TEXT-S&P rates Heartland Dental 'B', outlook is stable

Fri Nov 30, 2012 5:30pm EST

Overview
     -- U.S.-based dental practice management services provider Heartland 
Dental Care LLC is being acquired in a leveraged transaction. Its majority 
owner will be the Ontario Teachers' Pension Plan (OTTP).
     -- Pro forma for the transaction, leverage is over 8x.
     -- We are assigning Heartland our 'B' corporate credit rating.
     -- We are also assigning Heartland's $100 million first-lien revolving 
credit facility and $450 million first-lien term loan our 'B' credit rating 
and '3' recovery rating, and assigning its $200 million second-lien term loan 
our 'CCC+' credit rating and '6' recovery rating .
     -- The stable outlook reflects our expectation that leverage, initially 
very high, will decline to about 6.0x to 6.5x within two years largely as a 
result of EBITDA growth.

Rating Action
On Nov. 30, 2012, Standard & Poor's Ratings Services assigned Effingham, 
Ill.-based Heartland Dental Care LLC its 'B' corporate credit rating. The 
outlook is stable.

At the same time, we assigned Heartland's $100 million first-lien revolving 
credit facility and $450 million first-lien term loan our 'B' credit rating 
(the same as the corporate credit rating), with a recovery rating of '3', 
indicating our expectation for meaningful (50% to 70%) recovery of principal 
in the event of payment default.

We also assigned Heartland's $200 million second-lien term loan our 'CCC+' 
credit rating (two notches below the corporate credit rating), with a recovery 
rating of '6', indicating our expectation for negligible (0 to 10%) recovery 
of principal in the event of payment default.

Rationale
The rating on dental practice management (DPM) services provider Heartland 
Dental Care LLC reflects its "highly leveraged" (according to our criteria) 
financial risk profile. As of Sept. 30, 2012, pro forma adjusted debt to 
EBITDA is 8.2x. We expect leverage to decline to about 6.2x, still high, 
within about two years largely as a result of EBITDA growth. We consider 
Heartland's business risk profile to be "vulnerable," characterized by its 
narrow scope of operations in intensely competitive markets with low barriers 
to entry. Heartland's affiliated professional corporations, which are not 
owned by Heartland, operate 381 dental care offices in 21 states, with some 
concentration in the Midwest and Florida.

We expect Heartland to continue growing more rapidly than the total U.S. 
dental services industry, spurred by opening new offices and acquisitions, but 
we expect its growth to slow. For 2012, we estimate revenue growth of about 
25%, somewhat below its pace for the 12 months ended Sept. 30, 2012, boosted 
by a large acquisition late in 2011. For 2013, we expect revenues to grow 
about 10%, with mid-single-digit annual growth thereafter. Historically, 
Heartland had substantial non-cash expenses for ESOP stock compensation ($26.3 
million for the 12 months ended Sept. 30, 2012). These expenses ceased in the 
fourth quarter of 2012 and will not resume because all ESOP shares have been 
allocated to employees. Over the next few years, we expect the EBITDA margin 
to be in the 18% to 19.5% range, similar to historical levels, adding back the 
non-cash stock expense, capitalizing operating leases, and making other 
customary adjustments.

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. We also see vulnerabilities in the nature of the DPM 
structure. The DPM business has many retail industry attributes, and so 
carries risks associated with advertising and promotion, branding, real estate 
selection, and others. In addition, the ongoing attraction and retention of 
dentists is necessary to maintain good profitability. While 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. 

Heartland's affiliates offer a broad range of general and specialty dental 
services. As one of the large dental service organizations in the U.S., we 
believe Heartland has more favorable supply costs and reimbursement rates from 
commercial insurers, compared with the small dental practices with which it 
typically competes. However, it may lack some economies of scale possessed by 
DPMs that operate in a more centralized fashion than Heartland. It has a 
better payor profile (with minimal government revenue) than some of its large 
peers and targets a somewhat more affluent patient, which we believe gives it 
a bit more pricing flexibility. We believe Heartland also has had relatively 
low dentist turnover, which we view positively. Still, we see significant 
risks inherent in Heartland's growth strategies.

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. Heartland 
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.

OTTP plans to purchase a majority interest in Heartland primarily from another 
financial sponsor. Heartland's ESOP trust and members of management will 
retain minority stakes. As part of the transaction, nearly all of Heartland's 
existing debt will be repaid and preferred stock held by current owners will 
be redeemed. As of Sept. 30, 2012, pro forma adjusted debt to EBITDA is a very 
high 8.2x. Our adjustments include the capitalization of operating leases, the 
elimination of nonrecurring items, and adding back to EBITDA non-cash stock 
compensation including ESOP contribution expenses. We expect leverage to 
decline to about 6.2x and EBITDA interest coverage to increase to about 2.5x 
within two years.

Liquidity
We consider Heartland's liquidity to be "adequate" (according to our 
criteria). We expect funds from operations (FFO) in excess of $50 million per 
year in 2012 and 2013. Working capital needs are relatively modest. In our 
base-case scenario, we expect annual capital expenditures, mostly for new 
dental offices, to be about $25 million, and we assume about $20 million per 
year of acquisitions. However, we believe Heartland may expand more 
aggressively.

Our liquidity assessment is based on the following expectations and 
assumptions:
     -- Over the next 12-24 months, we expect sources of liquidity, including 
the $100 million revolver, to exceed uses by more than 1.5x. Even if EBITDA is 
15% below our projections, we estimate liquidity sources would exceed uses.
     -- As of Sept. 30, 2012, Heartland had $7 million of cash.
     -- Mandatory debt repayment amounts to about $10 million in 2013 and less 
in 2014.
     -- Heartland's new loan agreement contains a net total debt leverage 
limit that is applicable only if revolver borrowing exceeds 25% of the 
commitment. Unless Heartland makes a large acquisition, we do not expect 
significant revolver borrowing over the next two years.
     -- We believe Heartland might not be able to absorb a low-probability 
high-impact event without refinancing. 

Recovery analysis
For our complete recovery analysis, see our recovery report on Heartland, to 
be published after this report on RatingsDirect.

Outlook
Our outlook on Heartland is stable, reflecting the expectation that leverage 
will recede to the 6.0x to 6.5x range by the end of 2014 largely as a result 
of EBITDA growth. We also expect Heartland will add new affiliates (a 
combination of de novo offices and acquired practices) at a measured pace. We 
could lower our rating if larger than expected acquisitions or other 
developments retard improvement in credit metrics. We would also consider a 
rating downgrade if margins are 200 basis points lower than we expect, sharply 
reducing free operating cash flow. We are not likely to raise our rating 
during the next two years, based on private equity ownership and sustained 
high leverage.

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

New Rating

Heartland Dental Care LLC
 Corporate Credit Rating                 B/Stable/--        
 Senior Secured
  $450M first-lien term loan due 2019    B                  
   Recovery Rating                       3                  
  $100M first-lien revolver due 2017     B                  
   Recovery Rating                       3                  
  $200M second-lien term loan due 2020   CCC+               
   Recovery Rating                       6                  


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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 
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