Fitch Affirms Greene King Finance plc's Notes; Outlook Stable
The affirmations reflect Fitch's expectation that the transaction's fairly sound quality estate and management's pro-active approach in addressing industry challenges will continue to deliver stable performance. Fitch's revised base case, which takes into consideration recent weaker performance, is supportive of today's affirmations. The transaction is well positioned against its peers and our metrics forecasts at respective rating levels remain in line with Fitch's UK WBS criteria guidance.
KEY RATING DRIVERS
Industry Profile: Midrange
The operating environment is viewed 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 or various forms of home or other entertainment), and other macro factors such as minimum wages, utility costs and changes in regulation with the statutory pub code introducing in 2016 the market rent-only option (MRO) in the tenanted/leased segment. MRO breaks the traditional tied-model that requires tenants to buy drinks from the pubcos, usually in exchange for lower rent. Last but not least, the implementation of national living wage could put margins under further pressure.
The barriers to entry are viewed as 'midrange'. Licencing laws and regulations are moderately stringent, and managed pubs and tenanted pubs (ie, non-full repairing and insuring) are fairly capital-intensive. Switching costs within the drinking-eating out market, however, are generally viewed as low, even though there may be some positive brand and captive market effects.
The sustainability of the sector is viewed 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
The financial performance is viewed as 'stronger'. The securitised estate's performance has been resilient throughout the economic cycle, with combined managed and tenanted seven-year revenue and EBITDA CAGRs to May 2015 of 4.9% and 2.1%, respectively. Somewhat weaker recent financial performance would indicate a 'midrange' attribute but we would need to see more evidence of sustained weakened financial performance to change our assessment.
The company's operations are viewed as 'midrange'. Greene King Group has limited pricing influence but it is a fairly large operator within the pub sector. The acquisition of Spirit Pub Company in June 2015 could support further extraction of economies of scale. While operating leverage has been increasing over the last few years as a result of a growing food offer, the change in strategy is viewed favourably given that the food-led approach has led to revenue growth.
Transparency is viewed as 'midrange' with the more transparent managed business (self-operated) representing 68% and 46% of the securitised group by EBITDA and estate respectively, meaning good visibility on underlying profitability .
Dependence on operator is viewed as 'midrange'. Operator replacement is not viewed as straightforward but is possible within a reasonable period of time (based on the large number of operators and precedent transactions, e.g. Orchid pubs sold to M&B). Due to centralised management of managed and tenanted estates and common supply contracts, operational commingling is viewed as quite high.
Asset quality is viewed as 'midrange'. The pubs are considered to be well-maintained with capex representing on average 10% of total sales over the last five years. Assets are also well-located (significant portion in London and the south-east), and are almost all freehold. The secondary market is fairly liquid (extensive disposal programmes across the industry have been absorbed).
Debt Structure Class A: Stronger; Class AB, B: Midrange
The debt profile is viewed as 'stronger' for the class A notes and 'midrange' for the class AB and B notes. All debt is fully amortising on a fixed schedule, eliminating refinancing risk and the even debt profile is broadly commensurate with the industry and company risk profile. The class A notes have no interest-only periods, no material concurrent amortisation and benefit from the interest deferability of the junior class AB and B notes. Amortisation for the class AB and B notes is back-ended and their interest-only periods are substantial (until 2031 for the class B and 2033 for the class AB). Interest rate risk for all floating-rate notes is fully hedged.
The security package is viewed as 'stronger' for the class A and 'midrange' for the class AB and B notes. The security package is strong with comprehensive first ranking fixed and floating charges over the issuer's assets and ultimately overall operating assets. The class AB and B notes have equivalent security as class A, but are junior-ranking, hence the 'midrange' attribute.
The structural features are viewed as 'stronger' for all notes. All standard whole business securitisations legal and structural features are present, and the covenant package is comprehensive. The restricted payment condition level is standard (1.5x EBITDA debt service coverage ratio (DSCR), 1.3x free cash flow (FCF) DSCR - including step-up amounts), and the tranched liquidity facility is covenanted at 18 months peak debt service. Additionally, all counterparty ratings are above the required minimum levels as per Fitch structured finance counterparty rating criteria. The issuer is an orphan bankruptcy remote SPV.
In the year ended 3 May 2015, the securitised estate's revenue on a 52-week adjusted basis increased by 5.4% but EBITDA growth slipped into negative territory. Trailing 12 months (TTM) EBITDA as of 3 May 2015 fell 1.5% year-on-year (on a 52-week adjusted basis) to GBP191.5m, whereas Fitch base case assumed marginal growth.
The estate has undergone a strategic disposal programme over the last five years and adjusting for the proceeds added to the disposal account (which can be used to acquire new pubs), the agency estimates the underlying decline of TTM EBITDA to slow to 0.6%. The decline would reflect the impact of slower trading, ongoing cost pressures and effects of the strategic non-core pub disposal programme during which the worse performing non-core tenanted pubs are sold at lower valuations than what the securitisation pays for managed pubs with growth prospects.
New drink driving regulation in Scotland, disappointing world cup and sluggish consumer spending on going/eating-out have all contributed to the weaker sales performance. Greene King Plc's managed division's lfl sales increased by 0.4% in the 52 weeks to 3 May 2015, down from 4.1% a year earlier. Despite decelerating underlying growth, sales in the managed securitised pub portfolio continued to growth through acquisitions (38 pubs) and, to a limited extent, by conversions (five pubs) from the tenanted estate. TTM EBITDA per pub stood at GBP191,900 and continue to be below its peers. Margins have been under pressure from energy and labour costs and this trend has been factored into Fitch's revised base case.
The performance of the tenanted estate, which has been under pressure in recent years, is showing encouraging signs of stabilisation following the disposal of low-end pubs. Securitised EBITDA per pub has continued to increase, to GBP70,600 from GBP51,800 over the last five years. In addition, in the 52 weeks to 3 May 2015, Greene King Plc's tenanted division delivered core lfl net income growth of 3.5%
Under Fitch's revised base case, EBITDA 21-year CAGRs (to legal final maturity of the notes in 2036), which takes into consideration the recent performance remains, mildly positive and negative for the managed and tenanted divisions respectively. Combined EBITDA is forecast to grow gradually, while free cash flow (FCF) is expected to decline slightly due to increasing maintenance expenditure and tax expenses (as interest payments reduce over the life of the transaction).
These forecasts result in Fitch's base case FCF DSCRs to legal final maturity deteriorating slightly versus the last performance review, to around 1.9x, 1.8x and 1.6x for the class A, AB and B notes, respectively. The metrics at respective rating levels, however, remain in line with Fitch's UK WBS criteria guidance.
Greene King's closest peers are Marston's, Spirit Pub Company and M&B. It is well aligned with its peers in terms of FCF DSCR and leverage metrics relative to rating levels.
Any sustained deterioration of the forecast FCF DSCRs to below 1.8x, 1.65x and 1.5x for the class A, AB and B notes, respectively, could trigger a negative rating action. This could be a result of a change in consumer behaviour e.g. as result of an increase in drink driving alcohol limit in England& Wales or MRO/national living wage having a materially larger negative effect than currently expected.
A sustained shift in FCF DSCR metrics to above 2.05x, 1.85x and 1.7x for the class A, AB and B notes respectively could trigger a positive rating action.
SUMMARY OF CREDIT
GK is a whole business securitisation of a portfolio of 688 managed as well as 818 tenanted and leased (referred to as tenanted) pubs located in England, Scotland and Wales. The securitised pubs represent around 79% of Greene King Group's pub portfolio and are considered a representative sample of the total estate.
The rating actions are as follows:
GBP123.2m class A1 floating-rate notes due 2031: affirmed at 'BBB+'; Outlook Stable
GBP242.7m class A2 fixed-rate notes due 2031: affirmed at 'BBB+'; Outlook Stable
GBP84.9m class A3 floating-rate notes due 2021: affirmed at 'BBB+'; Outlook Stable
GBP258.9m class A4 fixed-rate notes due 2034: affirmed at 'BBB+'; Outlook Stable
GBP250.2m class A5 floating-rate notes due 2033: affirmed at 'BBB+'; Outlook Stable
GBP60m class AB1 floating-rate notes due 2036: affirmed at 'BBB'; Outlook Stable
GBP120.9m class B1 fixed-rate notes due 2034: affirmed at 'BBB-'; Outlook Stable
GBP99.9m class B2 floating-rate notes due 2036: affirmed at 'BBB-'; Outlook Stable.