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