(The following statement was released by the rating agency)
Dec 04 - Fitch Ratings has downgraded Wellington Pub Company plc's (Wellington) fixed rate notes, as follows:
GBP128.4m class A fixed-rate notes due 2029: downgraded to 'B+' from 'BB'; Negative Outlook
GBP33.7m class B fixed-rate notes due 2029: downgraded to 'B-' from 'B'; Negative Outlook
The downgrades are driven by further declines in business performance as demonstrated by rising rental arrears, growing numbers of lease forfeitures as well as pubs not let on long leases. The decline in performance is compounded by limited scope for operational change and structural weaknesses. The Negative Outlook reflects the agency's view that Wellington's performance remains challenged by macroeconomic factors such as the uncertainty about the jobs' market, the ongoing change in consumer behaviour, especially affecting wet-led pubs (estimated at ca. 80% of the portfolio), further exposure to alcohol taxation, the continued strength of the off-trade, all coinciding with a large number of leases coming up for renewal in 2013.
The agency's base case free cash flow (FCF) debt-service coverage ratio (DSCR) (minimum of both the average and median DSCRs to the notes' legal final maturity) for the class A and B notes is c. 1.23x and just under 1.0x, respectively. The minimum FCF DSCR for class A in Fitch's base case is c. 1.15x and is expected to occur towards the end of the transaction's life.
Fitch's FCF forecasts only give credit to operating cash flows. The agency's forecasted DSCRs will be constrained by modest declines in EBITDA, mainly due to a portion of lease expiries that are assumed not to be renewed on long leases, rental value declines and repossessions. FCF is forecast to decline more than EBITDA as Fitch understands that Wellington is expected to resume corporate income tax payments from FY13 onwards after group loss carry forwards have recently been exhausted. However, the transaction benefits from a flat, annuity debt profile for class A and even a downward sloping profile for class B.
A decline in Fitch's base case FCF DSCR metrics to anything substantially below 1.20x (minimum FCF DSCR of 1.15x) and 0.95x for the class A and B notes respectively (caused by any significant and continued decline in performance) could result in a downgrade of the notes.
The lease renewal process remains an area of concern for Fitch as a significant portion of the portfolio is due for renewal over the next three years - more than 16% of all leases are set to expire by 2013. Wellington continues to experience a shortage of experienced and financially strong tenants looking to enter substantive agreements for residential pubs, and as a result, 159 pubs are (as per September 2012 reporting) not on long leaseholds (up from 102 pubs at the same time in 2011), of which 55 are vacant. During the four quarters up to September 2012 73 properties have been repossessed (up from 38 properties the year before) - the highest number within any four quarter period thus far. More are expected in the next few quarters, partly due to expiring leases but also rising rental arrears deemed non-recoverable. Almost half of the portfolio is currently (at least in parts) in arrears with its rental payments by more than 180 days (vs. just about one-third last year). If a pub becomes vacant it takes on average 10 months to find a replacement tenant, although some pubs have remained closed for much longer. Consequently the closed house costs (e.g. security, legal, utilities, business rates, etc.) have remained high.
TTM rental income dropped only mildly by 1.4% with TTM EBITDA down by 2.3%. However, there is a risk that if the 63 pubs on temporary agreements closed (or a proportion of them) as well as the 57 leases currently in the process of being renegotiated did not extend/renew and the rental arrears grew further, revenues would shrink, operating costs increase and EBITDA would be further pressured.
Another area of concern is the state of repair of the portfolio. All substantive agreements are on full repairing and insuring (FRI) leases, placing the obligation to maintain the properties on the tenant. However, with tenants struggling to pay their rent (as indicated by the high delinquencies) the asset manager estimates that about 80% of the portfolio is suffering from some degree of deferred maintenance. Wellington tends to spend comparatively small amounts of capex on currently vacant properties.
Wellington is a securitisation of rental income from 805 free-of-tie pubs predominantly located in residential areas mainly in the south-east of the UK. As the landlord only receives a dry rent, there is limited visibility of the trading performance of the pubs. Consequently, Wellington is less able to estimate the affordability of the tenants' rental payment and has no influence in the publicans' offering (e.g. encouraging stronger focus on food, etc.).
Unlike traditional whole business securitisations (WBS) featuring an issuer-borrower loan structure, the transaction's pubs are directly owned by the bond issuer. The operational risk is mitigated to some extent by Wellington merely being a property holding company with the actual management of the estate outsourced to Criterion Asset Management Limited. However, in the agency's view, the transaction's risk profile is negatively impacted by the structure mainly due to a low liquidity support (only a liquidity reserve account covering around four months of debt service) and the lack of a financial covenant which in other WBS transactions gives bondholders more control by being able to appoint an administrative receiver well ahead of a payment default. As the liquidity reserve is not tranched among the class A and B notes, it could potentially be depleted by drawings to support the subordinated class B notes with nothing left to support the class A notes if needed. This makes the class A notes more vulnerable than suggested by an average or median DSCR but gives greater emphasis to minimum DSCR forecasts.
Fitch used its UK whole business securitisation criteria to review the transaction's structure, financial data and cash flow projections and to stress-test each of the rated instruments.
(Bangalore Ratings Team, Hotline: +91 80 4135 5898 Debanjali.Ghosh@thomsonreuters.com, Group id: BangaloreRatings@thomsonreuters.com, Reuters Messaging: Debanjali.Ghosh.firstname.lastname@example.org)
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