Fitch Downgrades Marston's Class A Notes to 'BBB'; Outlook Stable
The downgrade is based on financial underperformance as well as positioning relative to peers. The securitised estate's EBITDA has been below Fitch's base case for two consecutive years (EBITDA fell by 6.6% to GBP117.8m y-o-y in 2015 and by 0.9% to GBP116.7m in 2016). Even on an adjusted run-rate basis and accounting for the investments following the disposals we believe that the EBITDA would have been below the 2015 base case. The decline in total trailing 12 months (TTM) April 2016 EBITDA was primarily driven by a 2.2% decrease in the managed estate EBITDA, which more than offset the 0.3% increase in EBITDA for the tenanted estate. Managed pubs' underperformance was driven by an increase in operating costs mainly due to a 3% rise in the national minimum wage in October 2015.
The Fitch-calculated credit metrics are in line with the 'BBB' category lower guidance range as per Fitch's UK WBS criteria for the class A notes and the 'BB' upper range for the class B notes. The one-notch downgrade of the class A notes reflects a lower Fitch base case free cash flow (FCF) debt service coverage ratio (DSCR) and higher leverage in relation to 'BBB' rated peers, while taking into account our assessment of the 'Stronger' debt structure of the class A notes. This feature is not present in other 'BBB' and 'BBB-' rated classes for securitised pub peers, M&B and Greene King. As the liquidity facility is expected to be terminated and to default if the senior notes default, we have aligned its rating with the class A notes.
Fitch's forecast base case DSCR, calculated to legal final maturity, is below 1.6x for the class A notes and 1.4x for the class B notes in contrast to the 2015 forecast of slightly above 1.6x and 1.4x, respectively. The main drivers of the revised forecast are:
- Lower number of securitised pubs in the tenanted estate, although Fitch has given credit to the completion of the three-year conversion programme of tenanted pubs to the franchise model which is expected to result in further growth.
- Increased cost pressure on the managed estate until 2020, stemming from the phasing in of the national living wage, although Fitch also gives credit to management's planned strategy of targeted price increases to mitigate the impact.
- Uncertainty around long-term profit forecasts due to material changes to the composition of the tenanted estate following disposals and conversions to the franchise model despite the positive trends.
The Stable Outlooks reflect Fitch's view that the securitisation will perform in line with current expectations, reflected in the revised Fitch base case.
KEY RATING DRIVERS
Industry Profile - Midrange
Fitch views the operating environment as 'weaker'. While the pub sector in the UK has a long history, trading performance for some assets has shown significant weakness in the past. The sector is highly exposed to discretionary spending, strong competition including from the off-trade, and other macro factors such as minimum wages, rising utility costs and potential changes in regulation such as the proposed statutory code in the tenanted/leased segment.
Regulatory uncertainty has reduced significantly following the enactment of the change in legislation governing the beer tie, which resulted in the introduction of a statutory code with a market rent only option (MRO). While the MRO breaks the tied model that requires tenants to buy beer from the pubcos, the impact on the tenanted estate, including the franchised pubs, for Marston's is currently uncertain.
We view the barriers to entry as 'midrange'. Licencing laws and regulations are moderately stringent, and managed pubs and tenanted pubs (i. e., non-full repairing and insuring) are fairly capital-intensive. However, switching costs are generally viewed as low, even though there may be some positive brand and captive market effects.
We view the sustainability of the sector as 'midrange' with the strong pub culture in the UK expected to persist, thereby taking a large portion of the eating-drinking-out market. In relation to demographics, mild forecast population growth in the UK is a credit positive.
Company Profile - Midrange
Financial performance is viewed as 'midrange'. Over the last five years, performance has been relatively stable (securitised EBITDA CAGR of -2.3%, driven primarily by the large disposal of weaker tenanted pubs), with some vulnerability to negative industry trends.
We consider the company's operations to be 'midrange'. Fitch has given credit to management's strong pro-activeness in turning around its tenanted business, including being the first to launch the hybrid tenanted/managed pubs with their RA (franchise agreement) and tracker agreements. Results suggest that converted pubs experience a strong, double digit in many cases, uplift in sales.
Fitch views transparency as 'midrange'. While financial reporting still follows the managed/tenanted format, without separating out the franchise pubs, there is still some uncertainty about the exact impact of increased franchise pubs on profitability and flexibility. However, there is sufficient information to form a view on key trends.
Dependence on operator is viewed as 'midrange'. Due to the large size of the estate, operator replacement is not viewed as straightforward but should be possible within a reasonable period of time.
We view asset quality as 'midrange'. The pubs are reasonably well-maintained. In the past few years, management has channelled disposal proceeds into debt repayment (repayment of the GBP80m AB facility in January 2014), acquisitions and capex. In the TTM to April 2016, Marston's spent GBP20m on maintenance capex for the securitised estate, which is above the covenant level. The secondary market is reasonably strong.
Debt Structure: Class A: Stronger; Class B: Midrange
We view the debt profile is viewed as 'stronger' for the class A and B notes with all tranches fully amortising. The liquidity facility covers almost two years of debt service. Positive factors include 100% fixed or hedged debt, although there is some derivatives mark to market exposure.
Fitch views the security package as 'stronger' for the class A notes and 'midrange' for the class B notes. The security package is strong with comprehensive first ranking fixed and floating charges over borrower assets. Class A is the senior ranking controlling creditor, with class B lower ranking resulting in a 'midrange' assessment.
Structural features are viewed as 'stronger' for class A and class B. Stronger features include a greater than 18-month liquidity facility, highly rated financial counterparties with adequate downgrade language and a clear orphan SPV. Marston's also benefits from a non-ambivalent set of covenants and moderate restricted payment and default covenants relative to the industry.
A significant outperformance of the base case due to strong growth in the managed estate division and further success of the RA model, resulting in consistent deleveraging, could lead to an upgrade. Fitch could consider an upgrade if its base case DSCR returns to 1.8x for class A and 1.5x for class B.
However, an upgrade of the class A notes in the near term is less likely than the class B notes. The prepayment of the class AB1 improved the debt metrics of the class B notes, bringing them closer to the senior ranking class A notes. Hence, an upgrade of the class B notes is more likely subject to further deleveraging.
On the downside, the ratings could be negatively impacted if performance is significantly below the current base case, due, for instance, to greater than expected cost pressure from the introduction of the national living wage and/or even weaker than expected performance of tenanted pubs. A further deterioration of the Fitch base case DSCR below 1.4x for class A and 1.3x for class B could lead to a downgrade.
SUMMARY OF CREDIT
The transaction is a securitisation of both managed and tenanted pubs operated by Marston's comprising 281 managed pubs and 932 tenanted pubs.