend, including minority dividend payments, of about GBP135 million in 2013. -- We have revised our analytical consolidation and base-case scenario for FirstGroup and are affirming our 'BBB-/A-3' corporate credit ratings on the group. -- The negative outlook reflects our view that credit metrics will weaken in 2013 and may not recover to levels that we consider commensurate with the rating in the following year. Rating Action On Oct. 16, 2012, Standard & Poor's Ratings Services affirmed its 'BBB-' long-term and 'A-3' short-term corporate credit ratings on U.K.-based transport operator FirstGroup PLC. The outlook is negative. Rationale We are affirming the ratings despite the cancellation of the competition for the West Coast rail franchise in the U.K., which had previously been awarded to FirstGroup. The affirmation reflects our view that although we anticipate FirstGroup's credit metrics will be below our expectations for the rating in the financial year ending March 31, 2013, we believe they will recover thereafter. However, we expect that credit metrics will be below that level in financial year 2013. Following a review of U.K. rail franchise arrangements, we have amended our analytical scope for FirstGroup. We are now excluding FirstGroup's U.K. rail franchises from our analytical consolidation, and incorporating them in our analysis as investments. This is because, in our view, FirstGroup's train operating companies are ring-fenced from the rest of the group. (For further detail, see "The Impact Of U.K. Rail Franchise Reforms And Our Analytical Treatment Of Train Operating Companies," published earlier today on the Global Credit Portal.) Accordingly, we deconsolidate U.K. rail operations from FirstGroup's reported financials, and capture the dividends received from these investments in adjusted funds from operations (FFO). We also add to debt any undrawn subordinated loan facilities that the group provides its train operating companies. This is because, in our view, these commitments are akin to financial guarantees. On that basis, FirstGroup's adjusted FFO to debt was 21% on March 31, 2012 (it would be 21.6% excluding our adjustment to debt for contingent liabilities related to rail). Our ratings on FirstGroup reflect our assessment of its business risk profile as "intermediate" and of its financial risk profile as "significant." Despite continued weak economic conditions and high fuel prices, we anticipate that FirstGroup will be able to restore the profitability of its core U.K. and U.S. bus operations. We anticipate that the group will continue to benefit from its diversified portfolio of mainly stable businesses, its cost-control initiatives, and its fuel hedging strategy. We have updated our base-case scenario to reflect the group's latest trading update and the cancellation of the competition for the West Coast rail franchise. We have also incorporated our macroeconomic forecasts for FirstGroup's core markets, which have recently been revised downward. We forecast that, in the U.K., GDP will decline by 0.4% in 2012 and recover the following year, with 1% growth. In the U.S., we forecast GDP growth in the range of 2% a year over the period (see "The Eurozone's New Recession--Confirmed", Sept. 25, 2012, and "U.S. Economic Forecast: He's Buying A Stairway To Heaven", Sept. 21, 2012, available on the Global Credit Portal). Under our base-case scenario, we forecast that FirstGroup's adjusted revenues (excluding U.K. rail) will decline by about 2.6% in the financial year ending March 31, 2013, compared with the previous year, and that it will stabilize the following year. We also anticipate that adjusted EBITDA margin will be 12.2%, compared with 13.1% the previous year, and that it will increase moderately the following year. Variation in the profitability margin reflects our expectation that profitability at the group's U.S.-based First Student division will improve in 2013, on the back of measures to strengthen the operating model and increase the number of contract renewals. It also reflects our anticipation that FirstGroup's U.K. bus business' profitability will weaken in 2013, and gradually recover thereafter as less-profitable bus assets are sold. Our base-case scenario incorporates a slower implementation of the disposal program than that forecast by the management team; we expect to see proceeds of GBP50 million in 2013 and the remainder of the disposal program the following year. We understand that in the year to date, limited progress has been achieved in terms of disposals, and the management team indicated in its trading update that there could be delays in implementing the program. Our base-case scenario incorporates FirstGroup's stated dividend policy, which involves the payment of a dividend of about GBP135 million (including minority dividend payments) in 2013. Because the group has given no guidance on its dividend policy from 2014, we have not assumed any dividends after 2013. We forecast that over the next two years, reported net debt will remain broadly stable, at about GBP1.9 billion, while adjusted debt will decline as U.K. rail franchises reach their term. We also forecast that adjusted FFO will fall, reflecting weaker earnings and our forecast decline in dividends from U.K. rail franchises. We anticipate that adjusted FFO to debt will be below what we see as commensurate with the rating, at about 20% in 2013, before improving the following year to close to 25%. The negative outlook reflects the risk that FirstGroup's financial metrics may not recover sufficiently within the next two years. Although under our base-case scenario we forecast that adjusted FFO to debt will be about 23% in 2014, which is below the 25% level that we see as commensurate with the rating, we take some comfort from FirstGroup's commitment to its investment-grade rating, which it has maintained since 2002, the group's stated focus on further leverage reduction, and management's ability to manage dividend policy and asset disposals. Following its decision to cancel the West Coast award, the U.K. government ordered independent reviews to be undertaken urgently and halted all outstanding franchise competitions. We expect that this could delay the re-tendering timetable. FirstGroup could benefit from some of its rail contracts being extended to cover any delay. However, given that it is uncertain whether such extensions would be granted, for how long, and under what terms, we have not factored this into our base-case scenario. We understand that FirstGroup's strategy remains to bid for new rail franchises. Its intention is to maintain its current market share. New franchises would be beneficial to FFO, in our view. However, they will also result in an increase in adjusted debt as we capture in our debt adjustments the subordinated loans/guarantees provided by the group. The size of these instruments will depend, in part, on the riskiness of the bids, as assessed by the Department for Transport at the time of the franchise award. Any impact on the rating will depend on the relative weight of these two parameters. Liquidity The short-term rating is 'A-3'. We consider FirstGroup's liquidity to be "adequate" under our criteria. We estimate that sources of liquidity will cover uses by about 1.3x over the next 12 months. We calculate liquidity sources for the 12 months to June 30, 2013, of approximately GBP1.1 billion, comprising: -- Unrestricted cash and cash equivalents of about GBP155 million, excluding ring-fenced cash balances. -- About GBP410 million of availability under a $1.25 billion revolving credit facility (RCF) due Dec. 9, 2015, and a fully available GBP75 million RCF due April 3, 2015. -- FFO (prior to Standard & Poor's adjustments, except for U.K. rail) of about GBP410 million. We calculate liquidity uses for the same period of more than GBP800 million, comprising: -- Debt maturities of about GBP380 million. -- Capital expenditures (excluding U.K. rail) and dividends, including minority dividend payments, of about GBP430 million. There are no credit rating triggers with liquidity implications in the existing loan documentation, and FirstGroup expects to remain compliant with its bank financial covenants during the next 12 months. Outlook The negative outlook reflects our view that FirstGroup's financial risk metrics will be below what we consider commensurate with the 'BBB-' rating in financial year 2013, and may not recover sufficiently in the following year. We could lower the rating if FFO to debt were to deteriorate beyond our current expectations in the near term, or if it does not sustainably recover to about 25% thereafter. This could occur if the trading environment deteriorates, as a result of dividend policy, or because of debt-financed acquisitions that lead to a weakening of the group's credit profile. It could also occur, in our view, if the group takes on very large contingent liabilities associated with new rail franchises, although this will depend on the dividend stream generated by these franchises. We could revise the outlook to stable if FFO to debt were to recover to at least 25%, which is the level that we consider commensurate with the 'BBB-/A-3' ratings. This could occur if the group makes more-significant asset sales than we currently incorporate into our forecast and trading conditions improve, leading to a reduction in leverage. Related Criteria And Research Related Criteria -- Business Risk/Financial Risk Matrix Expanded, Sep. 18, 2012 -- Short-Term/Long-Term Ratings Linkage Criteria For Corporate And Sovereign Issuers, May 15, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Principles Of Credit Ratings, Feb. 16, 2011 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 -- Parent/Subsidiary Links; General Principles; Subsidiaries/Joint Ventures/Nonrecourse Projects; Finance Subsidiaries; Rating Link to Parent, Oct. 28, 2004 Related Research -- The Impact Of U.K. Rail Franchise Reforms And Our Analytical Treatment Of Train Operating Companies, Oct. 16, 2012 -- The Eurozone's New Recession--Confirmed, Sept. 25, 2012 -- U.S. Economic Forecast: He's Buying A Stairway To Heaven, Sept. 21, 2012 Ratings List Ratings Affirmed FirstGroup PLC Corporate Credit Rating BBB-/Negative/A-3 Senior Unsecured BBB- Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. 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