TEXT-S&P cuts Care UK & Social Care Investments rating
Overview -- On Nov. 5, 2012, U.K.-based health care group Care UK acquired Harmoni for an enterprise value of GBP48 million plus associated costs. -- The acquisition will weaken Care UK's debt protection metrics to levels that we no longer view as commensurate with a 'B+' rating. -- We are lowering the corporate credit rating and senior secured debt ratings to 'B' from 'B+'. -- The stable outlook reflects our estimate that the company will maintain Standard & Poor's adjusted EBITDA cash interest cover above 1.5x, while gradually improving EBITDA. Rating Action On Nov. 14, 2012, Standard & Poor's Ratings Services lowered its long-term corporate credit and senior secured debt ratings on U.K.-based health care group Care UK Health & Social Care Investments Ltd. to 'B' from 'B+'. The outlook is stable. Rationale On Nov. 6, 2012, Care UK announced that it had acquired Harmoni, a provider of out-of-hours health care services to the National Health Service (NHS) in England, for an enterprise value of GBP48 million. The rating action reflects that as a consequence of this acquisition, we estimate that Care UK's debt protection metrics will be significantly weaker for the next 12 to 18 months. As such, we no longer view them as commensurate with a 'B+' rating. Following the announced acquisition, we have revised Care UK's financial risk profile to "highly leveraged" from "aggressive," reflecting management's greater willingness to incur additional debt and to accept a more highly leveraged balance sheet following the debt-financed acquisition. We estimate that for the year ending on Sept. 30, 2013, Care UK's Standard & Poor's-adjusted leverage will be about 6x, decreasing to between 5x and 5.5x in the year ending Sept. 30, 2014. These figures include about GBP325 million of financial debt and about GBP134 million in the form of operating leases adjustments. The group's cash generation is likely to be temporarily impaired by about GBP100 million of cash outflow in 2003 as a result of the Harmoni acquisition and additional discretionary expansionary capital expenditure and development costs of about GBP52 million, which we understand will peak that year. We estimate the group should start to fully benefit from the combined scale from 2014, when we anticipate that the combined entity will generate free cash flow of about GBP18 million. Despite this, the additional debt taken on as part of the acquisition will, in our view, weigh on Care UK's credit metrics in the near future. In our opinion, the purchase will not in the short term materially improve Care UK's business risk profile, which we continue to view as "weak." The transaction fits well within the growing focus of the group on primary care as one of the pillars of its business. However, for it to meaningfully enhance EBITDA, in addition to the revenues from the existing Harmoni businesses (out of hours and offender health care services), the revenues achievable under the NHS 111 call service contracts will have to be realized over the next 12 to 24 months. This could prove difficult, especially as the 111 phone line is a new health care service and will require full cooperation by all engaged parties, including the public, to work efficiently. We view the transaction as an opportunity for Care UK to diversify and grow its business, but because it takes place at the time when the U.K. health care system is being overhauled, it comes with a high degree of uncertainty. The ratings continue to reflect the group's relatively small size, focus on the U.K. market, and a certain degree of reliance on public funds, which are exposed to the vagaries of the U.K.'s political climate and changes in reimbursement policies. We take a negative view of the risks associated with independent sector treatment centers (ISTCs), including a lack of guaranteed procedure volumes priced at NHS tariffs. These negative factors are partly offset by Care UK's good revenue predictability; a high proportion of its services are provided under forward contracts, especially in its residential care business. This is supported by the group's position as a leading operator of ISTCs and its entrenched position in the for-profit elderly and specialist care markets. Both of these markets are fragmented and consequently benefit larger operators with economies of scale. The group's record of winning healthcare tenders provides further support. Liquidity We currently assess Care UK's liquidity profile as "adequate" under our criteria (see "Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers," published on Sept. 28, 2011, on RatingsDirect on the Global Credit Portal). Our liquidity assessment is based on the following factors: -- We estimate that Care UK's liquidity sources (including cash, funds from operations, and an available revolving credit facility ) over the next 12 months will comfortably exceed its uses by more than 1.2x. Even if EBITDA were to decline by 15%-20%, we expect that net sources would remain positive. -- On June 30, 2012, Care UK had an adjusted balance-sheet cash position of GBP29.3 million. However, nearly all of this cash balance has been used up to purchase Harmoni. -- Its only financial debt is in the form of GBP250 million nonamortizing notes that mature in August 2017. Following the proposed bond tap, this will increase to GBP325 million. -- In connection with the acquisition, the group has increased its super senior revolving credit facility (RCF) to GBP97.5 million from GBP80 million due 2016. If the company successfully increases the amounts under the existing bond, we anticipate that the RCF should remain largely unutilized, apart from about GBP10 million in the form of performance bonds relating to certain health care contracts. The RCF documentation contains leverage and interest coverage maintenance covenants. As of June 6, 2012, the group has adequate headroom under these covenants and we estimate that this will remain the case for the next 12 months. -- Care UK's business model benefits from low working capital requirements and modest maintenance capital spending (about 2% of revenues). Recovery analysis The issue rating on Care UK's 9.75% senior secured notes due in 2017 is 'B'. The recovery rating on the notes is '3', indicating our expectation of meaningful (50%-70%) recovery prospects for note holders in the event of a default. Assuming that the proposed tap issuance is successful, the bond principal will increase to GBP325 million. The issue and recovery ratings on the senior secured notes are supported by the comprehensive security and guarantee package in place, and the favorable insolvency regime in the U.K. In addition, the ratings also incorporate our valuation of the company as a going concern, supported by a significant tangible asset base. Nonetheless, as a result of an increase in the super-senior revolver, which ranks ahead of the notes, we see a moderate decline in recovery prospects. To calculate recoveries, Standard & Poor's simulates a hypothetical default scenario. Our simulated default scenario contemplates a default in 2015, assuming deterioration in the quality of the care homes, leading to lower occupancy rates and a significant drop in fees, reflecting the budgetary constraints of the U.K. government. We also assume the RCF to be fully drawn at the time of default and a 1.5% stress on interest rates on variable debt to account for a potential base rate increase and covenant breaches. We expect that most of the company's value will stem from its significant real estate portfolio asset base. We have therefore valued the company primarily using a discrete asset valuation. Our valuation is based on the company's balance sheet as of Sept. 30, 2012. We then adjusted the book value of the company's tangible assets upward, with an GBP85 million positive adjustment to account for a third-party market valuation dated 2010 of some of the company's properties. Finally, we applied haircuts to reach our gross stressed enterprise value of about GBP300 million. This figure includes some value for the recent Harmoni acquisition. After deducting enforcement costs and priority liabilities of about GBP15 million from our gross enterprise value, we arrive at a net enterprise value of about GBP285 million. From this, we deduct GBP101 million (GBP97.5 million plus six months of interest) to reflect drawings under the increased RCF. Therefore, we assess recovery prospects in the 50%-70% range for the senior secured noteholders, hence our recovery rating of '3'. This assumes that the full amount of the bond is outstanding at default. Outlook The stable outlook reflects our view that Care UK should be able to balance potential fee and volume pressure against cost savings and new contract wins while maintaining its operating performance momentum, especially in its residential division. It also assumes that the company will successfully integrate Harmoni and achieve projected volumes under the new contracts and synergies stemming from merging the two business. By doing so, we believe that it should achieve EBITDA of about GBP60 million in 2013. This will cover by 1.5x cash interest payments of about GBP32 million. We anticipate that the group will achieve this despite potential U.K. government public spending cuts because of its size, leading market position, and diversified asset base. We could take a negative rating action if adjusted EBITDA interest coverage were to drop significantly below 1.5x, or if Care UK proves unable to return to generating free operating cash flow of at least GBP10 million from 2014. Factors that could contribute to such a development include a failure to successfully execute a proposed integration strategy and achieve operating efficiencies and deliver projected volumes. The company's residential care division represents a less likely cause of a negative rating action in our view, as about 43% of its beds are on long-term block contracts. In our opinion, a positive rating action is unlikely over the next 12-18 months, due to Care UK's high adjusted leverage. This is estimated to be well above 5x, a level that we would not view as commensurate with a higher rating. Related Criteria And Research All articles listed below are available on RatingsDirect on the Global Credit Portal. -- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Guidelines For Recovery Ratings On Global Industrials Issuers' Speculative-Grade Debt, Aug. 10, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Downgraded; CreditWatch/Outlook Action To From Care UK Health & Social Care Investments Ltd. Corporate Credit Rating B/Stable/-- B+/Watch Neg/-- Care UK Health & Social Care PLC Senior Secured* B B+/Watch Neg Recovery Rating 3 3 *Guaranteed by Care UK Health & Social Care Investments Ltd. 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.