OREANDA-NEWS. Fitch Ratings has downgraded France-based clinical laboratory services group Labco SA (Labco)'s Issuer Default Rating (IDR) to 'B' from 'B+' and removed it from Rating Watch Negative (RWN). The Outlook is Stable. The IDR, together with the instrument ratings on Labco's existing super senior revolving credit facility (RCF) (BB/RR2) and its EUR700m senior secured notes due 2018 (BB-/RR3), has been withdrawn.

The rating action follows the completion of the acquisition of Labco by funds advised by Cinven via Ephios Bondco PLC (Ephios; B(EXP)/Stable), and the repayment of Labco's legacy debt instruments. This has resulted in the removal of the RWN, on which the ratings were placed on 11 June 2015 on the agency's view that the acquisition would lead to a slightly more leveraged capital structure and hence no headroom at the previous rating level.

The expected ratings on Ephios and Ephios Holdco II PLC (Ephios Holdco) assigned as part of the acquisitions of Labco and synlab Holding GmbH (Synlab) by funds advised by Cinven and their proposed merger have been affirmed at their existing levels. Ephios' IDR has been affirmed at 'B(EXP)' with a Stable Outlook. Ephios' EUR1.48bn senior secured notes due 2022 have been affirmed at 'B+(EXP)'/'RR3'. Ephios' super senior revolving credit facility (RCF) - rated 'BB-(EXP)'/'RR2' - remains on Rating Watch Positive (RWP) while Fitch has further affirmed Ephios Holdco's planned EUR375m senior notes due 2023 at 'CCC+(EXP)'/'RR6'.

The assignment of the final ratings and the resolution of the RWP are contingent on the completion of the acquisition of Synlab and its merger with Ephios, the receipt of final documents materially conforming to information already reviewed and the publication of audited consolidated statements for the combined group.

Once these conditions have been satisfied, Fitch expects to assign a final IDR of 'B' to Ephios and then transfer it to Ephios Holdco, the new top holding entity within the enlarged restricted borrowing group. We also expect to upgrade the enlarged super senior RCF to 'BB'/'RR1'.

KEY RATING DRIVERS FOR EPHIOS' IDR

Weak Financial Metrics
The proposed capital structure backing the acquisition of Synlab and its merger with Ephios will maintain a high funds from operations (FFO) adjusted gross leverage close to 8.0x. We believe such high leverage is not commensurate with a 'B' IDR but we expect gradual deleveraging over the next two years driven by the combined group's positive free cash flow (FCF).

We also expect FFO fixed charge cover to improve mildly from our forecast low point of around 1.7x post-merger. These metrics are weak relative to peers including Cerberus Nightingale 1 SA (Cerba; B+/Negative) and Quest Diagnostics Inc. (BBB/Stable).

Moderate Deleveraging Prospects
The rating conservatively assumes that Ephios Holdco will continue with Ephios' and Synlab's respective consolidation strategies of sourcing and executing low-risk bolt-on acquisitions of laboratories at attractive multiples and extracting synergies, driven by the fragmented nature of the European laboratory testing market and weak organic growth prospects. As a result we expect FFO adjusted gross leverage to only gradually reduce to below 7.0x by 2017, a level compatible with an IDR of 'B' for the sector. Any large, transformational M&A would be considered as event risk.

Leader in European Laboratory Services
The rating reflects the enlarged group's market position as the largest clinical laboratory services group in Europe by revenue. The planned combination of Ephios and Synlab will expand Ephios' existing presence and place the combined entity as a top-three player in its core markets. It will reduce the exposure to single healthcare systems and therefore help strengthen the resilience of cash flows and earnings.

Steady Profitability
The merger would slightly dilute Ephios' legacy EBITDA margin as Synlab has significant exposure to a lower-margin market (Germany). We believe that the combined group is somewhat reliant on extracting cost savings from this greater scale, which may be limited due to little overlap between Ephios' and Synlab's existing operations. As a result we only expect a mild improvement in profitability by 2017.

Subdued Organic Performance
Fitch expects the pricing environment to remain challenging in Ephios Holdco's key markets, namely Germany (29% of 2014 pro forma sales), France (24%), Italy (12%), Spain (8%) and Switzerland (8%). Sustained reimbursement pressures by ultimate payers such as governments and insurance companies are likely to constrain organic growth prospects in the medium term.

As volumes have proven resilient to economic cycles, underpinned by broadly favourable demographics and socio-economic factors, we expect larger players, such as Ephios Holdco, to withstand the negative impact of tariff pressure on their profitability.

KEY RATING DRIVERS FOR THE INSTRUMENTS

Weak Creditor Protection
Upon completion of the transaction, the proposed super senior RCF and the senior secured notes (including the tap issue) will share the same security package, primarily comprising share pledges over Ephios Bondco Plc, Ephios France SAS, Ephios Acquisition GmbH as well as over subsidiaries representing around 60% of the consolidated EBITDA as of end-March 2015.

The senior notes issued by Ephios Holdco, however, will benefit from a junior-ranking share pledge over the same entities. The super senior RCF will include a single leverage covenant while the senior secured notes and the senior notes are protected by incurrence-based covenants, subject to permitted baskets.

Going Concern Distressed Valuation
We expect a going-concern restructuring to yield stronger recoveries for creditors than liquidation in a default scenario. We assume a distressed sale of the group as a whole at Ephios Holdco or possibly Ephios Bondco level as a liquidation of individual labs could prove challenging given laboratory ownership regulatory constraints in various European jurisdictions, in particular clinical pathologists' pre-emptive rights in France. Therefore, we have valued the group on the basis of a 6.0x multiple applied to an EBITDA that is 20% below the last 12-month combined EBITDA as of end-March 2015, factoring in acquisitions already completed and adding back UK operations' start-up costs.

Poor Recoveries for Holdco's Noteholders
The expected ratings of 'CCC+(EXP)'/'RR6' for Ephios Holdco's planned senior notes reflect poor recovery prospects for noteholders in a default scenario given their subordination to the super senior RCF and certain other obligations of non-guarantor subsidiaries as well as the enlarged senior secured notes in the debt waterfall.

We have placed the super senior RCF on RWP and expect to upgrade it to 'BB'/'RR1' upon completion, assuming full recoveries given its fairly small share and its seniority in the debt waterfall as we believe Germany will be the group's "Centre of Main Interest" instead of France.

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 include:

- Low to mid-single digit organic growth in key markets;
- Impact of launch of UK activities, strikes in France and increase of VAT in Spain on 2015 EBITDA and FFO margins;
- EBITDA margin improving towards 20% by 2017 (post-merger: 18%), due to cost savings and economies of scale achieved from the enlarged group;
- Up to EUR100m of bolt-on acquisitions per year after 2015;
- No dividends paid

RATING SENSITIVITIES

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

- Meaningful deleveraging such that FFO adjusted gross leverage (pro forma for further bolt-on acquisitions) falls to 6.5x, combined with FFO fixed charge cover improving towards 2.0x;
- Positive FCF as a proportion of sales sustainably in the mid to high single digits;
- More conservative financial policy reflected in lower debt-funded M&A spending, or growth funded more conservatively by existing cash flows or equity funds.

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

- FFO adjusted gross leverage (pro forma for acquisitions) above 8.0x on a sustained basis;
- FFO fixed charge cover (pro forma for acquisitions) below 1.3x on a sustained basis;
- EBITDA margin below 17% due to failure to extract synergies and more integration issues than expected;
- FCF margin falling to slightly positive territory while maintaining a debt-funded acquisition strategy;
- Large, debt-funded and margin-dilutive acquisitions, combined with profitability erosion in key markets, reflecting a more challenging operating environment.

LIQUIDITY AND DEBT STRUCTURE

We expect Ephios Holdco's liquidity to be satisfactory. Under the proposed capital structure, Ephios Holdco will have access to the enlarged super senior RCF of EUR250m, which can be used for general corporate purposes as well as for bolt-on acquisitions. The combined group has no meaningful debt maturities before 2022 and 2023, which will allow it and Cinven to focus on a successful strategy execution.