OREANDA-NEWS. September 15, 2015. Fitch Ratings has downgraded Elli Investments Ltd.'s (Elli) Long-term Issuer Default Rating (IDR) to 'CCC' from 'B-'. Elli trades under the following names: Four Seasons Health Care, The Huntercombe Group and brighterkind. A full list of rating actions is at the end of this commentary.

The downgrade reflects the continued deterioration in Elli's operating performance since 2014. This has mainly been driven by increasing staffing costs to address embargoes and associated agency usage and upward pressure on wages in a context of a shortage of nurses across the sector.

Elli continues to suffer from the funding constraints that affect the fee rates paid by local authorities, as the company is still highly dependent on funding from them (currently around 60% of its funding). The downgrade also reflects the company's excessive financial leverage and weak liquidity.

The rating action does not reflect any potential impact from the announced introduction of a national living wage from April 2016. Britain's biggest care home providers are currently in discussions with the government and local authorities to address the unsustainable funding gap that will result from the increase in the national minimum wage. The November 2015 British government spending review is expected to address this issue.

KEY RATING DRIVERS
Focus on High Acuity
Elli is the largest independent provider of elderly care in the UK with around a 6% share of beds. This solid positioning provides the group with certain bargaining power with local authorities. Moreover the group's focus on nursing services rather than residential services is relatively resistant to the trend towards care at home and the associated tightening in residential care eligibility criteria imposed by local authorities.

Dependence on Local Authority Funding
The rating reflects Elli's high dependence on local authorities' funding (currently around 60%) although this is expected to decrease with the new business segmentation and the increasing proportion of private payers. In light of the funding constraints which affect the fee rates paid by local authorities, we expect the group's EBITDA margins to remain under pressure.

Increasing Payroll Costs
Intense regulatory inspections and a substantial number of embargoes (albeit at the end of August 2015 these were at their lowest level for over two years) coupled with Elli's high, albeit decreasing staff turnover and a continued shortage of nurses in the UK, have contributed to an increase in agency spend and upward pressure on wages which has affected the sector as a whole. This led to a substantial EBITDA erosion in 2014 and 1H15.

Excessive Leverage, Refinancing Risk
In our view, the group's capital structure is unsustainable due to excessive financial leverage (funds from operations (FFO) adjusted leverage was 8.8x at the end of 2014) that will increase due to continued deteriorating cash flow. Fitch does not expect any operating improvement in 2015 and 2016. Refinancing risk is significant in 2016 (one year before the final maturity date of the GBP40m term loan in December 2017) with FFO adjusted leverage reaching 9.6x.

Weak Liquidity
Fitch expects that Elli will have to rely on additional liquidity within the next 15 to 18 months to avoid a liquidity shortfall. At the end of June 2015, the group's cash balance was GBP51.3m, down from GBP86.7m at the end of December 2014. Elli currently has no other available or committed liquidity buffers.

Recovery Prospects
In its recovery analysis, Fitch adopted the liquidation value approach as the resultant enterprise value is higher than the going concern enterprise value, primarily derived from the group's freehold and long-leasehold properties. Fitch believes that a 40% discount on the assets' current book value is fair in a distress case.

The recovery expectation for the senior secured loan and notes is high at 100%/'RR1' while the recovery expectation on the senior notes is weaker at 52%/'RR3'.

KEY ASSUMPTIONS
Fitch's expectations are based on the agency's internally produced, conservative rating case forecasts. They do not represent the forecasts of rated issuers individually or in aggregate. Key Fitch forecast assumptions include:

-Relatively flat EBITDAR margins of around 14.5% in 2015 and 2016 compared with approximately 14.0% at the end of 2Q15, mainly due to a slow improvement in occupancy rates and payroll costs.
- Capital expenditure of around 7.5% of FY15 revenue and 5.5% for FY16. On top of the maintenance capex which is necessary for the reputation and the occupancy rate of the business (around GBP25m per year), the group's new segmentation requires refurbishment capex, mainly in its brighterkind homes to attract a higher proportion of self-funded residents.
-Continued negative free cash flow generation.

RATING SENSITIVITIES
Positive: Future developments that could, individually or collectively, lead to positive rating action include:
- FFO adjusted gross leverage at or below 6.5x on a sustained basis.
- FFO fixed charge cover at 1.1x or above on a sustained basis.
- Improvement in liquidity providing visibility on the repayment of the GBP40m term loan maturing in December 2017.

Negative: Future developments that could, individually or collectively, lead to negative rating action include:
- Absence of any committed additional liquidity within the next six months in a context of unchanged or deteriorating operating performance.

FULL LIST OF RATING ACTIONS
Elli Investments Limited
Long-term IDR: downgraded to 'CCC' from 'B-'
Senior unsecured notes: downgraded to 'CCC+'/'RR3 /52%' from 'B+'/RR2'

Elli Finance (UK) plc
Super senior term loan: downgraded to 'B'/'RR1' /100%' from 'BB-'/'RR1'
Senior secured notes: downgraded to B'/'RR1' /100%' from BB-'/'RR1'