The rating reflects our assessment of Annington’s financial risk profile as “highly leveraged” and its business risk profile as “vulnerable.” Annington holds equity in a portfolio of residential properties that its operating subsidiaries rent to the U.K. Ministry of Defence (MoD).
Annington will replace Annington Holdings PLC as the holding company of the group’s three business divisions as part of a reorganization in connection with a change of ownership. Annington will guarantee the proposed GBP500 million senior PIK notes that a newly formed financing subsidiary, Annington Finance No. 5, will issue.
In accordance with our criteria, an issuer we rate ‘CCC+’ depends on favorable business, financial, and economic conditions to meet its financial commitments. In such circumstances, an issuer’s financial commitments appear unsustainable in the long term, although the issuer might not face a near-term credit or payment crisis. We believe that Annington’s long-term capacity to meet its debt obligations is highly dependent on factors outside its control, such as decisions by the MoD about its ongoing requirement for properties within the Annington estate.
We believe that Annington’s business risk profile is constrained by the fact that substantially all of the business’ assets and cash flows are currently trapped within the restricted securitization group at the operating company level. (See “Ratings Affirmed In U.K. CMBS Deal Annington Finance No. 4,” published Dec. 15, 2010, on RatingsDirect on the Global Credit Portal.) This group includes property owner Annington Property Ltd. and two financing subsidiaries, Annington Finance No. 1 PLC and Annington Finance No. 4 PLC.
The underlying business model drives both cash flows within the restricted securitization group and consequently, this group’s ability to upstream dividends to Annington and enable cash payments on the PIK notes. We believe that the group’s cash flows have the potential to be highly unpredictable. This is because the largest tenant, the MoD, may release properties from the retained estate with six months’ notice, after which time the MoD is no longer required to pay rent. Historically, there has been no consistency in the timing of releases and we consider that the outcome of the U.K. government’s Strategic Defence and Security Review will likely affect the rate at which future releases may occur. Once the MoD releases properties, the timing of re-letting, sales, or any expenditure on refurbishment and utilities will also affect the restricted securitization group’s availability of excess cash to upstream to Annington and service or repay the PIK notes. We note that the MoD currently benefits from a 58% discount to market rents, so Annington’s ability to re-let properties closer to market rents and/or sell released properties at close to market value will likely enhance the group’s cash flow profile. We understand that management has been able to achieve close to market value on the properties it has disposed of since 2000.
Under a scenario of a continued low number of property releases, moderate rent increases, and some annual asset sales, we believe that over the medium term, the restricted securitization group will be unable to upstream to Annington any dividends that it could use to make cash payments on the PIK notes. Furthermore, we believe that the other two business divisions--Annington Rentals Ltd. and Annington Developments Ltd.--will generate little surplus cash that can service or repay the notes. This scenario supports our assessment of Annington’s business risk profile as “vulnerable.” This is somewhat mitigated by a cash sweep mechanism on the PIK notes. We understand that should the financing structure permit the restricted securitization group to release dividends, funds in excess of permitted investment baskets and deemed surplus to the operational requirements of the business are required to make interest payments on the PIK notes.
We assess the financial risk profile of the business outside of the restricted securitization group as “highly leveraged,” reflecting our view of Annington’s very aggressive financial policy and weak debt protection metrics. We estimate debt of more than GBP620 million after the GBP500 million proposed PIK issuance (which will accrue non-cash-pay interest). We understand that the market value of the investment property within Annington Rentals and Annington Developments is about GBP250 million.
We forecast that on a consolidated basis, Annington’s loan-to-value ratio--based on the market value of its property portfolio--will exceed 60% post restructuring. Assuming no material increase in asset values, we believe that this ratio has the potential to rise toward 70% over the medium term, because we forecast that the PIK notes and some zero-coupon bonds accrue interest faster than the debt repayments from cash flow under the scenario we outline above. This ratio is higher still when we account for potential capital gains tax, because the value of the remaining portfolio when Annington acquired it in 1996 was about GBP1.5 billion.
In addition, we believe that Annington’s debt service metrics are weak, with EBITDA interest coverage of less than 1x and debt to EBITDA of about 18x on a consolidated basis after the proposed PIK issuance. This implies to us that any material deleveraging over the medium term will depend on asset sales. However, Annington could also deleverage if the MoD released a higher number of properties and Annington could re-let them at market rates. The timing of when and how many properties the MoD may release remains unpredictable. Additionally, the sudden release of a very large number of properties might create liquidity problems for Annington if it needed to refurbish and re-let the properties quickly in order to preserve rental income streams.
We assess the liquidity position outside the securitization group as “less than adequate” under our criteria. Given the current constraint on cash flow from the restricted securitization group, Annington’s primary source of cash flow is dividends from the operating companies in the Rentals and Developments divisions. We forecast that Annington will use substantially all of the cash that the Rentals and Developments divisions generate to meet these divisions’ ongoing operating requirements.
Annington has limited liquidity requirements because of the optional cash payment option on the PIK notes, whereby only unrestricted cash deemed surplus to the running of the business is required to service the notes. This mitigates Annington’s lack of internal cash flow generation. Consequently, we believe that Annington should be able to manage its liquidity requirements over the medium term, relying on shareholder support if necessary.
The issue rating on the proposed PIK notes to be issued by Annington Finance 5, a direct subsidiary of Annington, is ‘CCC+', in line with the corporate credit rating on Annington. The recovery rating on the PIK notes is ‘4’, indicating our expectation of average (30%-50%) recovery prospects in the event of a payment default.
We view the proposed PIK notes as a deeply subordinated debt instrument, secured only by first-priority share pledges over Annington Subsidiary Holdings Ltd., Annington Rentals, and Annington Developments. In addition, the majority of the group’s assets are ring-fenced, with active cash flow sweep mechanisms. That said, primary support for our recovery rating derives from Annington’s substantial asset base.
We base our assessment of recovery prospects for the PIK noteholders on our understanding that, under the preliminary documentation for the notes, Annington Subsidiary Holdings Ltd. will be limited in raising additional debt to a maximum of GBP250 million. Annington Subsidiary Holdings is where the securitization entities, Annington Finance No. 1 and Annington Finance No. 4 consolidate.
Our hypothetical default scenario assumes a default in 2017 in the ring-fenced group. We believe this would most likely occur in the context of a severe recession in the U.K. Our scenario assumes that the MoD changes its strategy in the context of budgetary constraints, and releases a significant number of properties back to Annington, which cannot sell or rent them quickly enough to prevent a payment default in the securitization. We assume shrinkage in the asset pool prior to a default, in line with Annington’s current business practises.
We value Annington using a discrete asset value approach, as we believe that, at the point of default, the MoD would have returned a significant proportion of dwellings to Annington for it to sell on the open market. On this basis, we have used both a special assumption of vacant possession and open market values in calculating potential recovery prospects. We apply fairly harsh haircuts to both these values, including a 20% reduction in Annington’s asset base prior to default, and a 30% asset haircut. However, after deducting priority liabilities--primarily comprising the debt remaining in Annington Finance No. 1 and Annington Finance No. 4, and associated swap break costs--we see sufficient value remaining for average (30%-50%) recovery prospects for the PIK noteholders. However, we note that the length of time it might take to liquidate the company’s assets could potentially reduce recoveries for the PIK noteholders.
The stable outlook reflects our view that Annington should be able to manage its small liquidity requirements over the short to medium term because of the variable cash payment feature of the PIK notes, which is determined by the cash sweep mechanism.
We could take a negative rating action if the business activities of the group’s principal operating subsidiaries within the restricted securitization group suffer a material disruption. This could happen if the MoD releases a high number of properties over a short period, and Annington cannot re-let or sell these properties quickly enough to maintain sufficient liquidity to meet its debt obligations.
We consider a positive rating action unlikely at this point due to the group’s structure. However, we could take a positive rating action if the group demonstrates an increased ability to upstream dividends to Annington from the restricted securitization group and use these dividends to service or repay the PIK notes. We believe this could happen if Annington sold a high number of assets and/or if it refinanced the current cash sweep instruments within the restricted securitization group with non-amortizing facilities.
Related Criteria And Research
All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated.
-- Criteria For Assigning ‘CCC+', ‘CCC’, ‘CCC-', And ‘CC’ Ratings, Oct. 1, 2012
-- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Ratings Affirmed In U.K. CMBS Deal Annington Finance No. 4, Dec. 15, 2010
-- Criteria Guidelines For Recovery Ratings On Global Industrial Issuers’ Speculative-Grade Debt, Aug. 10, 2009
-- Hybrid Capital Handbook: September 2008 Edition, Sept. 15, 2008
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
-- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
New Ratings; CreditWatch/Outlook Action
Annington Homes Ltd.
Corporate Credit Rating CCC+/Stable/--
Annington Finance No 5 PLC
Senior Secured Debt CCC+
Recovery Rating 4