September 30, 2016 / 1:52 PM / a year ago

Fitch Downgrades UK's Elli Investments to 'CC'

(The following statement was released by the rating agency) LONDON, September 30 (Fitch) Fitch Ratings has downgraded Elli Investments Ltd.'s (Elli) Long-Term Issuer Default Rating (IDR) to 'CC' from 'CCC'. 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 downgrade reflects uncertainty over the sustainability of Elli's capital structure in light of structural deterioration in the business's profitability and cash flow performance, despite an improving operating performance so far in 2016. As a result, Elli is required to supplement internal cash generation with non-core asset disposals to support liquidity, offering limited visibility on liquidity beyond December 2016 as the company approaches refinancing from 2017. Elli's parent company has entered into negotiations with its lenders with the aim of establishing a sustainable capital structure, which also drives today's downgrade. KEY RATING DRIVERS Operational Challenges, Stabilising Performance Elli's business model is challenged by constraints affecting profitability and cash flow generation. This is due to pressures 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. While in addition to the significant increase in funded nursing care, 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 fee rates during 2016, all these measures have so far been insufficient to fully restore profitability. Against this backdrop, Elli has increased its focus on a clear segmentation of its care homes across the three brands, disposed of under-performing assets, increased the focus on the quality of care, as well as actively managing staffing and costs. As a result, the group's embargo rate is currently the lowest since 2014 and reliance on agency workers has been managed down, while occupancy rates have been steadily increasing. Unsustainable Capital Structure We believe that the decline in Elli's profitability is structural, leading also to impaired operational cash flow, and in turn an unsustainable capital structure based on current debt levels. We estimate Elli's EBITDAR margin at 14% in 2016, compared with 20% in 2013. As a result, Fitch calculates funds from operations (FFO)-adjusted net leverage to remain at just below 10x for 2016, and FFO fixed charge cover at less than 1.0x. Without cash generation from asset disposals, operational cash generation remains insufficient to cover the annual interest payments of GBP55m, leading to limited liquidity visibility post 2016. Lender Negotiations Key Fitch would expect a restructuring of the group's capital structure, as currently discussed with its lenders, as well as improving liquidity and debt maturity profiles, and debt service coverage as prerequisite for a positive rating action. Recovery Prospects In its recovery analysis, Fitch has adopted the liquidation value approach as the resultant enterprise value is higher than the going concern enterprise value, underpinned by the group's freehold and long-leasehold properties. Fitch believes that a 35% discount on the assets' current market value provided by an independent valuer in April 2016 is deemed fair in a distress scenario. Recovery expectation for the 'CCC+' senior secured loan is still high at 100%, yielding a Recovery Rating of 'RR1'. Recovery expectations on the senior secured notes and the senior unsecured notes have respectively remained unchanged at 85%/'RR2 and 0%/'RR6'. KEY ASSUMPTIONS Fitch's expectations are based on the agency's internally produced, conservative rating case forecasts. They do not represent the forecasts of rated issuers individually or in aggregate. Fitch's key assumptions within the rating case for 2016 include: -EBITDA of GBP50m -Capex at GBP48m -Disposals of uneconomic care homes for GBP42m -Exceptional cash flows amounting to GBP15m RATING SENSITIVITIES Negative: Future developments that could, individually or collectively, lead to negative rating actions include: - Announcement of a default or distressed debt exchange Positive: Positive rating action is contingent on a restructuring of the group's capital structure, leading to improving liquidity and maturity profiles, and debt service coverage ratios. LIQUIDITY Fitch expects Elli to rely on additional liquidity by end-2016 to avoid a liquidity shortfall, with permitted property disposals being the most obvious source. At end-June 2016, the group's cash balance was GBP38m. The group currently has no other available or committed liquidity buffers. FULL LIST OF RATING ACTIONS Elli Investments Limited Long-Term IDR: downgraded to 'CC' from 'CCC' Senior unsecured notes: downgraded to 'C'/RR6/0% from 'CC'/'RR6'/0% Elli Finance (UK) plc Super senior term loan: downgraded to 'CCC+'/'RR1'/100% from 'B'/'RR1'/100% Senior secured notes: downgraded to 'CCC'/'RR2'/85% from 'B-'/'RR2' /85% Contact: Principal Analyst Victoria Ghannage Associate Director +44 20 3530 1190 Supervisory Analyst Frank Orthbandt Director +44 20 3530 1037 Fitch Ratings Limited 30 North Colonnade London E145GN Committee Chairperson Edward Eyerman Managing Director +44 20 3530 1359 Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: Summary of Financial Statement Adjustments - Fitch adjusts financial leverage for lease obligation capitalising these with a multiple of 8x. We also consider GBP10m of cash as restricted, absorbed by the group's working capital. 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