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Fitch Affirms Elli Investments at 'CC'
September 27, 2017 / 1:59 PM / in 21 days

Fitch Affirms Elli Investments at 'CC'

(The following statement was released by the rating agency) LONDON, September 27 (Fitch) Fitch Ratings has affirmed Elli Investments Ltd.'s (Elli) Long-Term Issuer Default Rating (IDR) at 'CC'. Elli is a leading UK-based care home provider trading under the following names: Four Seasons Health Care, The Huntercombe Group and brighterkind. A full list of rating actions is available at the end of this commentary. The affirmation at 'CC' reflects the lack of progress in debt restructuring negotiations between the company and its lenders since our last rating action in September 2016. Notwithstanding improvement in trading, Elli continues to face sustained operational challenges, excessive leverage and liquidity pressure. KEY RATING DRIVERS Operational Challenges: Fitch views Elli's business model as being challenged by constraints affecting profitability and cash flow generation. This is due to pressure on its cost base associated with an increase in the national living wage and shortage of nurses in the UK, leading to a reliance on agency workers. Although the 'social care' levy introduced by the UK Treasury to increase funding for care has been adopted by the majority of local authorities and has led to a moderate increase in rates during 2016, this has so far been insufficient to fully restore profitability. Staffing costs, including an increasing use of agency workers, represent around 70% of the cost base of care home operators. Unsustainable Capital Structure: We believe that the decline experienced in Elli's profitability is structural, leading to impaired operational cash flow, which in return yields an unsustainable capital structure based on current debt levels. We estimate Elli's EBITDA margin at around 8.5% in 2017, compared with around 13% in 2013. Fitch calculates funds from operations (FFO)-adjusted net leverage to remain around 9.6x in 2017, and FFO fixed charge cover around 1.0x. Short-term Liquidity Pressure: Elli has completed the segmentation of its estate across three brands, including disposal of underperforming assets, as well as improving the quality of care. As a result, the group's care quality assessments have been improving and occupancy rates continue to gradually increase. Importantly, without cash generation from asset disposals, we expect operational cash generation will be insufficient to cover the interest payments of GBP55 million and repay the GBP40 million term loan due in December 2017, leading to liquidity shortfall by the end of the year. Volatile Outlook for UK Social Care: Fitch expects the UK social care market will remain difficult and face short-term volatility, due to further expected wage inflation and potentially widening labour shortage as a result of greater focus on limiting immigration. We observe some easing of the immediate funding pressure as local authorities are now able to raise the social care council tax precept, which - as it is applied cumulatively over years - has alleviated the most imminent funding shortages. We, however, view this additional tax-based funding only as a short to medium-term solution for UK social care funding. Several reviews from government and regulatory bodies are expected to publish recommendations and discussion papers over the next six months to facilitate the debate about funding models and best industry practices for the long term. Significant Asset Base: Elli's recovery prospects are underpinned by ownership of over 50% of the group's registered properties. Total freehold assets were valued at GBP505 million in April 2016, which give Elli operating flexibility due to lower rental costs, and underpin our expectations of outstanding recoveries for the 'CCC+' rated super senior secured loan, three notches above the IDR. Fitch bases its recovery analysis on the underlying asset values, applying a liquidation approach. DERIVATION SUMMARY Fitch has observed significant rating pressure in the UK leveraged care home sector stemming from a reduction of local authorities' fee rates in real terms, increasing costs due to higher national living wage from April 2016 and growing use of agency due to a shortage of nurses. This has led to weak profitability across the sector as cost inflation could not be passed on to payers, which now threatens care operators' business model and makes leveraged capital structures increasingly unsustainable. The resilience of operators against these external pressures varies according to their exposure to public vs. private payers and their position on the acuity care spectrum. Care companies at the higher end of the dependency spectrum such as Voyage Bidco Limited (B-/Stable) with a larger share of disability care, have been comparatively resistant to funding cuts of local authorities but are facing strategic challenges as the care model evolves towards assisted living schemes. Care homes more at risk are those catering to residents with less complex needs such as Elli and Care UK. The business models of these three key players are also different, with Care UK operating an asset-light structure, leasing most of its care facilities, whereas Voyage and Elli own the majority of their assets. This leads to a differentiation in Fitch's recovery approach, as we apply a liquidation scenario to Voyage and Elli, while Care UK's recoveries are based on a going-concern scenario. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer for 2017 include: -Revenue decline of 3.2% due to reduction on the number of effective beds following asset disposals; -EBITDA of GBP58 million in line with that for LTM-June 2017; -Capex to reduce to less than 5% of sales; -Disposals of uneconomic care homes for GBP47 million. YTD June 2017 results showed GBP23.4 million of disposals; -Exceptional cash flow of GBP15 million expected in 2017. Recovery Assumptions -In its recovery analysis, Fitch assumes that a liquidation of Elli's assets will provide higher recoveries for lenders than a going concern restructuring scenario. This is primarily due to Elli's freehold and long-leasehold properties. -Fitch applied a 35% discount to the estimated current market value of remaining property assets following disposals of GBP485 million. - Fitch's recovery expectations for the super senior term loan (CCC+) remain high, at 100%, in line with a 'RR1' Recovery expectations on the senior secured notes (CCC) and the senior unsecured notes (C) remain unchanged, at 'RR2'/82% and 'RR6'/0% respectively. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -A restructuring of the group's capital structure, leading to improving liquidity and maturity profiles, and debt service coverage ratios. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action -Announcement of a default or a distressed debt exchange. LIQUIDITY Poor Liquidity: As of end-June 2017, Elli's cash balance was GBP26.1 million. Elli currently has no other available or committed liquidity buffers. Fitch views the group's liquidity as insufficient for the upcoming maturity of the GBP40 million term loan in December 2017. We have assumed GBP5 million of restricted cash required to run the operations and absorb periodic working capital swings. FULL LIST OF RATING ACTIONS Elli Investments Limited -- Long-Term IDR: affirmed at 'CC' -- Senior unsecured notes: affirmed at 'C'/RR6/0% Elli Finance (UK) plc -- Super senior term loan: affirmed at 'CCC+'/'RR1'/100% -- Senior secured notes: affirmed at 'CCC'/'RR2'/82% Contact: Principal Analyst Louise Liu Analyst +44 20 3530 1660 Supervisory Analyst Frank Orthbandt Director +44 20 3530 1037 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Paul-Antoine Conti Senior Director +44 20 3530 1292 Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Summary of Financial Statement Adjustments - Lease obligations have been capitalised using a 8x multiple. We also assume GBP5 million of restricted cash required to run the operations and absorb periodic working capital swings. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. Applicable Criteria Corporate Rating Criteria (pub. 07 Aug 2017) here Non-Financial Corporates Notching and Recovery Ratings Criteria (pub. 16 Jun 2017) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here#solicitation Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. 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Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. In issuing and maintaining its ratings and in making other reports (including forecast information), Fitch relies on factual information it receives from issuers and underwriters and from other sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. 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