Fitch Upgrades Priory's Senior Notes to 'BB+'; Affirms IDR at 'B+'

LONDON--()--Fitch Ratings has upgraded Priory Group No. 3 plc's (Priory) senior notes to 'BB+'/'RR1' from 'BB'/'RR2'. The ratings have been removed from Rating Watch Positive (RWP) on which they were placed on 17 October 2014. At the same time, Fitch has affirmed Priory's Long-term Issuer Default Rating (IDR) at 'B+' with a Stable Outlook and the RCF and senior secured notes ratings at 'BB+'/'RR1'.

The upgrade of the senior notes reflects Fitch's expectation of improved recoveries for senior noteholders assuming a default scenario, following the completion of the sale and leaseback transaction for six acute psychiatric hospitals as per the terms announced in October 2014 and the subsequent repayment of GBP244.7m of prior-ranking senior secured notes due 2018. All other ratings remain unaffected.

KEY RATING DRIVERS

Improved Recoveries for Senior Notes

While the proportion of freehold and long-leasehold properties within Priory's overall portfolio will be reduced to 83% from 85%, Fitch estimates the value of assets in a liquidation scenario to remain sufficient to ensure recoveries for unsecured noteholders up to 'RR1' (i.e. 91% to 100% recovery rate). Outstanding recoveries are supported by the lack of structural subordination for unsecured noteholders and by the UK jurisdiction where any liquidation of the assets would likely take place.

Increased IDR Headroom

Following the sale and leaseback transaction, Fitch expects funds from operations (FFO) adjusted gross leverage to decrease to 5.7x from 6.7x at fiscal year-end 2013 (FYE13) and FFO fixed charge coverage to improve to about 2.0x from 1.8x. As a result, financial flexibility has improved, providing additional headroom under the current 'B+' IDR and thereby further differentiating Priory from lower-rated health and social care providers. However, Fitch does not expect credit metrics to reach the agency's positive rating triggers in the near term, hence the Stable Outlook on the IDR.

Operating Challenges Remain Manageable

The group's performance through to September 2014 remains satisfactory despite a challenging operating environment, driven by higher staff and compliance costs across the sector as well as unfavourable pricing in the Education division. Fitch believes that Priory is well placed to manage these challenges, given its leading market position as the UK's largest provider of independent acute mental health care, strong brand and good relationship with the National Health Service (NHS). The rating of 'B+' is supported by management's proactive approach in adapting to a new operating environment, in managing costs, in conducting asset sales to reduce debt and in investing in marketing and systems to help drive growth.

Adequate Business Diversification

Priory's diversification across high acuity mental health care, elderly care homes, educational and other specialist services helps mitigate the impact of potential challenges arising from one single segment. Recently, the under-performance of the Education division resulting from a structural change in pupils' mix towards lower-margin day placements and away from higher-margin residential placements has been partly compensated by sustained growth in other divisions.

Supportive Long-Term Fundamentals

Fitch continues to believe that Priory is well placed to benefit from the outsourcing of high acuity patients by the NHS in the long term. Fitch expects future volumes to largely offset pricing pressure stemming from fee negotiations with the NHS over the near-to-medium term as a result of budget constraints.

Moderate Execution Risks

Fitch considers the underlying execution risk inherent in Priory's expansion plans for its Healthcare and Craegmoor divisions to be moderate given management's track record. The group has recently indicated that it will prioritise growth opportunities in private outpatients and new autism services where it can achieve higher growth than the wider market. Fitch believes that these targeted growth areas will not affect Priory's business risk profile materially.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

--FFO lease-adjusted gross leverage below 5.0x (or 4.5x net of unrestricted cash) on a sustained basis;

--FFO fixed charge cover above 2.5x on a sustained basis;

--Improvement in EBITDAR margin towards 30% or free cash flow (FCF) margin of 5% on a sustained basis.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

--FFO lease-adjusted gross leverage above 6.5x (or 6.0x net of unrestricted cash) on a sustained basis;

--FFO fixed charge cover below 2.0x on a sustained basis;

--Permanently weak FCF resulting from further price and cost pressure.

LIQUIDITY AND DEBT STRUCTURE

Long Dated Debt Maturity Profile

The debt structure provides the group with financial flexibility as the maturity profile is back-ended and long-dated. Following the sale and leaseback, debt will include GBP386.3m of senior secured notes due 2018 and GBP175m of senior notes due 2019.

Satisfactory Liquidity

Fitch expects liquidity to remain satisfactory given the absence of significant debt maturity until 2018, together with the agency's expectation of positive FCF from FY15. In addition, Priory has access to a committed GBP70m senior secured revolving credit facility (RCF) expiring in 2017 that can be used for capex purposes of up to GBP50m. As of September 2014, GBP49m was available under the RCF.

Additional information is available on www.fitchratings.com

Applicable criteria, 'Corporate Rating Methodology', dated 28 May 2014, are available at www.fitchratings.com.

Applicable Criteria and Related Research:

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=950036

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

Contacts

Fitch Ratings
Supervisory Analyst
Paula Murphy
Director
+44 203 530 1718
Fitch Ratings Limited
30 North Colonnade
London E14 5GN
or
Principal Analyst
Paul-Antoine Conti
Director
+44 203 530 1292
or
Committee Chairperson
Pablo Mazzini
Senior Director
+44 203 530 1021
or
Media Relations:
Peter Fitzpatrick, +44 20 3530 1103, London
peter.fitzpatrick@fitchratings.com

Contacts

Fitch Ratings
Supervisory Analyst
Paula Murphy
Director
+44 203 530 1718
Fitch Ratings Limited
30 North Colonnade
London E14 5GN
or
Principal Analyst
Paul-Antoine Conti
Director
+44 203 530 1292
or
Committee Chairperson
Pablo Mazzini
Senior Director
+44 203 530 1021
or
Media Relations:
Peter Fitzpatrick, +44 20 3530 1103, London
peter.fitzpatrick@fitchratings.com