TEXT - S&P cuts Smile Brand Group rating, revises outlook

Wed Nov 21, 2012 2:54pm EST

Overview
     -- U.S. dental practice management services provider Smile Brands Group 
Inc. had negative free operating cash flow after elevated capital spending for 
the past four quarters, resulting in depleted liquidity.
     -- Early in 2013, we expect Smile Brands to bring capital expenditures, 
mainly for new dental offices, into line with internally generated cash flow.
     -- We are lowering our corporate credit rating on Smile Brands to 'B-' 
from 'B' and revising our rating outlook to negative. At the same time, we are 
lowering our rating on the company's senior secured debt to 'B-' from 'B'.
     -- The negative rating outlook reflects the possibility that Smile Brands 
will exhaust the $13.5 million of funds available from its revolving credit 
facility as of Sept. 30, 2012, or breach a loan agreement covenant.
 
Rating Action
On Nov. 21, 2012, Standard & Poor's Ratings Services lowered its corporate 
credit rating on Irvine, Calif.-based Smile Brands Group Inc. to 'B-'
from 'B'. At the same time, we revised the outlook on the rating to negative.

In addition, we lowered our rating on Smile Brands' senior secured debt to 
'B-', in conjunction with the downgrade, from 'B'. Our recovery rating on this 
debt remains unchanged at '3', indicating our expectation for meaningful (50% 
to 70%) recovery of principal in the event of payment default.

Rationale
The rating on dental practice management (DPM) services provider Smile Brands 
Group Inc. continues to reflect its "vulnerable" business risk profile 
(according to Standard & Poor's Ratings Services' criteria), characterized by 
its narrow scope of operations in intensely competitive markets with low 
barriers to entry. Smile Brands had negative free operating cash flow (FOCF) 
after elevated capital spending for the past four quarters and we expect this 
to continue in the fourth quarter of 2012. Our downgrade is based on the 
expectation that early in 2013, Smile Brands will stem the trend of negative 
FOCF by reducing spending for new dental offices or taking other actions, such 
as paying interest on its holding company debt in kind, rather than in cash. 
We also expect adjusted debt to EBITDA will rise to about 8x by the end of 
2012, significantly higher than our prior expectations, but still consistent 
with a "highly leveraged" financial risk profile. As of Sept. 30, 2012, debt 
to EBITDA was 7.7x, adjusted to capitalize operating leases and including 
holding company debt. We have lowered our expectations for Smile Brands' 
revenue growth, EBITDA generation, and cash flow over the next one to two 
years. 

We expect revenues will grow at a mid-single-digit annual rate, somewhat 
faster than the total U.S. dental services industry over the next few years, 
primarily fueled by Smile Brands' geographic expansion and a slowly 
strengthening economic climate. Our prior growth expectations were mid- to 
high-single-digit annual growth. Although Smile Brands' revenue growth slowed 
in the second and third quarter of 2012, revenues increased 4.2% for the 12 
months ended Sept. 30, 2012. We believe an unsuccessful marketing strategy, 
which was subsequently abandoned, contributed to the growth slowdown. Still, 
we believe underlying industry fundamentals remain sound and relatively 
resistant to downturns. During the 2008 to 2010 recession, when revenue for 
the total U.S. industry was nearly flat (according to data from the Centers 
for Medicare and Medicaid Services), Smile Brands grew modestly, supporting 
our expectation for continued, albeit modest, growth.

As newer offices mature, we expect the lease-adjusted EBITDA margin (11.7% in 
the third quarter of 2012, compared with 12.8% in the third quarter of 2011) 
to gradually recover to the 12% to 14% range, with some quarter-to-quarter 
variation. Smile Brands' profitability is supported by its infrastructure, 
economies of scale, and supplier discounts. More rapid office expansion in 
recent quarters contributed to lower profitability. Smile Brands' EBITDA 
margin (adjusted for leases, stock compensation and nonrecurring items) began 
to dip in the fourth quarter of 2011, after rising substantially and steadily 
from 8.9% in 2005 to 14.8% for the 12 months ended Sept. 30, 2011. Our lowered 
expectations for 2012 and 2013 EBITDA also affect cash flow generation.

Smile Brands' affiliated dental practices operate a network of approximately 
350 dental offices that offer general and specialty dental services. The $110 
billion U.S. dental practice industry is extremely fragmented and highly 
competitive, contributing to our vulnerable business risk assessment. 
Treatment volume, especially for more discretionary services such as 
orthodontics, and patient financial capacity exhibit some sensitivity to 
economic conditions. The availability of financing for patients influences 
demand. We also see vulnerabilities in the nature of the DPM structure. While 
we believe potential changes in state or federal laws, regulations, or 
accounting rules could hurt the DPM industry, we do not currently incorporate 
any adverse developments in our base-case scenario.

The DPM business model has many retail industry attributes, and so carries 
risks associated with advertising and promotion, branding, and real estate 
selection, among others. Smile Brands markets its brands, selects high-traffic 
office locations, and offers customers convenient hours, comprehensive 
treatment, financing, and prices typically 15% to 25% below those of 
traditional dentists. It targets middle-income patients in growing 
metropolitan areas. Affiliated offices operate in 18 states, but there are 
material concentrations in Texas and California.

The company provides administrative, financial, and operating services to 
affiliated professional corporations (PCs). Although the company does not own 
the affiliated PCs, its financial statements consolidate them. Smile Brands 
generally owns the dental office assets, but dentists and hygienists generally 
are not employees of the company, in accordance with state laws. We analyze 
the consolidated financial statements on the basis presented (adjusted for the 
capitalization of operating leases and other standard adjustments) because we 
believe they best reflect the economic substance of the company's business 
model.

Liquidity
We revised our assessment of Smile Brands' liquidity to "less than adequate" 
(according to our criteria), reflecting its diminished liquid resources. As of 
Sept. 30, 2012, Smile Brands reported a negative cash balance of $0.5 million, 
and $13.5 million was available from its $35 million revolving credit 
facility. We believe Smile Brands may borrow an additional $1 million to $5 
million in the fourth quarter of 2012.

We estimate Smile Brands will generate about $20 million of funds from 
operations (FFO) in 2012 and $25 million in 2013. We expect small, if any, 
annual increases in working capital. We project about $32 million of capital 
expenditures in 2012 (actual spending for the first nine months was $27.5 
million), including the recently completed roll out of digital x-rays. In 
2013, we expect Smile Brands to bring capital expenditures, mainly for new 
dental offices, into line with internally generated cash flow. We believe 
annual maintenance capital spending is less than $10 million.

Our assessment of Smile Brands' liquidity profile incorporates the following 
assumptions and expectations:
     -- Over the next 12 months, we expect sources of liquidity, including 
potential borrowing under the revolver, to exceed uses by 1.2x. Even if EBITDA 
is 15% below our projections, we estimate liquidity sources would cover cash 
needs, although in that scenario the revolver could be fully drawn.
     -- Debt amortization is only $2.4 million annually through 2014.
     -- Our analysis of Smile Brands includes unrated holding company notes 
with a face value of $100 million ($87 million after the original issue 
discount). Smile Brands has been paying the 10% coupon in cash. To conserve 
cash, we believe it may begin to pay interest in kind at 13%.
     -- We expect Smile Brands to remain in compliance with its loan agreement 
covenants, notwithstanding requirement tightening. As of Sept. 30, 2012, there 
was a 17% cushion under the tightest covenant.
     -- We assume Smile Brands will not make any acquisitions over the next 
two years.
 
Recovery analysis
For our complete recovery analysis, see our recovery report on Smile Brands, 
to be published following this report on RatingsDirect.

Outlook
Our negative rating outlook on Smile Brands reflects the possibility that it 
will exhaust the $13.5 million of funds available from its revolving credit 
facility as of Sept. 30, 2012, or breach a loan agreement covenant. We would 
consider lowering the rating if negative FOCF persists in the first quarter of 
2013 or we expect the covenant cushion to approach 5%.

We would consider revising the outlook to stable if Smile Brands generates 
discretionary cash flow (through a combination of improved EBITDA and lower 
capital spending), restores availability of its revolver, 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; Outlook Revision
                                        To                 From
Smile Brands Group Inc.
 Corporate Credit Rating                B-/Negative/--     B/Stable/--
 Senior Secured                         B-                 B
   Recovery Rating                      3                  3
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