OREANDA-NEWS. Fitch Ratings has revised UK gaming group Ladbrokes Plc's (Ladbrokes) Outlook to Negative from Stable. The ratings have been affirmed at Long-term Issuer Default Rating (IDR) at 'BB', Short-term IDR at 'B' and senior unsecured rating at 'BB'.

The change in the Outlook reflects continuing poor trading performance, particularly in its UK retail division (evidenced by weak 1Q15 results) where key structural challenges remain. The examinership of the Irish operations also adds uncertainty to the group's current trading profile. We expect this trend to continue through 2015 and push the return to positive cash flow generation further back to 2016. This will likely put the 'BB' rating sensitivities under pressure for the next two years.

Ladbrokes recently announced a possible merger with Gala Group Plc (B/Stable Outlook), but until there are further developments Fitch will continue to rate Ladbrokes on a stand-alone basis. We will review its ratings and/or Outlook in the event of possible capital structure enhancements and cash protection measures should the merger not take place.

KEY RATING DRIVERS

Trough Expected for 2015
We expect the group's EBIT margin to fall to 7.4% at 2015 from 11.9% in 2014 as the group continues to face intense competition, regulatory pressure and increasing taxes, before improving to 10.5% by 2017. The expected improvement will be driven by a stabilisation in over the counter gross win in UK retail and steady growth in machine revenues.

Trading was mixed for 2014 with Ladbroke's divisions impacted by significant sector-wide one-off loss on Boxing Day and poor operating performance in Ireland. Its digital business showed encouraging signs of stabilisation following steep declines in 2013 when the group transferred its platform over to Playtech.

Leverage and Cashflow Weakened
Free cash flow (FCF) and leverage weakened in 2014 due to lower profits and continued shareholder-friendly pay-outs. As management has announced its intention to maintain the level of dividends, we expect FCF to be negative in 2015 before returning to positive territory (around 2% of sales) by 2017. Funds from operations (FFO) adjusted net leverage will also peak at around 4.8x in 2015 before declining to 3.6x by 2017. If achieved, such cash flow generation and leverage would remain compatible with the 'BB' rating.

UK Retail Still Recovering
Operating profit at the UK retail division fell 10.9% in 2014 due to sector-wide Boxing Day losses, increased taxes and the introduction of new responsible gaming regulation. We expect the introduction of new machines to translate into modestly higher machine profits; however, this will be offset by rising taxes, increasing regulation and fierce competition. As a result, the division's EBIT margin is likely to fall to around 12% in 2015 before improving steadily thereafter. Our forecasts specifically exclude high roller contribution to EBIT, which came to GBP14m in 2014 (2013: GBP6m) and provides a positive contingency for the group.

Structural Shift to Online Betting
The UK gaming sector is a mature industry which is undergoing a structural shift towards more online betting, where Ladbrokes is currently behind its peers. On-going investment in product innovation and marketing is of paramount importance to maintain leading positions. Fitch believes that successful operators will be adept at providing new and innovative products to online customers, which is a key long-term growth area. The recently appointed Ladbrokes CEO has a strong background in digital gaming, which should help chart the group's future direction.

Execution Risk Remains
Ladbrokes is making sound progress in its transformation to a digital platform, and we consider execution risk to remain moderate. The group is. however, still transferring its desktop functionality over to Mobenga (Playtech), which has recently taken over its mobile offering.

Digital Performance Lagging Peers
Ladbrokes' digital performance lagged its peers in 2014, generating just 18% of total net revenue behind Paddy Power (55%) and William Hill (32%). Digital was also the poorest performer in the group, with EBIT margins falling to just 6.5% in 2014 from 37% in 2010, due to loss of market share following the transfer of its platform to Playtech. We expect Digital to remain challenged and conservatively forecast a slight decline in profit following a poor 1Q15 performance in sportsbook with heavy competition. However, we expect Digital to see a small increase from 2016 onwards, as product and customer relationship management (CRM) improvements start to take effect.

Drive to Reduce Costs
Given the tough UK gaming environment, management has begun to reduce the size and costs in the UK betting estate, closing 89 underperforming shops in 2014 and a further 60 shops in 2015. Given the UK-wide presence of the estate, we do not expect revenue to be materially affected as we expect punters to be able to use other Ladbrokes shops close by.

Poor European performance
Overall contribution from its European retail division has been declining y-o-y, with Ireland particularly suffering falling volumes despite a slowly recovering economy. The division represented 9% of group EBIT in 2014. We expect continued subdued performance with margins remaining unchanged as the recent examinership of its Irish division is a constraint on profit growth in 2015.

Increasing Regulation and Taxes
The rise in machine games tax to 25% from 20% and the introduction of a new point of consumption tax has eroded margins in the UK as we had expected. In our view it is likely that the government's focus on regulation and increased taxes will continue, albeit on a manageable basis.

KEY ASSUMPTIONS

-Group revenue to fall 4% to GBP1,128m in 2015, weighed down by tighter regulation, increased taxes and intense competition, tempered by a more competitive online offering.
-EBITDA margin to fall to 14% in 2015 from 18.5% in 2014 as the group adjusts to the rise in machine games duty. EBITDA margin to rise to 17% by 2017.
-New point of consumption tax at around GBP30m pa.
-Capex at 5.8% of sales (2014: 5.1%).
-Flat dividend payout.

RATING SENSITIVITIES

Future developments that could lead to a negative rating action include:
- Further material deterioration in UK retail operating profits, adverse regulatory developments and no significant improvement in digital operating profits
- FCF in negative territory
- FFO adjusted net leverage rising towards 4.0x (2014: 3.8x) on a sustained basis due to continued weak trading, or for over 12 to 18 months due to M&A activity
- FFO fixed charge cover below 2.5x (2014: 2.7x)

Future developments that could lead to a stabilisation of the rating Outlook include:
- Stable UK operating profits, stable or growing digital profits and no change in regulation or tax environment leading to at least neutral FCF (post dividends)
- FFO adjusted net leverage below 3.5x on a sustained basis
- FFO fixed charge cover above 2.5x

Although Fitch considers that the probability of an upgrade is low in the foreseeable future, future developments that could lead to positive rating action include:
- Further strengthening of operations with an established competitive profile in online gaming, a stabilised UK retail business and lower reliance on the UK market
- Positive FCF on a sustained basis
- FFO adjusted net leverage sustainably below 3.0x
- FFO fixed charge cover above 3.0x

LIQUIDITY

At end-2014 Ladbrokes had GBP21m of unrestricted cash on balance sheet and access to GBP283m of the group's GBP405m bilateral facilities available. This is sufficient as Ladbrokes does not face any meaningful debt redemptions in 2015. The next major debt maturity is its GBP225m bond due in March 2017.