S&P: Various Rating Actions Taken In U. K. Corporate Securitization Unique Pub Finance Co. Following Performance Review
We have removed our stable outlook on the ratings to reflect our view that outlooks, which are generally assigned, where appropriate, to corporate and government entities and some structured finance ratings, are no longer appropriate for our ratings on the notes issued by Unique Pub Finance Co., given that our ratings approach assumes that we can rate through the insolvency of the borrower.
BUSINESS RISK PROFILE
Unique Pub Properties Ltd.'s (Unique) fair business risk profile is constrained by its exposure to U. K. consumers' discretionary spending and the structural decline of the U. K. tenanted pub sector. The structural decline stems from: the oversupply of pubs; downward pressure on pub valuations and rental incomes; falling on-trade beer volumes; growth in off-trade sales, with more consumers entertaining at home; high alcohol excise duties; and changing consumer preferences. These weaknesses are offset by Unique's large scale and market share, and its strong operating margins.
Unique's business risk profile reflects the following risk strengths and weaknesses.
STRENGTHS OF THE BORROWING GROUP
Industry RiskThe industry has demonstrated moderate cyclicality relative to other industries in revenue, and moderately high cyclicality in profitability. The U. K. pub market is a cash-generative industry with high margins (40%-50% for tenanted pub estates and 20%-25% for managed pub estates). In our view, this is a defensive feature as they could be squeezed in unfavorable circumstances. There are material barriers to entry, including planning and licensing regulations and economies of scale.
Competitive PositionWith 2,349 pubs, as of March 31, 2016, Unique has the U. K.'s largest securitized pub estate, resulting in a strong market position. Its closest peer, Punch Taverns, has a portfolio of almost 4,000 pubs. Other rated peers operate a mixed model, consisting of managed and tenanted pubs, and their securitized tenanted portfolios are significantly smaller: Marston's Pubs has 960 pubs (out of 1,239), Greene King Retailing 803 pubs (out of 1,489), and Spirit Pub Company only 417 (out of 1,046). However, after Greene King acquired Spirit (at the beginning of the 2016 fiscal year), Greene King has 3,100 pubs, including pubs not included in the securitized portion.
WEAKNESSES AND MITIGATING FACTORS OF THE BORROWING GROUP
Competitive PositionUnique has historically lacked the diverse revenue generated by a mixed model, as its only revenue diversity used to be achieved by optimizing the mix between rent and beer revenue streams. In the fiscal year 2015, Unique generated 52.5% of its revenue from rents, and 47.4% from the supply of beer. The tenanted model limits Unique's ability to weather changes in consumer demand, which, in our view, limits the operating efficiency of an estate.
ProfitabilityWe believe that the biggest risk is currently related to the Market Rent Option legislation, which is likely to reduce the profitability of the tenanted pub companies (Pubcos), and potentially change the whole pub industry dynamics. However, as a tenant's lease may only be affected by the Market Rent Option legislation when some trigger events occur (see "RECENT DEVELOPMENTS" below), its effect is not immediate and it could take up to five to six years for the effect to fully filter through a tenanted Pubco's estate. The business is highly seasonal, with better trading over the summer months and is significantly affected by weather. Key success factors for running pubs are: a scale leading to purchasing power, a wide range of product offerings, a well-invested pub estate, diversification, financial strength, and staff experience.
Industry RiskThe number of operational pubs in the U. K. is decreasing. This decline is in line with the falling demand for alcohol consumption, which is due to growth in the number of food-serving outlets. This growth was strongest in the pub sector during the past 10 years, with the number of pub restaurants with food sales that exceeded wet sales increasing by 135%, to 6,100 in 2014 from 2,600 in 2001.
OPERATING PERFORMANCE FISCAL YEAR 2015
Unique's strategy for enhancing or stabilizing EBITDA involves the disposal of underperforming pubs. Although the average number of pubs in the estate has declined by 5.0% between fiscal years 2014 and 2015, EBITDA declined by only 1.1%. Over the same period, EBITDA per pub has increased by 3.1%, which suggests that the overall quality of the estate has improved. We currently don't expect a recovery in the medium-term as the U. K. pub industry is facing considerable and fundamental long-term challenges. Our base-case scenario assumes a revenue decline by 1%-2% per year in 2016 to 2018 as we believe that the continued difficult trading conditions in the U. K. tenanted pub sector are likely to persist (see "RECENT DEVELOPMENTS" below).
CREDIT STRUCTURE
Refinancing RiskThe liabilities of the borrower or the issuer are fully amortizing, mitigating any reliance on access to the market for new funding.
Interest, Currency, And Inflation RiskThere is no currency or interest rate risk in the transaction.
Counterparty RiskDue to weaker replacement provisions in the related agreements, we do not consider the liquidity facility and bank account providers to be in line with our current counterparty criteria (see "Counterparty Risk Framework Methodology And Assumptions," published on June 25, 2013). As a result, our ratings may be no higher than our long-term issuer credit rating on the bank account providers, National Westminster Bank PLC and Barclays Bank PLC, and the liquidity facility provider, The Royal Bank of Scotland PLC.
Dividend Policy Risk Up-streaming of cash to the parent is limited by a rigid set of covenants. The requirement to retain excess cash flows is stronger than we typically see in other transactions. The post-enforcement and pre-acceleration priority of payments requires that all funds be directed into the reserve account if the debt service coverage ratio (DSCR) falls below 1.5 to 1.0 and withdrawals may be made for the purpose of covering senior costs and expenses, as well as payments due under the loans.
CREDIT ENHANCEMENT
There is a ?190 million liquidity facility. Importantly, the facility would remain outstanding despite the appointment of an administrative receiver. Specifically, the facility's agreement carves out the appointment of an administrative receiver by the trustee from the events of default. In addition, in the event that the liquidity facility provider does not extend the available period for the facility before the expiration of a 365-day period and a substitute provider is not arranged for, the issuer must draw down the full available amount of the liquidity facility.
A ?65 million cash reserve remains outstanding exclusively for debt service. This reserve is maintained at ?65 million until all of the class A notes have been repaid, amortizing pro rata with the class N notes thereafter. We also note that if the DSCR falls below 1.5 to 1.0, given that more than ?300 million of the class A notes have be repaid, all cash is directed into the reserve account, without limit, under the post-enforcement and pre-acceleration priority of payment and may not be used for any purpose other than to cover fees and expenses, and service the loans according to the priority of payments.
COVENANTS
The reported DSCR is based on the amount of principal required for the total outstanding principal of the loans to be equal to a targeted amount of total outstanding principal.
Through the application of intercompany receipts and excess cash, the borrower has made unscheduled principal payment on the class A3 and A4 notes. As a result, the outstanding principal balance of the notes, in aggregate, is lower than the targeted aggregate outstanding balance by ?72.4 million, as of March 2016 (down from ?124.4 million in March 2013). For the purposes of the reported free cash flow (FCF) DSCR, no principal is considered to be due. However, in March 2016, ?11.6 million was due on class A3 loan (based on a targeted principal balance of ?312.5 million and an outstanding principal balance of ?324.1 million).
Over the prior 12-month period, a total of ?44.98 million principal payments were due on the class A3 notes that were not reflected in the reported DSCR.
Looking ahead, we project that, if no other prepayments are made, principal will become due and payable on the class A4 notes in March 2019 and will result in an incremental increase of ?5.4 million in debt service. This would have an immediate effect on the FCF DCSR.
RECENT DEVELOPMENTS
BrexitAt this time, it is unclear the potential effect that Brexit may have on the pub industry. However, we have lowered our current expectations for economic growth (see "Europe's Economic Outlook After The Brexit Vote," published on July 4, 2016). We also assume that consumer sentiment will decline, as both changes will decrease discretionary spending.
Following the referendum, Enterprise Inns PLC has release its latest results and has signaled its confidence that it would be able to sustain the positive results despite the headwinds that we expect following Brexit (see "As Brexit Takes Shape, Europe Is Set To Slow--Not Stall," published on July 8, 2016).
Market Rent Option LegislationAfter some delays, the "Pubs Code" came into effect on July 20, 2016, which includes the market rent option. The market rent option allows publicans, following certain trigger events (e. g., a rent review, a significant price increase, or a significant change in circumstances), to break their beer tie with the Pubco and buy beer on the open market. In exchange, the publican would pay what will most likely be an increase in rent to a market rate.
Selling beer to publicans typically makes up a significant portion of a Pubco's earnings and the free-of-tie business model will pose some downside risk to operating cash flows. Unique, falling within the scope of the legislation with over 499 tied pubs, is partly addressing the market rent option through the implementation of a more flexible business model involving the introduction of new leases (see below). However, there is uncertainty as to the extent to which this will materialize, with the full effect likely to be seen after five years.
Introduction Of New LeasesThe holders of the notes issued by Unique Pub Finance Co. voted in favor of a consent solicitation. Under the asset management agreement, Unique is only allowed to lease pubs to tenants under certain lease terms, which are also spelled out in the asset management agreement, with a limited number being let to Enterprise Inns. The approved consent solicitation has not changed this. However, the effect is that a greater number of pubs within the securitized portfolio may be managed by Enterprise Inns as the tenant under the leases. The leases are required to be free-of-tie.
The consent solicitation resulted in amendments to the asset management agreement that allow Unique to lease pubs to the asset manager (Enterprise Inns) under lease terms that tie the rental payment to the operational performance of the pub, which Enterprise Inns will operated as a managed pub. Specifically, the total number of pubs that can be leased to Enterprise Inns is limited to:125 pubs in the period from March 24, 2016 to the interest payment date (IPD) falling in March 2017;250 pubs in the period from the IPD in March 2017 to the IPD in March 2018;350 pubs in the period from the IPD in March 2018 to the IPD in March 2019; and450 pubs thereafter. The terms of the leases will set the initial rent (in the first year under the lease) that Enterprise Inns will pay to Unique. This initial rent will be the greater of the open market rent, and 110% of the average rent received before the lease plus the procurement fee Unique received under the beer supply agreement during the two years proceeding Enterprise Inns' tenancy.
In subsequent years, the rent payable to Unique by Enterprise Inns will be the greater of:The maximum of (i) 85% of the pub's prior year net income and (ii) the pub's prior year net income less ?15,000, increased annually by the retail price index (RPI); andThe 110% of the average rent received before the lease plus the procurement fee Unique received under the beer supply agreement during the two years proceeding Enterprise Inns' tenancy, increased by annually by RPI. In effect, the rental income to be realized by Unique is floored at 110% of the current rent and the procurement fee. The minimum 10% increase in cash flow for the pubs that would be leased to Enterprise Inns means that the potential effect may be credit positive (there is a 10% premium received on both the rent and the beer-tie income under the beer supply agreement).
Given the current state of the pub industry, we see the gradual change in strategy of Enterprise Inns toward a portfolio that includes managed pubs as potentially beneficial to Unique. This is because rent payments will be linked to the operating income of the managed pubs with downside protection through a link to the previous rent and beer-tie revenue.
RATING RATIONALE
Our ratings on the notes reflect our assessment of Unique's (the borrower) fair business risk profile, the estate's performance and cash flow generating potential, and structural protection available to the noteholders.
Class A NotesOur ratings address the full and timely payment of interest and timely payment of principal due on the notes. We base this primarily on our ongoing assessment of the underlying business risk of the borrowers, the integrity of the legal and tax structure of the transaction, and the robustness of the cash flow supported by structural enhancements.
Under our cash flow projections that are commensurate with a 'BBB-' stress scenario, we do not expect the class A3 or A4 notes to experience any interest shortfalls, and we expect principal will be fully repaid according to its terms and conditions. We have therefore affirmed our 'BBB - (sf)' credit ratings on the class A3 and A4 notes.
We project that, at the 'BBB-' rating level, our projected cash flows, along with the credit enhancement the liquidity facility provides, would be sufficient to meet the interest and principal obligations on the class A3 and A4 notes. The cash flows we project under each rating scenario in our analysis are based on our view of the borrower's business risk profile. In addition, they are guided by the parameters defined in our criteria "Understanding Standard & Poor's Rating Definitions," published on June 3, 2009. We have subsequently applied our projected cash flows available for debt service at each rating level, in line with the priority of payments.
Class M And N NotesUnder the conditions of the notes, if there are insufficient funds available to the issuer to pay principal and interest on the class M and N notes, then the unpaid amounts are deferred and ultimately due in March 2032, along with accrued interest on the deferred amounts. An event of default for the class M and class N notes may only be called if there is still any principal or (deferred) interest outstanding at legal maturity in 2032.
We expect that the class M and N notes will receive ultimate principal and interest, along with interest accrued on any deferred amounts, before March 2032. Under our cash flow stress, that is commensurate with a 'BB-' stress and a 'B' stress for the class M and N notes, respectively. We have therefore lowered to 'B (sf)' from 'B+ (sf)' and placed on CreditWatch negative our rating on the class N notes and affirmed our 'BB - (sf)' rating on the class M notes. We have placed our rating on the class N notes on CreditWatch negative pending our assessment of the potential effect of Brexit on the pub sector, which we expect would put pressure on our ratings on the class N notes.
Unique Pub Finance Co. is a whole business securitization (WBS) of Unique's operating business of a tenanted pub estate in the U. K. This transaction closed in 1999, and has been tapped several times since, most recently in 2005.
RATING STABILITY CONSIDERATIONS
As business profile risk is a significant factor in our review of credit risk and in determining stresses, a material change in a company's business risk profile would likely lead to a material change in our stresses. A material weakening of the company's business risk profile would likely lead us to apply harsher stresses when considering the ratings in the transaction.
Under our cash flow analysis, we project that the class A notes would receive scheduled interest and principal when due at a level of stress higher than the stress commensurate with a 'BBB-' rating level. Likewise, we project that the class M notes would receive ultimate interest and principal, along with interest on any deferred amounts at a level of stress higher than the stress commensurate with a 'BB-' rating level.
However, the likely effect of Brexit on the U. K. economy in general and discretionary spending may affect the pub industry (see "As Brexit Takes Shape, Europe Is Set To Slow--Not Stall," published on July 8, 2016, and "Europe's Economic Outlook After The Brexit Vote," published on July 4, 2016).
The effect of both events may be a downward revision to our flat case that begins in fiscal year 2017, where we assume no growth and no decline in EBITDA over the tenor of the transaction, and a lowering of Unique's business risk profile. In light of that uncertainty, it would not be prudent to upgrade the notes at this time.
We do not currently see a scenario that would lead us to raising our assessment of Unique's business risk profile.
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