OREANDA-NEWS. Fitch Ratings has affirmed Spirit Issuer plc's (Spirit) notes at 'BB'. The Outlooks is Positive. Spirit is a whole business securitisation of managed pubs and leased and tenanted pubs located across the UK. A full list of rating actions is available at the end of this commentary.

The affirmation reflects Spirit's healthy revenue growth, supported by extensive but targeted investments in its mostly branded pub estate, its strict cost control and its continued disposal of weaker tenanted pubs. The transaction's financial performance has been in line with Fitch's expectations.

The Positive Outlook reflects our expectation of continued managed growth and further stabilisation within the tenanted estate over the next two years.

KEY RATING DRIVERS

Industry Profile: Midrange
The operating environment is viewed as 'weaker'. While the pub sector in the UK has a long history, trading performance for some assets has shown significant weakness in the past. The sector is highly exposed to discretionary spending, strong competition (including from the off-trade or various forms of home or other entertainment), and other macro factors such as minimum wages, utility costs and changes in regulation with the statutory pub code introducing in 2016 the market rent-only option (MRO) in the tenanted/leased segment. MRO breaks the traditional tied-model that requires tenants to buy drinks from the pubcos, usually in exchange for lower rent. Last but not least, the implementation of national living wage could put margins under pressure.

The barriers to entry are viewed as 'midrange'. Licencing laws and regulations are moderately stringent, and managed pubs and tenanted pubs (ie, non-full repairing and insuring) are fairly capital-intensive. Switching costs within the drinking-eating out market; however, are generally viewed as low, even though there may be some positive brand and captive market effects.

The sustainability of the sector is viewed as 'midrange', with the strong pub culture in the UK expected to persist, thereby taking a large portion of the eating-drinking-out market. In relation to demographics, mild forecast population growth in the UK is a credit-positive.

Company Profile: Midrange
Financial performance is viewed as 'midrange'. Over the past five years, the managed estate has achieved an EBITDA per pub CAGR of 9.1%, in addition to a peer-leading like-for-like (LFL) sales growth of 3.5% on average. In relation to the tenanted estate both absolute and per pub performance has been fairly weak; however, this weakness is mitigated to some extent by Spirit's low exposure to the tenanted model, with total securitised EBITDA contribution from the tenanted estate at 21%. In addition, the tenanted estate has started to show signs of stabilisation.

The company's operations are viewed as 'midrange'. Recently-branded pubs represent a significant portion of total securitised pubs. Spirit has limited pricing influence but it is a fairly large operator within the pub sector. Its acquisition by Greene King could support further extraction of economies of scale. While operating leverage has been increasing over the last few years as a result of a growing food offer, the change in strategy is viewed favourably given that the food-led approach has led to revenue growth. Management has demonstrated a good track record since the closing of the securitisation, implementing sensible and effective strategies in a timely manner (increasing food offer, brand development, reducing tenanted model exposure).

Transparency is viewed as 'midrange' with the more transparent managed business (self-operated) representing 79% and 60% of the securitised group by EBITDA and estate, respectively. Historically management has demonstrated some ability to adapt to industry changes with the extensive rollout of branding and food led offers to mitigate the declining performance of the tenanted model.

Dependence on operator is viewed as 'midrange'. Operator replacement is not straightforward but is possible within a reasonable period of time (several alternative operators available). Centralised management of the managed and tenanted estates and common supply contracts result in close operational ties between both estates.

Asset quality is viewed as 'midrange'. The pubs are considered to be well-maintained following the recent completion of a three-year GBP200m investment programme in relation to the managed estate. Assets are also well-located (significant portion in London and the south-east); however, Spirit has a significant portion of managed pubs on leasehold, with an annual lease expense of around GBP30m. The secondary market is fairly liquid (extensive disposal programmes across the industry have been absorbed).

Debt Structure Class A: Stronger
The debt profile is viewed as 'midrange' for the class A notes. The majority of principal (around 80%) is to be repaid via scheduled amortisation, with the class A6 and A7 notes due to be paid down via cash sweep under Fitch' base case (although they also benefit from back-ended scheduled amortisation).

Debt service increases gradually until 2028, meaning it is not very well aligned with the industry risk profile; however, it gradually reduces from 2028 to 2036. As a result of the mismatch between the scheduled amortisation profile of the class A6 and A7 notes and the class A1 and A3 swaps, under-hedging is set to increase gradually up to 100% by 2033. However, floating-rate risk is mitigated by the cash sweep as prepayments eliminate under-hedging to a maximum of 10% in 2018 and in full by 2020 under Fitch's base case.

The security package is viewed as 'stronger' for the class A notes with comprehensive first ranking fixed and floating charges over the issuer's assets and ultimately over all of the operating assets.

The structural features are viewed as 'stronger'. All standard whole business securitisation legal and structural features are present, and the covenant package is comprehensive. The financial covenant level is fairly high (with debt service coverage ratio (DSCR) at 1.3x) and the restricted payment condition, calculated using synthetic debt service, is set currently at 1.45x DSCR, higher than industry levels. The liquidity facility reduces in line with principal, meaning it falls below the usual 18 months peak debt service coverage (to around 15 months by 2020) and is not available for the last two years of the transaction. This is credit-negative but mitigated by debt then being fully repaid through cash sweep under Fitch base case scenario.

TRANSACTION PERFORMANCE

The transaction's trailing-12-month (TTM) EBITDA as of 7 March 2015 is in line with Fitch's expectations, growing 3.1% (on an adjusted 52-week basis) to GBP160.6m.

Growth has been primarily driven by the managed estate. Spirit Group's LfL sales growth of the managed division (a proxy for securitised group) has been strong, reflecting an improvement in both drink and food sales. In FY14, LfL sales were 4.4% up (on a 52-week basis) yoy and 10.8% over the last three years. Growth continued, although at slower pace, in 1HFY15 with 1.5% LfL increase due to a general slowdown in consumer spending on going/eating-out. On a per pub basis, annual EBITDA of the securitised managed estate increased 27% to GBP200k over the last three years catching up and now being in the territory of immediate peers (Greene King at GBP192k or Marston's at GBP210k).

The performance of the leased and tenanted estate is showing encouraging signs of stabilisation. On a per pub basis, performance continued to improve during the year (by 1.6%) as smaller, weaker pubs were disposed of. Spirit Group's LfL net income (a proxy for securitised group) was up 4.2% in FY14 and 2.3% in 1HFY15. Notably, Spirit has consistently reduced its reliance on the tenanted estate, with securitised group leased and tenanted EBITDA contribution declining to 21% in March 2015 from 33% in May 2009. This is credit-positive, given the perceived weakness of the tenanted model.

Under Fitch's base case, EBITDA 21-year CAGRs (to legal final maturity of the notes in 2036) are mildly positive and negative for the managed and tenanted divisions respectively. Combined EBITDA is forecast to grow gradually, while free cash flow (FCF) is expected to decline slightly due to increasing maintenance expenditure and tax expenses (as interest payments reduce over the life of the transaction). These forecasts result in FCF DSCRs (lease adjusted) to legal final maturity improving marginally versus the most recent projections in September 2014 to 1.37x.

As the transaction features an uneven debt profile and will face increased debt service from 2020 and subsequently in 2027-28, Fitch also monitors the minimum of the average/median over the first 14 years of the transaction given the overall lower coverage during this period. On this basis the forecast FCF DSCR is just 1.31x.

Peers
Spirit's closest peers are Marston's, Greene King and M&B. The transaction is well aligned with its peers in terms of FCF DSCR and leverage metrics relative to rating levels but is heading towards the higher end of 'BB' category.

RATING SENSITIVITIES

Positive - Improvement in Fitch's base case FCF DSCR above 1.4x due to continued strong performance of the managed division, in addition to further stabilisation in the tenanted performance could trigger an upgrade.

Negative - Deterioration of the forecast FCF DSCR below 1.2x could put the ratings under pressure. This could be a result of a change in consumer behaviour e.g. as result of an increase in drink driving alcohol limit in England & Wales or MRO/national living wage having a materially larger negative effect than currently expected.

SUMMARY OF CREDIT

Spirit is a whole business securitisation of 635 managed pubs and 424 leased and tenanted pubs located across the UK owned and (in the case of the managed pubs) operated by Spirit Pub Company plc (Group) and its subsidiaries. The securitised pubs represent around 87% of group's pub portfolio and are considered a reasonably representative sample of the total estate. The group was acquired by Greene King in June 2015.

The rating actions are as follows:

GBP29.5m Class A1 notes due 2028: affirmed at 'BB'; Outlook Positive
GBP186.6m Class A2 notes due 2031: affirmed at 'BB'; Outlook Positive
GBP51.6m Class A3 notes due 2021: affirmed at 'BB'; Outlook Positive
GBP207.7m Class A4 notes due 2027: affirmed at 'BB'; Outlook Positive
GBP158.5m Class A5 notes due 2034: affirmed at 'BB'; Outlook Positive
GBP101.3m Class A6 notes due 2036: affirmed at 'BB'; Outlook Positive
GBP58.4m Class A7 notes due 2036: affirmed at 'BB'; Outlook Positive