OREANDA-NEWS. S&P Global Ratings today raised its long-term corporate credit rating on Spain-based NH Hotel Group S. A. (NH) to 'B' from 'B-'. The outlook is stable.

At the same time, we raised our issue rating on NH's senior secured debt to 'BB-' from 'B+'. The recovery rating on the senior secured debt remains at '1', indicating our expectation of very high (90%-100%) recovery prospects in the event of a payment default.

The upgrade reflects our view that NH will maintain its now stronger liquidity, which we consider to be adequate versus less than adequate previously, coupled with its solid operating performance that has exceeded our expectations. To date, we understand that NH has completed about 75% of its planned asset sales for 2016, while improving working-capital trends through enhanced controls, all of which help boost our liquidity assessment.

The upgrade also incorporates the group's turnaround plan, in response to marked underperformance after the 2008-2009 global financial crisis. In 2015 and the first six months of 2016, NH has improved occupancy rates and revenue per available room (RevPAR) beyond our expectations, with particular strengthening in Spain, where it reported double-digit RevPAR growth. As a result, profitability, revenues, and EBITDA have increased, translating into stronger credit metrics. In our view, this improvement has mainly followed the group's plan to reposition capital expenditures (capex), which we expect it will finalize this year. We think the plan will enable the group to restore generating positive free operating cash flow (FOCF) in 2017 and beyond. For the 12 months ended June 30, 2016, adjusted debt to EBITDA improved to about 7.5x and EBITDA interest coverage surpassed 2.0x.

Our assessment of NH's business risk profile remains weak and continues to take into account our view of NH's business model, which is centered on operating owned and leased hotels (approximately 75% of total rooms). In our opinion, this concentration contributes to a high and relatively inflexible fixed-cost base, although we note that the group is taking steps in renegotiating lease contracts to secure more variable leases in its structure. Our adjusted EBITDA margins of around 30% for NH in the current financial year are broadly in line with those of NH's peers. However, we think cyclical downturns will put more pressure on the group's earnings than on asset-light franchised or managed businesses.

We view NH's presence outside Europe as relatively limited. Its recent acquisition of Hoteles Royal in Latin America is still far from bearing fruit. We note the group's weaker performance in that region, with RevPAR in the first half of 2016 down by 5%, strongly affected by currency fluctuations. Still, we recognize that Latin America represents about 10% of group revenues.

In addition, although we view midsize properties as having lower cost bases than luxury hotels, we believe that NH's key market segment has relatively low barriers to entry and is therefore more exposed to competition. At the same time, we recognize that NH's strategy is to continue increasing its presence in the upper upscale category. On the positive side, we view NH as having a strong position in the midsize hotel markets of Spain and Italy, with an urban focus. Its operating performance is positive overall, with improving occupancy, available daily rates, and RevPAR.

Overall, we view as positive for the ratings NH's current strategy to move toward a more asset-light ownership model and a more upmarket segment, while restructuring its cost base to keep improving profitability, generating positive cash flows, and reducing debt.

Our assessment of NH's financial risk profile as highly leveraged reflects the group's substantial, albeit declining, levels of adjusted debt and relatively low EBITDA interest coverage metrics. A large share (about 75%) of the group's adjusted debt stems from our operating-lease adjustment. But even on an unadjusted basis, we view NH's projected financial debt to EBITDA as high. S&P Global Ratings' adjusted debt to EBITDA for NH had decreased to 7.9x as of Dec. 31, 2015, from 8.9x a year before, and we expect it will drop further to about 7.4x by Dec. 31, 2016. Still, we expect NH's capacity to generate FOCF will remain constrained over the next 12 months as it finalizes its investment program. We understand that NH plans to sell its Jolly Hotel Madison Towers in New York, which we currently do not incorporate in our base case. But this potential deal may be via a sale-and-leaseback transaction, under which we would typically capitalize the entire sale price. We would likely view this as credit neutral.

Lastly, we note that the current shareholder dispute, recently resulting in ousting HNA (29.5% ownership) from the Board of Directors on account of a conflict of interest, as well as the unforeseen departure of the CEO, could be a negative for NH's credit quality. In particular, in our assessment of its financial policy, we view the potential for aggressive shareholder distribution policies as a risk to the rating.

In our base case, we assume: GDP growth expectations in NH's main countries of operations--Spain, Italy, Netherlands, Belgium, and Germany--should support group revenue growth over the next two years.4%-8% growth in revenues for 2016 and a low - to mid-single-digit revenue increase in 2017.Improvement in the adjusted EBITDA margin in 2016 and 2017 to about 31%-32%, owing to the proposed cost-structure plans, although smooth execution could be challenging; andA ratio of capex to sales of about 10% in 2016, before declining to a more normalized 4%-5% from 2017. This ratio excludes the acquisition of Hoteles Royal and any additional mergers or acquisitions. Based on these assumptions, we arrive at the following credit measures for NH: Adjusted debt to EBITDA of between 7.0x and 7.5x in 2016 and 2017;Adjusted funds from operations (FFO) to debt of between 5% and 7% in 2016 and 2017; andAdjusted EBITDA interest coverage of between 1.9x and 2.2x in 2016 and 2017. We apply a positive comparable ratings analysis modifier to NH, resulting in our 'B' long-term rating on the group after a positive one-notch adjustment to our 'b-' anchor. The modifier reflects our view that NH's business risk profile is at the high end of our weak category, particularly compared with its peers.

The stable outlook reflects our view that NH will continue to focus on improving its operating performance, while controlling working-capital, liquidity, capex, and cost management. This, coupled with our expectations of improving profitability and gradual debt reduction, should continue to strengthen the group's credit metrics over the next 12 months. Specifically, we expect NH will post adjusted EBITDA interest coverage above 2x in 2016 and start generating positive FOCF in 2017.

We could lower the ratings if NH's operating performance deteriorates due to macroeconomic, geopolitical event risks, or competition. In this scenario, a significant profit decline could weaken cash flow, leading to a constrained liquidity, covenant cushion below 15% or adjusted EBITDA interest going below 1.5x. We could also take a negative rating action if the group distributes dividends that are higher than we currently anticipate, undertakes debt-financed acquisitions, or posts significant negative FOCF.

An upgrade of NH is unlikely over the next 12 months. Over the long term, we could raise the ratings if NH's credit metrics and financial policy support a revision of its financial risk profile to aggressive. This could occur if the group sustained a ratio of total adjusted debt to EBITDA of less than 5x and a ratio of FFO to total adjusted debt above 12%. In addition, a potential upgrade would follow positive FOCF generation on a sustainable basis and greater stability at the group's shareholder level.