S&P: SourceHOV LLC Downgraded To 'CCC+' On Weak Liquidity And Covenant Issues; Outlook Negative; Debt Ratings Also Lowered
Concurrently, we lowered our issue-level rating on the company's $780 million first-lien senior secured term loan and $75 million revolving credit facility due 2019 to 'CCC+' from 'B-'. The recovery rating on these facilities is unchanged at '3', indicating our expectation for meaningful (50% to 70%; upper half of the range) recovery in the event of a payment default.
In addition, we lowered our issue-level rating on the company's $250 million second-lien term loan due 2020 to 'CCC-' from 'CCC'. The recovery rating is unchanged at '6', indicating our expectation for negligible (0% to 10%) recovery in the event of payment default.
"The rating action reflects SourceHOV's weaker-than-expected operating performance in 2016, which has resulted in continued weak liquidity and under 1% covenant cushion at the end of the second quarter 2016," said S&P Global Ratings credit analyst Minesh Shilotri.
With upcoming maximum leverage stepdowns at the end of the year and again at the end of the second quarter 2017, we believe there is a possibility of a covenant default over the next 12 months. On the other hand, SourceHOV is exploring strategic options for certain business units (with project based revenue) that are not aligned with its long term strategy of growing the recurring transaction processing business. The company has stated that these proposed divestitures will be de-leveraging for the company and strengthen its liquidity profile. Additionally, it will also help management focus its efforts to grow its core transaction processing business. Also, the company is working towards closing the Transcentra acquisition, which has the potential to increase the company's EBITDA base and therefore improve its covenant cushion. In our view, the risk of covenant default will be reduced if the company executes on these two transactions. However, at this point, the transaction details and the timeline for both these events are unknown.
For the first half of 2016, revenues came in below our expectations in all three divisions (Financial Transaction Solutions, Healthcare, and Legal Claims) that the company operates in. With total liquidity of around $12 million at the end of the second quarter and quarterly amortization of $9.75 million on the first-lien term loan, we believe the company has little room for performance missteps. SourceHOV also faces steep covenant leverage stepdowns, with maximum leverage dropping from its current level of 5.375x to 4.75x at the end of 2016 and to 4.25x by the end of second quarter 2017. On the other hand, the company has aggressively reduced its operating expenses, while it deploys further automation to drive productivity improvement. These actions will help the company improve its margins. We project SourceHOV to generate free cash flow of greater than $50 million in 2016, which should help with the mandatory amortization payments.
The negative outlook reflects SourceHOV's underperformance relative to our base-case assumptions, and an increased risk of covenant breach over the next 12 months, given existing tight covenant cushion, upcoming maximum leverage stepdowns, and less-than-adequate liquidity.
We could lower the rating if the company continues to underperform our base-case assumptions, and is unable to immediately benefit from the Transcentra investment, such that we believe the covenant breach is likely over the next 12 months.
We could revise the outlook to stable if the company can maintain its debt service obligations, while improving covenant cushion percentage to the high single digits. We view that the company could achieve this cushion by closing on the Transcentra acquisition or through the proposed asset sale.
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