(The following statement was released by the rating agency) Overview
-- U.S.-based American Residential Services' (ARS') credit metrics weakened after a combination of operational factors and unfavorable weather patterns in key markets led to a decline in operating performance during the first half of 2012.
-- We are lowering our corporate credit rating on ARS to 'B-' based on the company's poor operating results, our lower profitability forecast, and our view that the company has "less than adequate" liquidity.
-- The outlook is stable, reflecting our expectation for leverage to decline modestly, cash flow metrics to strengthen slightly, and for covenant cushion to improve over the next several quarters.
Rating Action On Oct. 2, 2012, Standard & Poor's Ratings Services lowered its corporate credit rating on Memphis-based American Residential Services LLC to 'B-' from 'B'. The outlook is stable. At the same time, we lowered our issue-level rating on the company's $165 million senior secured second-lien notes due 2015 to 'B-' from 'B'. The recovery rating is unchanged at '4', indicating our expectation of average (30% to 50%) recovery for noteholders in the event of a payment default. We also lowered our issue-level rating on the company's $50 million senior secured holding company notes to 'CCC' from 'CCC+', with a '6' recovery rating. The '6' recovery rating indicates our expectation of negligible (0% to 10%) recovery in the event of a default.
The one-notch downgrade reflects our view that ARS' credit measures have weakened as a result of a decline in operating performance. The company's financial profile has weakened as leverage has increased, and we now view the company's liquidity to be "less than adequate" given its very tight covenant compliance cushion.
Our ratings on ARS reflect our view that the company's financial risk profile will remain "highly leveraged," which incorporates a very aggressive financial policy following the company's recent debt-financed shareholder distribution transactions. We characterize ARS' business risk profile as "vulnerable" because of its narrow product focus, the seasonality of its business, and its susceptibility to weather and economic cycles.
The company's operating performance deteriorated as a result of operational and weather-related factors in the first half of 2012, and we believe its credit measures weakened accordingly. We estimate the company's debt-to-EBITDA leverage increased to about 7.4x for the 12 months ended June 30, 2012, as compared to the already elevated 6.8x level one year ago following the company's debt-financed $50 million equityholder distribution in May 2011. This also follows the company's roughly $15 million equityholder distribution in 2010, which also resulted in higher debt levels. The company's EBITDA to interest coverage declined to 1.4x for the 12 months ended June 30, 2012, from 1.6x one year ago. (ARS is a privately held corporation and does not publicly disclose its financial statements).
For the remainder of the year we expect modest improvement in the company's credit metrics, with leverage declining to the 7x area. As such, we believe credit measures will remain in line with indicative ratios for a "highly leveraged" financial risk profile. These credit measures include leverage of over 5x debt-to-EBITDA and a ratio of funds from operations (FFO) to total debt of less than 12%. In particular, our forecast for 2012 incorporates the following assumptions:
-- Sales decline in the low-single-digit area, reflecting weak operating performance from ARS' HVAC, plumbing, and reinsulation service lines.
-- EBITDA level is modestly lower as a result of lower sales and relatively flat profit margins as compared to 2011.
-- Capital expenditures of about $5 million, roughly in line with historically low levels.
-- Debt levels decline modestly as the company reduces borrowings under its revolver with cash flow from operations.
-- The company does not pursue any debt-financed distributions or acquisitions.
ARS has a stable but distant No. 2 market position in its two primary business segments--HVAC and plumbing. The benefit of a No. 2 market position is somewhat mitigated because these markets are extremely fragmented. Lennox International's Service Experts subsidiary is the largest HVAC competitor, with less than 3% market share. Chemed Corp.'s Roto-Rooter subsidiary is the largest plumbing competitor, with about 1.5% market share. Local-level competition is intense and barriers to entry are low. Although ARS should benefit from its decentralized geographic diversification as a national provider, we view this benefit to be muted by the company's heavy debt burden resulting in greater sensitivity to fluctuations in regional weather patterns.
ARS has some exposure to weak economic conditions, reduced consumer spending, and tight credit conditions. Still, ARS' services are less discretionary than other residential services. Homeowners may delay repair or replacement over the near term but cannot delay indefinitely because HVAC and plumbing is essential to the home.
We assess the company's liquidity as "less than adequate." In particular, our assessment reflects our expectation that covenant cushion could remain below our 15% threshold for "adequate" liquidity for the next several quarters. However, we expect the company's free operating cash flow to remain positive for the next year and the company does not have any material debt maturities until 2014 when its revolving credit facility expires.
Our assessment of the company's liquidity profile includes the following expectations, assumptions, and factors:
-- We expect coverage of uses to exceed 1.0x for the next 12 months.
-- Covenant compliance headroom could remain very tight over the next 12 months with cushion under the company's maximum leverage and fixed charge coverage covenants. However, we forecast cushion levels to slightly improve to above 10% over the next 12 months, due largely to modestly lower debt level.
-- We do not believe the company would be able to absorb high-impact, low probability stress events.
Recovery analysis The issue-level rating on ARS' $165 million senior secured second-lien notes due 2015 is 'B-', with a '4' recovery rating. The '4' recovery rating indicates our expectation for noteholders to receive average (30% to 50%) recovery in the event of a payment default. We also lowered our rating on the company's $50 million senior secured holding company notes to 'CCC' from 'CCC+', with a '6' recovery rating. The '6' recovery rating indicates our expectations for noteholders to receive negligible (0% to 10%) recovery in the event of a default. For the complete recovery analysis, please see the recovery report on ARS to be published on RatingsDirect following this article.
The outlook is stable. We believe the company's credit measures will modestly strengthen as a result of debt repayment and modest EBITDA growth, particularly with normalized weather patterns. We could lower our ratings if operating performance does not improve such that covenant compliance cushion increases to the 10% area and EBITDA to interest coverage is not sustainable in the 1.5x area, possibly as a result of a further decline in operating performance or additional debt-financed dividend activity. Alternatively, we could raise our ratings if we believe the company could sustain leverage in the 6x area, likely due to improved operating performance and maintenance of a less aggressive financial policy. With stable debt levels, EBITDA would need to rise over 22% from current levels for this to occur.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
Ratings List Downgraded To From
American Residential Services LLC
Corporate credit rating B-/Stable/-- B/Stable/--
American Residential Services LLC ARS Finance Inc. Senior secured B- B Recovery rating 4 4
ARS Intermediate Holdings LLC
Senior secured CCC CCC+ Recovery rating 6 6
Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at
. All ratings affected by this rating action can be found on Standard & Poor's public Web site at . Use the Ratings search box located in the left column. (New York Ratings Team)