S & P
cuts Smile Brand Group rating, revises outlook
Overview
-- U.S. dental practice management services provider Smile Brands Group Inc. had negative free operating cash flow after elevated capital spending for the past four quarters, resulting in depleted liquidity.
-- U.S. dental practice management services provider Smile Brands Group Inc. had negative free operating cash flow after elevated capital spending for the past four quarters, resulting in depleted liquidity.
-- Early in 2013, we expect Smile
Brands to bring capital expenditures, mainly for new dental offices, into line
with internally generated cash flow.
-- We are lowering our corporate
credit rating on Smile Brands to 'B-' from 'B' and revising our rating outlook
to negative. At the same time, we are lowering our rating on the company's
senior secured debt to 'B-' from 'B'.
-- The negative rating outlook
reflects the possibility that Smile Brands will exhaust the $13.5 million of
funds available from its revolving credit facility as of Sept. 30, 2012, or
breach a loan agreement covenant.
Rating Action
On Nov. 21, 2012, Standard
& Poor's Ratings Services lowered its corporate credit rating on
Irvine, Calif.-based Smile Brands Group Inc. to 'B-'from 'B'. At the same time,
we revised the outlook on the rating to negative
In addition, we lowered our
rating on Smile Brands' senior secured debt to 'B-', in conjunction with the
downgrade, from 'B'. Our recovery rating on this debt remains unchanged at '3',
indicating our expectation for meaningful (50% to 70%) recovery of principal in
the event of payment default.
Rationale
The rating on dental practice
management (DPM) services provider Smile Brands Group Inc. continues to reflect
its "vulnerable" business risk profile (according to Standard
& Poor's Ratings Services' criteria), characterized by its narrow scope
of operations in intensely competitive markets with low barriers to entry.
Smile Brands had negative free
operating cash flow (FOCF) after elevated capital spending for the past four
quarters and we expect this to continue in the fourth quarter of 2012. Our
downgrade is based on the expectation that early in 2013, Smile Brands will stem
the trend of negative FOCF by reducing spending for new dental offices or
taking other actions, such as paying interest on its holding company debt in
kind, rather than in cash.
We also expect adjusted debt to
EBITDA will rise to about 8x by the end of 2012, significantly higher than our
prior expectations, but still consistent with a "highly leveraged"
financial risk profile. As of Sept. 30, 2012, debt to EBITDA was 7.7x, adjusted
to capitalize operating leases and including holding company debt. We have
lowered our expectations for Smile Brands' revenue growth, EBITDA generation,
and cash flow over the next one to two years.
We expect revenues will grow at a mid-single-digit annual rate, somewhat faster than the total U.S. dental services industry over the next few years, primarily fueled by Smile Brands' geographic expansion and a slowly strengthening economic climate. Our prior growth expectations were mid- to high-single-digit annual growth.
Although Smile Brands' revenue
growth slowed in the second and third quarter of 2012, revenues increased 4.2%
for the 12 months ended Sept. 30, 2012.
We believe an unsuccessful
marketing strategy, which was subsequently abandoned, contributed to the growth
slowdown. Still, we believe underlying industry fundamentals remain sound and
relatively resistant to downturns. During the 2008 to 2010 recession, when
revenue for the total U.S. industry was nearly flat (according to data from the
Centers for Medicare and Medicaid Services), Smile Brands grew modestly,
supporting our expectation for continued, albeit modest, growth.
As newer offices mature, we
expect the lease-adjusted EBITDA margin (11.7% in the third quarter of 2012,
compared with 12.8% in the third quarter of 2011) to gradually recover to the
12% to 14% range, with some quarter-to-quarter variation.
Smile Brands' profitability is
supported by its infrastructure, economies of scale, and supplier discounts.
More rapid office expansion in recent quarters contributed to lower
profitability. Smile Brands' EBITDA margin (adjusted for leases, stock
compensation and nonrecurring items) began to dip in the fourth quarter of
2011, after rising substantially and steadily from 8.9% in 2005 to 14.8% for
the 12 months ended Sept. 30, 2011. Our lowered expectations for 2012 and 2013
EBITDA also affect cash flow generation Smile Brands' affiliated dental
practices operate a network of approximately 350 dental offices that offer
general and specialty dental services.
The $110 billion U.S. dental
practice industry is extremely fragmented and highly competitive, contributing
to our vulnerable business risk assessment.
Treatment volume, especially for
more discretionary services such as orthodontics, and patient financial capacity
exhibit some sensitivity to economic conditions. The availability of financing
for patients influences demand.
We also see vulnerabilities in the nature of
the DPM structure. While we believe potential changes in state or federal laws,
regulations, or accounting rules could hurt the DPM industry, we do not
currently incorporate any adverse developments in our base-case scenario.
The DPM business model has many retail
industry attributes, and so carries risks associated with advertising and
promotion, branding, and real estate selection, among others. Smile Brands
markets its brands, selects high-traffic office locations, and offers customers
convenient hours, comprehensive treatment, financing, and prices typically 15%
to 25% below those of traditional dentists. It targets middle-income patients
in growing metropolitan areas. Affiliated offices operate in 18 states, but
there are material concentrations in Texas and California.
The company provides
administrative, financial, and operating services to affiliated professional
corporations (PCs). Although the company does not own the affiliated PCs, its
financial statements consolidate them. Smile Brands generally owns the dental
office assets, but dentists and hygienists generally are not employees of the company,
in accordance with state laws.
We analyze the consolidated
financial statements on the basis presented (adjusted for the capitalization of
operating leases and other standard adjustments) because we believe they best
reflect the economic substance of the company's business model.
Liquidity
We revised our assessment of
Smile Brands' liquidity to "less than adequate" (according to our
criteria), reflecting its diminished liquid resources.
As of
Sept. 30, 2012, Smile Brands reported a negative cash balance of $0.5 million,
and $13.5 million was available from its $35 million revolving credit facility.
We believe Smile Brands may borrow an additional $1 million to $5 million in
the fourth quarter of 2012.
We
estimate Smile Brands will generate about $20 million of funds from operations
(FFO) in 2012 and $25 million in 2013. We expect small, if any,annual increases
in working capital. We project about $32 million of capital expenditures in
2012 (actual spending for the first nine months was $27.5 million), including
the recently completed roll out of digital x-rays. In 2013, we expect Smile
Brands to bring capital expenditures, mainly for new dental offices, into line
with internally generated cash flow. We believe annual maintenance capital
spending is less than $10 million.
Our
assessment of Smile Brands' liquidity profile incorporates the following
assumptions and expectations:
-- Over
the next 12 months, we expect sources of liquidity, including potential
borrowing under the revolver, to exceed uses by 1.2x. Even if EBITDA is 15%
below our projections, we estimate liquidity sources would cover cash needs,
although in that scenario the revolver could be fully drawn.
-- Debt
amortization is only $2.4 million annually through 2014.
-- Our
analysis of Smile Brands includes unrated holding company notes with a face
value of $100 million ($87 million after the original issue discount). Smile
Brands has been paying the 10% coupon in cash. To conserve cash, we believe it
may begin to pay interest in kind at 13%.
-- We
expect Smile Brands to remain in compliance with its loan agreement covenants,
notwithstanding requirement tightening. As of Sept. 30, 2012, there was a 17%
cushion under the tightest covenant.
-- We
assume Smile Brands will not make any acquisitions over the next two years.
Recovery
analysis
For our
complete recovery analysis, see our recovery report on Smile Brands, to be
published following this report on RatingsDirect.
Outlook
Our
negative rating outlook on Smile Brands reflects the possibility that it will
exhaust the $13.5 million of funds available from its revolving credit facility
as of Sept. 30, 2012, or breach a loan agreement covenant. We would consider
lowering the rating if negative FOCF persists in the first quarter of 2013 or
we expect the covenant cushion to approach 5%.
We would
consider revising the outlook to stable if Smile Brands generates discretionary
cash flow (through a combination of improved EBITDA and lower capital
spending), restores availability of its revolver, and we expect the covenant
cushion to stay above 15%.
