OREANDA-NEWS. Fitch Ratings has affirmed UK-based dental group Turnstone Midco 2 Ltd's Long-term Issuer Default Rating (IDR) at 'B+' with Stable Outlook. A full list of rating actions is available at the end of the commentary.

The ratings are underpinned by IDH's leading market position in the UK NHS dental sector, its stable cash flow driven by long-term evergreen contracts accounting for a large majority of practice revenue, its expanding network which delivers economies of scale, and its close relationship with the National Health Service (NHS). The ratings are constrained by the group's weakening adjusted leverage and financial flexibility, which is more commensurate with a 'B' rating although we expect IDH to generate positive free cash flow (FCF). Other factors constraining the ratings are increasing regulatory reforms, and increased risk of integrating acquisitions within practice services than originally envisaged.

Failure to achieve successful integration of acquisitions, or to improve profit margins from currently low levels due to, for example, inability to manage increasing operating costs, or if future acquisitions materially increase leverage on a sustained basis will put downward pressure on the already stretched credit metrics and the 'B+' rating.

The Stable Outlook is, however, underpinned by IDH's relative resistance to cyclicality and the stability of its NHS contracts, which provides visibility of revenue. We expect IDH to continue to build scale primarily from bolt-on acquisitions which together with the planned launch of its 'mydentist' brand nationally will provide potential revenue and profit upside over the coming years. We believe IDH has the capability to maintain units of dental activity (UDA) volumes and to deliver cost synergies over the next 12-24 months.

KEY RATING DRIVERS
Weak Leverage & Financial Flexibility
IDH's financial strength has weakened and is not commensurate with a 'B+' rating, although the group retains a slight deleveraging capacity (with and without acquisitions). We expect pro-forma funds from operations (FFO)-adjusted net leverage to be 6.5x (adjusted for bolt-on acquisitions) in the financial year to March 2017, leaving IDH with no headroom under its leverage nor financial flexibility for its current rating. This follows IDH's transformational acquisition of the Dental Directory in 2014, delays in achieving meaningful cost synergies in FY15 as well as additional investment in infrastructure to support future growth, translating into weaker profitability than expected.

As a result of the tight rating headroom any material acquisition above our assumption of around GBP50m p.a. that is not funded by external sources other than debt will likely have a negative impact on the rating.

Moderate Execution Risk
Fitch's prior expectation of EBITDA margin of 16% by FY16 has not been achieved due to slowing NHS revenue, delay in the integration of its Dental Directory and Dental Buying Group and additional costs incurred. We therefore now expect EBITDA margin to remain subdued at below 15% up to FY17 as the group adjusts to vertical integration and delivers cost savings.

Although some savings will be achieved as the integration of the two businesses is close to completion, weaker profitability growth reflects moderate execution risks in the group's strategy that are exacerbated by increasing regulatory, equipment and staff costs, including the introduction of the National Living Wage

UK's Largest Dental Practice
IDH is the largest dental corporation in the UK and is twice the size of its closest competitor Oasis Dental. The group's dominant market positioning and size makes it an important market participant and provides it with benefits of scale in sourcing, administration, marketing and advertising. IDH's growth continues to be driven by acquisitions and, to a lesser extent, by the private sector, as organic market growth continues to be limited by pricing pressure within its NHS contracts.

NHS Dental Contract Reform Neutral
The NHS is committed to reforming its contracts from an activity-based reward system to a more mixed system, incorporating quality and capitation as well as activity. If implemented the timeframe is expected to be around three years. There may still be unexpected costs and structural implications from this change which, together with our expectation that NHS spending will continue to be constrained by budgetary pressures, is reflected in the 'B' category rating.

Acquisition Risk Manageable
We believe management has the ability to control slightly higher integration risk following the larger acquisition of leading dental supply business, Dental Directory in April 2014, given its track record so far. The current rating, however, does not envisage any further large purchases as the group continues to implement its strategy of acquiring 40-60 small practices per annum, spending around GBP1m per transaction for EBITDA multiples of 4.5x-6.0x. As a result we factor in around GBP50m p.a. in acquisitions which, if integrated well, should allow (FFO)-adjusted net leverage (pro forma for such acquisitions) to trend towards 6.0x over the next two to three years, with FFO fixed charge cover improving to above 2.0x.

Steady Cashflow
We expect FCF as a percentage of revenues to remain positive at a more normalised level of 2%-4% over the next two years (FY15: 5.7%). This will be driven by steady FFO margins of 7%-8% and predictable capex, even though working capital could be more irregular due to UDA accruals, which are recovered or repaid within six and 12 months of the financial year-end.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Turnstone Midco 2 Limited include:
- Revenue growth of 8% in FY16 and 9% in FY17
- Ongoing acquisitions of around 50 practices per year
- Modest growth in private patients, albeit subject to economic cycles
- Modest uplift from UDA prices
- EBITDA margins above 14% as the group undertakes additional investment in infrastructure to support future growth
- Capex at 4% of revenue over the next two years
- Acquisitions of around GBP50m pa

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Reduced profitability from failure to achieve UDA delivery, achieve cost synergies or to manage cost inflation, leading to EBITDA margin falling below 13.5%
- Reduced FCF in the low single digits as a percentage of sales, for example, as a result of an unsuccessful acquisition strategy driving weaker credit metrics such as FFO adjusted net leverage above 6.0x (pro forma for acquisitions)
- FFO fixed charge coverage below 2.0x on a sustained basis (FYE15: 1.9x)

Positive: It is unlikely that the rating would be upgraded in the foreseeable future; however, future developments that may, individually or collectively, lead to positive rating action include:
- Ability to increase diversification and scale via acquisitions without diluting profits or FCF, while maintaining FFO adjusted net leverage below 4.5x on a sustained basis;
- FFO fixed charge coverage above 2.5x

LIQUIDITY
IDH's liquidity is satisfactory, with GBP17.9m of readily available cash available at end-Sep 2015 together with an undrawn committed GBP61m RCF available. There is no material debt maturity until December 2018 when the GBP200m senior secured fixed rate and GBP225m FRNs are due.

FULL LIST OF RATING ACTIONS

Turnstone Midco 2 Limited
-Long-term IDR: affirmed at 'B+'; Outlook Stable

IDH Finance plc
-Senior secured fixed rate notes; affirmed at 'BB-/RR3'
-Senior secured FRN, affirmed at 'BB-/RR3'
-Second lien notes; affirmed at 'B-/RR6'