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July 18 (Reuters) - (The following statement was released by the rating agency)
Fitch Ratings has downgraded Elli Investments Ltd's (Elli) Long-term Issuer Default Rating (IDR) to 'B-' from 'B'. The Outlook is Stable. A full list of rating actions is available at the end of this commentary. Elli is the parent company of the Four Seasons HealthCare group.
The downgrade reflects changes in the regulatory environment within UK elderly care homes, which is under greater scrutiny, Elli's high level of embargoes on care homes (no new residents until inspectors' findings are rectified) and the impact on costs, as well as its exposure to the elderly care market compared with its rated peers. We forecast funds from operations (FFO) adjusted leverage will exceed 7.5x in 2014 and only gradually decline thereafter. In addition, senior covenant headroom is eroding quickly.
The Stable Outlook reflects our expectation that profitability will stabilise towards the end of 2014 and in 2015; albeit at levels structurally lower than previously anticipated assuming that the current level of embargoes will not increase further from 2013 average levels. It is also supported by lack of meaningful debt redemptions until 2018, the steady visibility of earnings, Elli's leading market position in the growing independent UK elderly care market and its long-standing relationships with local authorities (LA) and the NHS.
Occupancy Constrained, Margin Erosion
Fitch does not foresee short-term scope for organic growth in Elli's occupancy given the increased regulatory environment mainly reflected in the high level of inspections and embargoes. Elli's rating factors in Fitch's assumption that the level of embargoes will average 10-15 per year (from a peak of 28 in December 2013). This will affect Elli's margins as these inspections lead to the requirement for additional resources; typically funded through more expensive agency staff. Consequently we only envisage a modest increase in occupancy levels in the near term.
Although we expect staff costs as a percentage of sales to peak at 64% in 2014 due to high agency costs and the impact of the increase in the minimum wage (2013: 62%), each percentage point variance in staff costs represents, roughly 0.5x in terms of FFO gross leverage, all other things being equal, reflecting the high operating leverage in a context of subdued fee increases.
High Capex in 2014 & 2015
As part of management's strategy to diversify further into private pay clients, Elli's owner, Terra Firma has injected GBP50m into the business to fund a refurbishment and rebranding programme, which together with cash flow from operations will fund relatively high capex. We view the owner's support as an important factor for the ratings.
Weakened Credit Metrics
Elli's EBITDAR has declined over the past two quarters, leading to a last-12-month March 2014 EBITDAR of GBP137.2m (2013: GBP146.3m) and higher forecast FFO adjusted leverage of 7.8x at FY14, which has deteriorated compared with our original forecast of 6.4x. Fitch believes that EBITDAR will remain under pressure as the financial impact of increased embargoes continues. We forecast FFO adjusted leverage to start falling to below 7x by FY16 on the back of mild average weekly fee increases and cost control. As a result, we consider the financial risk profile commensurate with a 'B-' rating.
Dependent on LA Funding
Elli currently has a high dependence on LA funding, which contributes more than half of the group's revenues. Consequently, the exposure to low/stagnant fee increases has contributed to slow growth in the revenues for the group. Fitch believes that Elli's strong relationships with the LAs, provision of high dependency care in the homes, and management's plan to grow the private segment as part of the new business restructuring should mitigate the heavy exposure to LA public sector funding.
Focus on High Dependence Service
Elli's focus on high-dependence services in its elderly care division is relatively resistant to the recent trend towards care at home and the associated tightening in residential care eligibility criteria. In an environment of reduced real spending on elderly care by the government, the nursing and complex residential care segments will continue to benefit from a shift in the focus to higher intensity of care.
Solid Market Positioning
Elli enjoys a leading position in the growing independent UK elderly care market and benefits from entrenched relationships with LAs and NHS commissioners.
Superior Recovery Prospects
In our assumptions, we have taken the higher value derived from a liquidation scenario, due to the high quality property assets on the balance sheet. In our view, many of the homes are in a location with an oversupply of beds, whilst the potential for alternative use is limited with the most likely option being conversion to residential depending on the location and demand at the time. In addition, we consider the position of unsecured bondholders weaker than secured creditors thus supporting the view of less than par recoveries for the senior unsecured notes at 'B+'/'RR2' compared with 'BB'/'RR1' previously.
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Increase in FFO adjusted leverage to above 8.0x. (FYE 13: 6.80x)
- Significant further decrease in occupancy rate due for example to a drop in reputation and/ or ongoing high embargoes together with increased operating costs leading to EBITDAR margin eroding to below 16%. (FYE 13: 20.3%)
- FFO fixed charge cover below 1.1x, together with stretched liquidity exacerbated by covenant breaches. (FYE 13: 1.3x).
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- FFO adjusted leverage below 6.5x.
- FFO fixed charge cover ratio consistently above 1.5x.
Lower Liquidity Expected to Be Sufficient
Elli's liquidity is supported by access to its revolving credit facility of GBP40m maturing 2018, of which GBP25m was undrawn at FYE13. Together with available unrestricted cash of GBP18.7m, Fitch considers this sufficient relative to no meaningful debt repayment in 2014. The debt maturity profile of the bonds is acceptable, with an average remaining maturity of 4.5 years. Elli's ability to raise additional funding is restricted by debt incurrence clauses under the terms of the bonds requiring a minimum fixed charge coverage above 2x, which we calculated at about 1.6x at FYE13 (based on consolidated EBITDA) and highly unlikely to reach 2.0x any time soon. We also note that senior covenant headroom is tightening.
Elli Investments Limited
--Long-Term IDR: downgraded to 'B-' from 'B'; Outlook Stable
--Senior unsecured notes: downgraded to 'B+'/'RR2' from 'BB'/'RR1'
Elli Finance (UK) plc
--Super senior revolving credit facility: downgraded to 'BB-'/'RR1' from 'BB'/'RR1'
--Senior secured notes: downgraded to 'BB-'/'RR1' from 'BB'/'RR1'