EBITDA margins at U.K. corporate securitizations are being squeezed by structurally higher costs, especially high labor costs. At the same time, higher interest rates are increasing issuers' debt servicing costs. Over the past two years, average refinancing rates on the senior debt have increased to 7.0% from 4.5%, while those on junior debt have jumped to 8.0% from 5.0%.

In this article, S&P Global Ratings assesses the potential impact of these increased refinancing rates on our ratings on U.K. cash sweep transactions, as their expected maturity dates (EMDs) approach. Our analysis indicates that a 20% increase in refinancing rates could result in a one-notch downgrade on some tranches, while a 40% increase could result in a two-notch downgrade.

Most Non-Pub Transactions Continue To Perform Resiliently

Revenue and EBITDA at most non-pub transactions that we rate in the leisure, business services, and media and telecoms sectors have either already recovered to pre-pandemic operational levels, or performed well through the pandemic. These companies' business models--whether based on subscriptions or long-term contracts--either showed resilience during the pandemic or recovered swiftly following lockdowns. The sole exception is funeral service provider Dignity PLC, which is an amortizing transaction (see appendix).

Chart 1

Although EBITDA margins at the other non-pub transactions we rate have recovered to a pre-pandemic level, Dignity is still bearing the brunt of high operating costs because of the fixed costs nature of its offerings. Overall, the EBITDA margins for AA Bond Co. Ltd. (the AA), Arqiva Ltd., Center Parcs, and RAC Bond Co. PLC (RAC) are marginally lower in absolute terms than before the pandemic, primarily due to higher labor and energy costs (see chart 2).

Chart 2

U.K. Pub Corporate Securitizations' Revenue Exceeds Pre-Pandemic Levels

Among the U.K. pub corporate securitizations we rate, Marston's Issuer PLC (Marston's), Greene King Finance PLC (Greene King), and Mitchells & Butlers PLC either operate a fully managed model or a hybrid model, with a mixture of managed and leased and tenanted (L&T) pubs. On the other hand, The Unique Pub Finance Company PLC's (Unique's) business model is based on a fully L&T structure, where revenue comes from rental income linked to the retail price index (RPI) and food- and beverage-supply contracts with the leased estate. Unique's revenue has recovered to pre-pandemic levels and its EBITDA margins reached our long-term forecasts in 2022, although there are fewer pubs in the estate. The EBITDA margins of Marston's, Greene King, and Mitchells & Butlers will likely take longer to recover; we anticipate that they will be slightly below pre-pandemic levels until 2025-2026 (see charts 3 and 4).

Chart 3

Chart 4

Revenue at pub corporate securitizations has surpassed pre-pandemic levels thanks to pub operators' ability to raise food and drink prices and a general trend of premiumization across the sector increasing overall spending per customer. While pub operators have been able to increase prices and pass through some of the cost inflation, weaker consumer confidence and pressure on discretionary spending continue to suppress sales volumes. The EBITDA margins of L&T pub operators have recovered more rapidly from low sales during the pandemic than those of managed pub operators. This is because the managed model directly exposes the publican to increasing costs, which makes earnings more volatile.

That said, structural changes to pubs' cost base since the pandemic, combined with geopolitical uncertainty and weak economic growth, have disrupted supply chains and set labor and energy costs at higher levels, despite the reduction in inflation. Inflationary headwinds, specifically those due to labor costs, continue to pose a major challenge to the hospitality sector, even as energy and food prices fall (see "Greene King Finance PLC Class A, AB, And B U.K. Corporate Securitization Ratings Affirmed," published on May 31, 2024).

Most Transactions Achieved Or Outperformed Our Forecasts In 2023

Despite rising labor costs and energy prices causing an increase in costs, nearly all the corporate securitization transactions we rate either met or exceeded our revenue forecasts in 2023 (see chart 5). Revenue for Unique, Greene King, and Marston's also reflects the smaller size of their estates--they have fewer pubs than they did in 2022 (see table 1).

Table 1

Most issuers' reported EBITDA is in line with our forecasts (see chart 6). For the AA and RAC, reported EBITDA was marginally lower due to higher exceptional costs over 2023; for Marston's, EBITDA was lower because of higher food and labor costs. Meanwhile, for Dignity, we expect budget-conscious customers' shift to cheaper cremation options, coupled with elevated operating costs and working capital swings due to the drop in prepaid plan sales, to continue to reduce profitability and cash flow.

Chart 5

Chart 6

Unique's EBITDA margin is considerably higher than the margins of the other pub corporate securitizations we rate. This is primarily due to the L&T model being based on a lease agreement, whereby the lessee or publican assumes the right to occupy the pub for a predetermined period and operate it as their own business. The expense of operating the pub, including utility bills, wages, and all repairs and building upkeep, are entirely the publican's responsibility.

Consequently, operators under the L&T model, which mostly generate revenue from rent and, in most cases, tied-in drink-supply agreements, have less direct exposure to inflation. Fundamentally, L&T pubs benefit from higher EBITDA margins and steady earnings, although net earnings and cash flow are typically lower than those of a managed operator of the same estate size (see chart 7).

Center Parcs and Arqiva also have strong operating margins, with S&P Global Ratings-adjusted EBITDA-to-sales margins consistently above 45%. In Center Parcs' case, this is thanks to high occupancy rates and its ability to increase its revenue per available lodge. In Arqiva's case, it is due to its product mix and long-term RPI-linked contracts. To manage inflationary cost pressures, companies have implemented cost-efficiency measures that involve labor scheduling, digitization initiatives, forward energy contracts, and operational efficiency.

Chart 7

How Cash Sweep Refinancings Work

Unlike transactions with scheduled principal amortization payments prior to the final legal maturity of the respective notes, cash sweep structures typically require limited principal repayments prior to an EMD. On the EMD, the notes can be repaid, but a failure to repay on the EMD is not an event of default. Upon a failure to repay following the EMD, the cash flows are allocated according to an accelerated repayment schedule.

To assess a borrower's ability to service debt in a cash sweep transaction on a comparable debt service coverage ratio (DSCR) basis, we assume a benchmark principal amortization schedule, whereby the debt is repaid over a fixed number of years following its EMD and ahead of its final maturity.

Across the various rated cash sweep structures, Arqiva is the only whole business corporate securitization that features both turbo amortization and scheduled amortizing notes (see chart 8). Typically, if a class of debt is time-tranched, with each tranche ranking pari passu, we view the credit quality of all the tranches as the same, as per our corporate securitization methodology.

Historically, the issuers have managed to refinance their debt within one-to-two years of the EMD, although the onset of the COVID-19 pandemic and increased interest rates temporarily interrupted this trend. As market conditions stabilize, we expect issuers to return to their prior debt-management strategies. We anticipate that central banks will cut interest rates as the year progresses and inflation continues to fall.

Chart 8

Arqiva has the lowest senior debt-to-EBITDA leverage across all the cash sweep transactions we rate, while AA has the highest leverage. Similarly, RAC has lower leverage for the junior notes than AA and Center Parcs (see chart 9). In cases where the senior term facilities are included in the senior debt calculations, they rank pari passu with the rated senior notes.

Chart 9

Our Ratings Are Resilient To An Increase In Debt Service Costs

Most of the debt refinanced over the past two years has a fixed coupon and an expected maturity of six years (see chart 10). Overall, the cost of the senior debt went up by close to 2.5 percentage points from about 4.5% to 7.0%. Over this period, only one class of junior (class B) debt was refinanced, the coupon of which increased by about 3%.

Monetary policy will likely ease further during 2024 as inflation cools, with additional rate cuts expected this year and next. This should spur investment and could add about two percentage points to economic activity, although most of the impact will come in 2026 and 2027 (see "U.K. Economic Outlook Q3 2024: A Cooling Labor Market Paves The Way For Rate Cuts," published on June 24, 2024). We forecast that the Bank of England base rate will fall to 3.3% by end of 2025, and 3.0% in 2026, as CPI inflation falls to 2.4% and 2.1% over the same period. Our scenario analysis therefore assumes a further increase in interest rates of 1.5%-3.0% above the current level for both the senior and junior debt across all cash sweep structures that are nearing maturity. The results of our analysis demonstrate the resilience of our ratings to an increase in debt service due to higher interest rates.

Subsequent refinancing at these higher rates--7.0% on the senior debt and 8.0% on the junior debt--could result in a one-notch downgrade on some tranches. In more extreme scenarios, an increase in refinancing rates to 10% and 11% for the senior and junior debt, respectively, could result in a two-notch downgrade on some tranches.

Additionally, some issuers, such as Center Parcs, have made dividend payments to their shareholders. AA held the proceeds from its new issuance in a mandatory prepayment account for the part-repayment of a senior note with an upcoming maturity, while Arqiva used the proceeds for general corporate purposes.

Looking more closely at the interest rates for the notes that are due to mature in each of the cash sweep transactions, we see a widening gap between the interest rates paid on these notes and the higher rates they may be refinanced at (see chart 11).

Chart 10

Chart 11

Our Scenario Analysis In Detail

For the transactions we rate under our corporate securitization methodology, we have seen numerous refinancings in cash sweep structures over the past few years, where operators manage the debt structure more actively. Although there have not been any refinancings in the scheduled amortization structures--namely, the pub corporate securitizations and Dignity--our scenario analysis focuses on debt refinancing across the cash sweep structures only.

In our short-term sensitivity analysis, we focused on three scenarios where the earliest senior upcoming maturities over the next three years for cash sweep transactions are refinanced at like-for-like fixed rates of 7.0%, 8.5%, and 10.0% and, where applicable, at 8.0%, 9.5%, and 11.0% for the junior notes, without any dividend payments to the shareholders. The current average rate for debt is 4.5% for the senior debt and 5.0% for the junior debt. We applied a flat fixed rate to each of the senior and junior notes, rather than an incremental increase, because there are a limited number of transactions across the various sectors.

We first performed our base-case analysis to determine the effect on the base-case anchor. For cash sweep transactions, we expect the effect of higher interest costs to be limited, given the current resilience-adjusted anchor. As a result, we focused our sensitivity analysis primarily on the base-case anchor of the senior notes.

Where applicable, we rate the junior notes in the cash sweep transactions no higher than the creditworthiness of the borrowing group. Accordingly, the higher refinancing rates have a limited effect on our ratings on the junior notes. However, for example in AA, the interest due on the junior notes is included in the DSCR for the class A notes until the EMD on the class A or class B notes. Therefore, refinancing the junior debt at a higher rate may have an adverse impact on the base-case anchor for AA's senior notes.

Table 2

Scenario 1

Table 3

Scenario 2

Table 4

Scenario 3:  

Table 5

Table 6

Table 7

We expect a limited impact on the current resiliency-adjusted anchor given the current levels in the respective ranges as per table 3 of our criteria.

Limitations And Caveats

• The refinancing rate stresses we selected for each scenario are hypothetical, are not meant to be predictive, and may not be a precise representation of reality.
• These stresses were for our cash flow analysis only. Credit risk, operational risk, counterparty exposure, and legal considerations were not part of this analysis.
• Any ratings impact based on modifier analysis and comparable ratings analysis were not part of this analysis. We will incorporate these additional considerations during our full reviews of these issuers.
• The results are based primarily on the most recent cash flow data available for debt service forecasts, and the cash flow modeling assumptions we use to rate these issuers.
• A rating committee applying the full breadth of S&P Global Ratings' criteria and including qualitative factors might, in certain instances, assign a rating that differs from the largely quantitative analysis we undertake here.
• We do not include pub corporate securitizations and Dignity in these sensitivities as the notes in these transactions have a predefined payment scheduled, unlike synthetic amortization for cash sweep transactions post EMD. In addition, these notes have not been refinanced over the past two years.
• We assume lower interest rates, but mainly from 2026. First, we expect most rate cuts to occur in 2025, when inflation is closer to 2.0%. Second, we estimate that it takes 1.5-2.0 years for a change in monetary policy to have its full effect on economic activity (see "U.K. Economic Outlook Q3 2024: A Cooling Labor Market Paves The Way For Rate Cuts," published on June 24, 2024).

Related Criteria

• Global Methodology And Assumptions For Corporate Securitizations, June 22, 2017

Related Research

• U.K. Economic Outlook Q3 2024: A Cooling Labor Market Paves The Way For Rate Cuts, June 24, 2024
• Greene King Finance PLC Class A, AB, And B U.K. Corporate Securitization Ratings Affirmed, May 31, 2024
• Dignity Finance PLC Class B U.K. Corporate Securitization Rating Lowered On Virtual Certainty Of Default, Dec. 13, 2023
• Dignity Finance Class A U.K. Corporate Securitization Rating Lowered; Class B Notes Affirmed, Nov. 2, 2023
• Will Lower EBITDA Recovery Leave U.K. Pub Corporate Securitizations In The Cellar?, Sept. 18, 2023

Appendix

Weakening performance for Dignity

Dignity is one of the transactions most affected by the social distancing restrictions and price restrictions imposed by regulators during the pandemic. In addition, its business model and financials have taken a hit from the introduction of customer-friendly regulations in 2020 that, among other measures, require it to offer more affordable prices. At the same time, Dignity absorbed higher operating costs amid the inflationary environment in the U.K. and had to contend with a shift in customer preferences to lower-margin cremation options, a trend that started during the pandemic. The new rules on preneed funeral arrangements, coupled with consumers' lower discretionary spending, have also led to a sharp decline in the sales of preneed plans, and subsequently, to high working capital volatility.

The concurrence of operational, regulatory, and macroeconomic challenges has prevented a turnaround of the business. In November 2023, following a significant deterioration in the debt service coverage we expected from Dignity Finance PLC's operating cash flows and its failure to reduce its senior debt, we lowered to 'B+ (sf)' from 'BBB- (sf)' our rating on the class A notes (see "Dignity Finance Class A U.K. Corporate Securitization Rating Lowered; Class B Notes Affirmed," published on Nov. 2, 2023). In December 2023, we lowered to 'CC (sf)' from 'CCC+ (sf)' our rating on the class B notes. The downgrade followed Dignity Finance's announcement of its intention to undertake a debt restructuring that we viewed as distressed. Most of the class A and B noteholders approved the restructuring on Dec. 12, 2023 (see "Dignity Finance PLC Class B U.K. Corporate Securitization Rating Lowered On Virtual Certainty Of Default," published on Dec. 13, 2023).

Table 8