OREANDA-NEWS. Fitch Ratings has affirmed UK-based auto dealership group Pendragon plc's (Pendragon) Long- and Short-term Issuer Default Ratings (IDR) at 'B' and its senior secured rating at 'B+'. The Outlook on the Long-term IDR is Stable.

KEY RATING DRIVERS

High but Gradually Improving Leverage
Pendragon has considerable off-balance-sheet operating lease obligations, which totalled GBP342m at end-2014. Bank debt and other on-balance-sheet instruments such as operating leases were GBP200m at end-2014.

Fitch also adjusts debt by adding the portion of stock financing provided by third-party institutions (GBP180m at end-2014), unlike for other manufacturers' stock financing, which is not treated as debt. In Fitch's view Pendragon's stock financing is debt-like and would probably be replaced by other forms of bank debt were it to stop being available. This adjustment raises leverage by around 1x.

Nevertheless, Fitch-adjusted gross and net leverage ratios at end-2014 were 4.1x and 3.6x, largely unchanged from 4.2x and 3.9x at end-2013, but significantly lower than the 2010 peaks of 6.9x and 6.2x. Fitch expects leverage to continue to improve gradually over the medium term.

UK Auto Market Recovery
UK auto sales continued their post-slump rebound in 2014, and new car sales have returned to their 2008 peak. Pendragon has benefited, with sales and EBITDA growth last year of 4% and 18%, respectively. The outlook for auto sales remains a key indicator of Pendrago's future performance due to the sensitivity of earnings to volume movements.

Strong Auto OEM Relationships
Pendragon benefits from strong long-term relationships with most of the large auto original equipment manufacturers (OEMs), from which it sources vehicles. The diverse range of the company's franchise agreements acts to stabilise its gross margin, although it remains exposed to the financial strength and/or strategy of the OEMs.

Cost Structure Flexibility
The flexibility of Pendragon's operating cost structure is important to offset possible volatility in demand, due to low operating margins in vehicle sales. The company benefits from mid-range EBITDA margins, and since the downturn of 2008 and 2009 has improved its flexibility. Nevertheless, another sharp downturn in the market could put considerable stress on Pendragon's financial profile.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

-Low-single digit volume growth driven by a stabilisation in both the new and used car markets and little change in Pendragon's market share
-A stable pricing environment with prices rising by about 1% p.a. in line with inflation
-In addition to low single-digit growth in the aftersales segment, overall revenues are expected to increase modestly at slightly under 3% p.a.
-A stable gross margin through the medium term given little historical volatility and the pricing arrangements in place with OEMs
-In line with the company's historical margin stability and supported by the flexible operating cost structure, the EBITDA margin is expected to remain stable
-In 2015 and 2016, net capex is expected to be above historical levels due to expansion activities in both the UK and California. After 2016, net capex is expected to be around 1% of revenue
-Gradual increase in dividend payments
-No new debt or debt reduction is assumed
-The level of stock financing in the forecast period is also assumed to remain fairly stable in relation to revenue and total inventory levels

RATING SENSITIVITIES

Positive: Future developments that could lead to positive rating actions include:
- Funds from operations (FFO) adjusted leverage below 3x (FY14: 4.1x) on a sustained basis
- FFO fixed charge cover above 2.5x (FY14: 2.5x) on a sustained basis
- Free cash flow (FCF) above 1% (FY14: 0.1%) on a sustained basis

Negative: Future developments that could lead to negative rating action include:
- FFO adjusted leverage above 6x on a sustained basis
- FFO fixed charge cover below 1.5x on a sustained basis
- Negative FCF on a sustained basis