TEXT-S&P cuts Aurora Diagnostics Holdings to B-minus

Mon Nov 19, 2012 1:22pm EST

Nov. 19 - Overview

-- The Centers for Medicare & Medicaid Services (CMS) announced a surprisingly large reduction in reimbursement rates for certain anatomic pathology (AP) services, effective Jan. 1, 2013.

-- We believe these reimbursement rates will substantially reduce U.S. AP services provider Aurora Diagnostics Holdings LLC's revenues, EBITDA generation, and cash flow beginning in 2013 and will hinder its ability to generate cash over the next few years.

-- We are lowering our corporate credit rating on Aurora to 'B-' from 'B', our rating on subsidiary Aurora Diagnostics LLC's senior secured debt to 'B+' from 'BB-', and our rating on Aurora Diagnostics Holdings LLC's senior unsecured debt to 'CCC' from 'CCC+'.

-- The rating outlook is negative, reflecting the possibility that Aurora's cost-reduction initiatives will not sufficiently offset the Medicare rate cut and other market pressures, and the potential for slim headroom under Aurora's loan covenant. Rating Action On Nov. 19, 2012, Standard & Poor's Ratings Services lowered its corporate credit rating on Palm Beach Gardens, Florida-based Aurora Diagnostics Holdings LLC to 'B-' from 'B'. We also lowered our rating on subsidiary Aurora Diagnostics LLC's senior secured debt to 'B+', two notches above the corporate credit rating, from 'BB-', and our rating on Aurora Diagnostics Holdings LLC's senior unsecured debt to 'CCC', two notches below the corporate credit rating, from 'CCC+'. We affirmed our '1' recovery rating on the senior secured debt, indicating our expectation for very high (90% to 100%) recovery of principal, and our '6' recovery rating on the senior unsecured debt, indicating our expectation for negligible (0 to 10%) recovery of principal, both in the event of payment default. Rationale The ratings on Aurora Diagnostics Holdings LLC, a provider of anatomic pathology (AP) diagnostic services, continue to reflect the company's "vulnerable" business risk profile (according to our criteria), unchanged as a result of the CMS decision. We downgraded the company because we expect the Medicare rate cut to substantially reduce Aurora's revenues, EBITDA generation, and cash flow, beginning in 2013 and to hinder its ability to generate cash over the next few years. We previously expected Aurora to borrow modestly in 2012 and 2013 to finance large earn-out payments, and then to resume generating discretionary cash flow after earn-out payments in 2014. The business risk profile is characterized by a narrow operating focus, vulnerability to customer in-sourcing, price pressure, and weakened profitability. Despite lower margins, we expect Aurora to continue generating discretionary cash flow, but it will require borrowing from its revolving credit facility to cover large earn-out payments in 2012 and 2013. Further borrowing may be needed in subsequent years. We expect Aurora's adjusted debt to EBITDA to rise above 6x, higher than our earlier expectation that leverage would peak at about 5.5x, but still consistent with the company's "highly leveraged" financial risk profile. We revised our liquidity assessment to "less than adequate" from "adequate," primarily on weakened cash flow and loan covenant concerns. We expect 2012 revenues to grow about 5%, propelled by 2011 acquisitions; growth was 11.2% for the 12 months ended Sept. 30, 2012, but declined 4.7% year over year in the third quarter of 2012. In 2013, we expect a double-digit revenue decline mainly as a result of the Medicare rate cut. From this lower base, we expect low-single-digit annual organic volume and revenue growth for Aurora, similar to growth for the total U.S. outpatient AP market. We believe revenue per accession (generally correlated with profitability) will continue to decline, reflecting reduced Medicare payment rates, customer in-sourcing, price pressure from commercial insurers, and possibly a continued unfavorable shift in service mix. In the third quarter of 2012, Aurora wrote off $115 million of goodwill and intangibles and we expect further write-offs in the fourth quarter. These noncash charges do not affect cash flow or covenant compliance, but they do signal the reduced earning power of the business. Management recently implemented staff reductions and is taking other cost-cutting actions that we believe could save about $5 million per year, but this will be partly offset by information technology investments and higher costs to retain pathologists. Under our base case, we expect the EBITDA margin (adjusted for nonrecurring items, stock compensation, and the capitalization of operating leases) to fall to about 21.0% in 2012, corresponding to adjusted EBITDA of about $60 million. Although we expect Aurora to implement additional cost controls, we estimate adjusted EBITDA could drop to about $40 million in 2013 (a 500-basis-point margin decline). Medicare accounted for about 30% of Aurora's 2011 revenue; 25% on the physician fee schedule. In 2013, Medicare will sharply reduce reimbursement rates for the technical component and modestly raise rates for the professional component of a common procedure. Aurora estimates these changes will reduce its revenue by $21 million. We also expect some commercial insurers to follow suit, and we expect Aurora to lose an additional $1.5 million in annual revenue as a result of new rules that require it to bill hospitals, rather than Medicare, for in-patient testing. The 2013 Medicare rate cut follows a reduction in reimbursement rates on the physician fee schedule that are reducing Aurora's Medicare revenue by about 3.5% to 4.5% in 2012. Since its founding in 2006, Aurora has grown rapidly, fueled by more than 20 acquisitions. We believe Aurora has curbed its appetite for acquisitions and is now focusing on organic growth, efficiency improvements, and cost cutting. Aurora competes mainly in the AP subsector of the diagnostic laboratory industry. AP is the examination of tissue samples and cells to detect cancer and other diseases. The AP market has fairly low barriers to entry and remains very fragmented, which contributes to Aurora's vulnerable business risk profile. We estimate the two largest participants, Quest Diagnostics Inc. and Laboratory Corp. of America Holdings, have a combined share of only about 10% to 15%. They also have been hurt by customer in-sourcing. We believe independent labs are generally losing market share to hospital labs when previously independent doctors become hospital employees, an ongoing trend. Aurora has established positions in dermatology and women's health within its local markets, but its scale is small relative to LabCorp and Quest, which offer a broader, more diverse range of diagnostic services. Aurora's competitors also include local providers, as well as its own customers that can in-source the technical component (e.g., specimen preparation) of diagnostic testing. We believe in-sourcing has materially reduced Aurora's revenue and EBITDA growth during the past few years. Despite its smaller scale, we believe Aurora generally has had higher profit margins than LabCorp and Quest because the larger companies are more concentrated in lower-margin clinical testing and may receive lower reimbursement rates under national contracts with commercial insurers. Aurora typically has been paid an in-network rate under local contracts, but we believe large commercial insurers may push the company to accept national contracts at lower rates. Commercial payors (57% of Aurora's 2011 revenue) generally have been aggressive in reimbursement negotiations with service providers. We expect adjusted debt to EBITDA (5.5x as of Sept. 30, 2012) to rise to above 7x by the end of 2013, largely as a result of sagging EBITDA. The main adjustments we make when calculating leverage are to capitalize operating leases and add to debt the fair value of contingent consideration, including our estimate of that amount for pre-2009 acquisitions. The fair value of contingent consideration ($47.2 million as of Sept. 30, 2012) will decline substantially over the next few quarters as earn-outs are paid, but we expect Aurora to borrow to finance some of these payments. Therefore, while we expect little change in adjusted debt, leverage will increase. Over the next two years, we assume Aurora will not take on new debt to finance acquisitions or shareholder-friendly actions. Financial sponsors own a majority of Aurora. Liquidity We have revised our assessment of Aurora's liquidity to less than adequate, as defined in our criteria, reflecting diminished cash flow generation and the potential for a thin covenant cushion. Its business has relatively low capital requirements. We expect about $30 million in funds from operations (FFO) in 2012 and $15 million to $20 million of FFO in 2013 to easily finance about $5 million in annual capital expenditures and, at most, small annual increases in working capital. We expect earn-out payments of $29 million in 2012 and $22 million in 2013 to be the largest use of cash. However, these payments will be much smaller in subsequent years. We believe Aurora will require incremental borrowing in 2012 and 2013. Our analysis is based on the following assumptions and expectations:

-- We expect liquidity sources, including the $60 million revolving credit agreement, to exceed uses by more than 1.2x for the next 12 to 24 months.

-- If EBITDA is 15% lower than we expect, coverage would still be positive.

-- As of Sept. 30, 2012, Aurora had $5.7 million in cash and $52 million of the $60 million revolving credit facility was available.

-- We assume Aurora will not make any acquisitions in 2012 and 2013.

-- In connection with a recent loan amendment, Aurora prepaid $10 million of its term loan.

-- Debt maturities are minimal until the term loan matures in 2016.

-- The loan amendment included the elimination of an interest coverage test and a loosening of the leverage limit. We believe headroom under this covenant could decline to 10% to 15% in 2013. As of Sept. 30, 2012, there was ample headroom under the old financial covenants. Recovery analysis For our complete recovery analysis, see our recovery report on Aurora Diagnostics, to be published as soon as possible after this report on RatingsDirect. Outlook The rating outlook is negative, reflecting the possibility that Aurora's cost-reduction initiatives will not sufficiently offset the Medicare rate cut and other market pressures, and the potential for slim headroom under Aurora's loan covenant. We would consider lowering the rating if liquidity is impaired, evidenced by a projected loan covenant cushion below 10%, limited revolver availability, or our belief that after 2013 Aurora could not generate cash after earn-out payments. We would consider revising the outlook to stable if Aurora is able to reduce its costs or take other actions that enable it to generate cash after earn-out payments, and we expect the covenant cushion to stay above 15%. Related Criteria And Research

-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012

-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011

-- Standard & Poor's Revises Its Approach To Rating Speculative-Grade Credits, May 13, 2008

-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

-- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 Ratings List Downgraded

To From Aurora Diagnostics Holdings LLC Aurora Diagnostics Inc. Corporate Credit Rating B-/Negative/-- B/Negative/-- Aurora Diagnostics Holdings LLC Senior Unsecured CCC CCC+

Recovery Rating 6 6 Aurora Diagnostics LLC Senior Secured B+ BB-

Recovery Rating 1 1 Temporary contact number: Gail Hessol, (646) 285-7768. 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. Primary Credit Analyst: Gail I Hessol, New York (1) 212-438-6606;

gail_hessol@standardandpoors.com Secondary Contact: Jesse Juliano, CFA, Boston (1) 617-530-8317;

jesse_juliano@standardandpoors.com

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