OREANDA-NEWS. Fitch Ratings has downgraded Turnstone Midco 2's (Turnstone) Long-Term Issuer Default Rating to 'B' from 'B+' and removed it from Rating Watch Negative. The Outlook is Stable. The downgrade follows the completion of IDH Finance PLC's issue of GBP425m new senior notes, to which we have assigned a final senior secured rating of 'B+' with a Recovery Rating of 'RR3'.

We have also assigned a final rating of 'BB' with a Recovery Rating of 'RR1' to the GBP100m super senior revolving credit facility (RCF) with recourse to Turnstone.

These rating actions are in line with the agency's expectations as detailed in the Rating Action Commentary dated 25 July 2016, following the launch of the refinancing, with the terms of the final documentation of the bonds in line with the information already reviewed at the time of assigning the expected ratings.

The proceeds from the issue, together with the cash on balance sheet and proceeds from an unrated second lien issue, have been used to refinance the group's existing GBP539m debt (senior and second lien notes, as well as drawings under a senior secured RCF) and associated transaction costs, improving the group's liquidity and maturity profile.

The downgrade of Turnstone's IDR reflects weaker debt service and coverage ratios post refinancing to levels more commensurate with a 'B' rating. Funds from operations (FFO)-adjusted net leverage will increase to 6.7x in the financial year ending 31 March 2017 and FFO fixed-charge cover will weaken to below 2.0x, due to the larger amount of debt, higher cost of debt, and weaker profitability as the result of under-delivery of units of dental activity (UDA) and negative FX impact.

The rating, however, remains underpinned by the strengths of Turnstone's brand, IDH, which was recently rebranded Mydentist. IDH has a leading market position in the UK's National Health Service (NHS) dental sector. This provides the company with stable cash flow driven by long-term evergreen contracts accounting for around 59% of total revenue.

Turnstone also has a record of acquiring and successfully integrating small dental businesses; self-sufficiency in dental supply services; an expanding network of dental practices, which delivers economies of scale; and a close relationship with the NHS.

Following the downgrade, the 'B' rating has significant headroom for Turnstone to deliver on its growth strategy as a consolidator in the still fragmented dental services market in the UK. This is reflected in the Stable Outlook.

KEY RATING DRIVERS

Increased Leverage, Improved Financial Flexibility

Debt protection ratios have weakened as the result of the completed refinancing, with FFO adjusted net financial leverage increasing to 6.7x in FY17 from 6.4x a year earlier and FFO fixed charge cover weakening to below 2.0x, from 2.1x per our previous expectations. This will be predominantly driven by the larger amount and higher cost of debt as well as weaker profitability as the result of UDA underperformance and FX headwinds. We now view these metrics as commensurate with a 'B' rating, although the new debt has lengthened Turnstone's maturity profile and improved liquidity, providing the company with sufficient financial flexibility to continue its strategic development.

Lower-than-Average Business Risk

Fitch views the business profile of Turnstone as stronger than its financial metrics for the 'B' rating category. The business is supported by growing scale in its operations, self-sufficiency and brand investments. IDH benefits from its leading market position in the UK NHS dental sector, and enjoys stable cash flows, which are underpinned by long-term evergreen contracts.

IDH is also well-placed to tap a structurally growing private dental market. As a result, we project sustainable free cash flow (FCF) margin of 2%-4% for the business over the four-year rating horizon, with the exception of FY17, where FCF will be negative due to exceptional costs, which are mostly associated with the debt refinancing. Constraints are its modest scale and limited diversification, compared with international healthcare peers rated by Fitch.

'Sticky' NHS Contracts

The rating reflects a decrease in UDA delivery to 92.4% in FY16 from 95.8% in FY15 and compared with a target of 96%. The decline was a result of fewer exempt patients due to an improving economy, a change in patient mix, and increased NHS scrutiny on delivery, claims and performance benchmarks, which we view as an industry-wide trend to improve value generated in the system.

As a result IDH's productivity suffered and management is taking active measures to recover UDA performance towards the long-term target of 96%, which include actively managing dentist productivity, simplifying administration and achieving an improved patient and appointment mix, in addition to increasing the share of private treatments.

Fitch projects a long-term average EBITDA margin trending towards 15% (against historical margins of closer to 19% and FY16 margin at 14.2%) based on expected improvement in UDA performance, greater value focus in NHS contracts, the shifting patient mix to private dental services as well as the integration of the dental supply operations, both of which have structurally lower margins. A key risk to the margin targets are FX headwinds following the recent depreciation of sterling, as some of the Practice Service division's costs are based in euros and US dollars.

Acquisitions Add Scale, Diversification

Fitch expects Turnstone to continue its targeted and carefully executed acquisition strategy as the fragmented UK dental sector consolidates further. However, the current weaker UDA performance and profitability, together with increased acquisition valuations, have led to management prioritising improvement of operating performance over aggressive acquisition growth for FY17.

Fitch has reflected this strategy shift in its rating case assumptions, lowering the acquisition budget for FY17 to GBP13m (from GBP40m previously) but increasing thereafter in line with an improvement in operating performance. We view this change in strategic emphasis as prudent in the current uncertain environment, confirming management's disciplined approach to external growth. We view the integration and execution risk as manageable based on IDH's good track record and will treat larger acquisitions outside our defined parameters as event risk.

KEY RATING DRIVERS FOR THE NOTES

Fitch believes that expected recoveries would be maximised in a going-concern scenario rather than a liquidation given the scale benefits, self-sufficiency and increasing investment in the brand, which we believe are key value drivers for the business. The 'RR3' Recovery Rating on the proposed senior secured notes indicates healthy recovery prospects of 51%-70% of current principal and related interest. We estimate a post-restructuring EBITDA of approximately GBP80m and a going-concern multiple of 6.0x enterprise value (EV)/EBITDA.

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. Key Fitch forecast assumptions are listed below.

-Recovery in UDA delivery leading to an organic increase in NHS patient services revenues. This, combined with acquisitions, will lead to annual revenue growth of around 7% in 2017 and 2018.

-Continued strong like-for-like growth in private patient services as the rebalancing and rebranding strategies continue to take effect. This is projected to lead to revenue growth of just under 10% a year through to 2018.

-Moderate growth in practice services (3.7% in FY17).

-Increased focus on profitability, UDA performance and mitigation of FX headwinds should see EBITDA margins trending towards 15%.

-Continuation of acquisition strategy, albeit at a slower pace, as management shifts focus to performance improvements over external growth. Acquisition multiples are projected to be greater than 6.0x EV/EBITDA. This will lead to acquisition cash outflows of about GBP20m on average a year, which will be partly funded by drawings under the RCF.

RATING SENSITIVITIES

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

- Ability to increase diversification and scale via acquisitions without diluting profits or FCF, while maintaining FFO-adjusted net leverage below 6.0x (FYE16: 6.4x) on a sustained basis;

- FFO fixed-charge coverage above 2.0x (FYE16: 1.9x)

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

- Reduced profitability from failure to achieve UDA delivery, achieve cost synergies or to manage cost inflation, leading to EBITDA margin falling below 10%

- Negative FCF, for example, as a result of an unsuccessful acquisition strategy driving weaker credit metrics such as FFO-adjusted net leverage to above 7.5x (pro forma for acquisitions)

- FFO fixed-charge coverage below 1.5x on a sustained basis

LIQUIDITY

With no material debt maturity over the four-year rating horizon post-refinancing, we assess liquidity as adequate for Turnstone to implement its prudent growth strategy. Post refinancing, Turnstone has readily available cash of GBP9m in addition to the GBP100m super senior RCF.