OREANDA-NEWS. Fitch Ratings has upgraded Gala Coral Group Limited's (Gala Coral or GCG) Long-Term Issuer Default Rating (IDR) to 'B+' from 'B' and maintained it on Rating Watch Positive (RWP).

Fitch has also upgraded GCG's subsidiary Gala Group Finance plc's senior secured notes to 'BB+' from 'BB', with an unchanged Recovery Rating of 'RR1' (96% recoveries). The agency has simultaneously upgraded Gala Electric Casinos plc's subordinated senior notes to 'B-' from 'CCC+' with a Recovery Rating of 'RR6' (0%). These ratings remain on RWP.

The upgrade reflects the expected strong performance of Gala Coral in FY16 (financial year ending September 2016) ahead of the planned merger with Ladbrokes plc (BB/RWN), particularly in the online business and in Italy, and the repayment of GBP227m of debt in 2015 further to the sale of the Bingo business. This is despite a challenging UK gaming environment with strong betting shop and online competition and increasing taxation and social responsibility requirements. The recent debt repayment should lower funds from operations (FFO)-adjusted net leverage to 4.3x-4.5x in FY16, more in line with a 'B+' IDR.

As with other UK gaming operators such as Ladbrokes, the group has been subject to increased taxation on its activities, such as higher Machine Games Duty (MGD) and Point of Consumption Duty (POC). However, robust marketing management and significant capex in online/digital/customer relationship management (CRM) have allowed the group to achieve above-average operating profits in the sector, a trend that was confirmed in its 1HFY16 (ended 9 April 2016) results.

The ratings remain on RWP pending completion of Gala Coral's merger with Ladbrokes. This is expected to be completed by end-September 2016, subject to the disposal of between 350 and 400 shops. At present we estimate that the combined entities' IDR will be at least one notch higher than Gala Coral's 'B+' IDR, subject to the final capital structure at completion.

KEY RATING DRIVERS

Strong 2016 Performance Expected

We expect a strong trading performance in 2HFY16 as the Coral mobile-app is re-launched, further growth comes from sports betting at Coral. co. uk and Coral Connect sign-ups accelerate compared with FY15. 1HFY16 reported group EBITDA on a stand-alone basis rose 16% to GBP124.6m (up 43% after adjusting for additional regulatory and gaming tax costs, at GBP107.4m in 1HFY15), due to a recovery in football betting margins and growing revenue across lower-cost web-related betting channels. Gala Coral's above-sector average operating profits and free cash flow (FCF) further underpins the IDR upgrade to 'B+'.

Improving Digital Profitability

The UK gaming sector is undergoing a structural shift towards more online and mobile betting. Coral. co. uk has shown strong growth in the number of active players, driven by successful marketing programmes and a high level of Coral Connect multi-channel sign-ups in FY15. As a result, Gala Coral's digital EBITDA rose to GBP56.2m at FYE15 from GBP49.5m in FYE14 despite increased regulatory and tax costs. The group continues to acquire active website customers at competitive prices, and we expect further revenue and profit growth in the online business in 2016.

Bingo Business Sold

In December 2015 Gala Coral sold its Gala Retail Bingo business for GBP241m and used GBP227m of the proceeds to partially repay the GBP315m 2018 senior secured notes, thus strengthening financial flexibility and mitigating refinancing risks The group achieved a sound exit multiple for a stagnating betting business with falling average spending, despite the UK government's reduction of bingo duty to 10% from 20%.

Declining Leverage

We estimate at merger date Gala Coral's net debt at around GBP865m and leverage (on an FFO lease-adjusted basis net of cash) should reduce to 4.3x-4.5x by FY16 (5.0x at end-September 2015), due to positive free cash flow (FCF) of around GBP59m in 2015 and the repayment of GBP227m of debt. Merger financing and cash at Gala Coral is in place to repay all outstanding Gala Coral debt at merger completion.

Creating a Market Leader

The combination of Gala Coral with Ladbrokes Plc should create a UK market leader with a stronger business profile, particularly in digital, than either group could achieve separately. The merged group will operate over 3,600 betting shops in the UK and have a significant online business with around 27% of the total UK market, making it a market leader in this channel.

Strengthening Business Profile

The enlarged group's business will be enhanced by the combination of Gala Coral's strong online presence, where Ladbrokes has underperformed, and its Italian operations, with Ladbrokes' and Gala Coral's large UK shop portfolios, well-known brands and long UK track records. Following the announcement by the Competition and Markets Authority (CMA) that the merger can proceed, subject to the disposal of between 350 and 400 shops, the merged entity should therefore be better able to compete in a now rapidly consolidating market.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Gala Coral on a stand-alone basis include:

-Low single-digit growth in gross wins in FY16;

-A full-year annualised impact on profitability in 2016 due to the GBP50 'limit' on machine games; we assume increased social responsibility regulatory costs of between GBP12m and GBP13m in FY16;

-Capex to remain 5%-6% of sales with a growing emphasis on online activities to remain competitive;

-Positive FCF of between GBP40m and GBP87m p. a. between FY16 and FY17;

-No dividends paid;

-Horse racing levy: we do not include any adjustments for the Horse Racing Right, which may replace the existing horse racing levy from 2017;

RATING SENSITIVITIES

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

-Continued improvement in UK retail and online operations leading to steady EBITDA margin;

-FFO fixed charge cover (FCC) above 2.5x (FY15: 1.7x albeit not adjusted for recent debt redemption) on a sustained basis

-FFO lease-adjusted net leverage below 4.0x and gross leverage below 4.5x on a sustained basis

The completion of the merger resulting in a strengthened business profile could result in a rating that we currently estimate to be at least one notch higher than Gala Coral's 'B+' IDR, subject to the final capital structure at completion.

Future developments that may, individually or collectively, lead to a Stable Outlook on a stand-alone basis include:

-EBITDA margin falling below 18% on a sustained basis due to weaker operating performance, shrinking FCF to neutral or 1% to 2% of revenues.

-FFO fixed charge cover below 2.5x on a sustained basis

-FFO lease-adjusted net leverage above 4.5x and gross leverage above 5.0x on a sustained basis

LIQUIDITY

At end-2015 Gala Coral had acceptable liquidity with GBP231m of unrestricted cash and GBP64.5m available under a revolving credit facility due May 2017. Gala Coral's next major debt maturity is a GBP711.9m term loan due May 2018 although we expect this to be refinanced as part of the merger financing (upon completion).