Fitch Assigns First-Time 'B' Rating to Drive DeVilbiss Healthare; Outlook Stable

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has assigned a 'B' Issuer Default Rating (IDR) to Medical Depot Holdings, Inc. (dba Drive DeVilbiss Healthcare). The Rating Outlook is Stable.

KEY RATING DRIVERS

Player in Highly Competitive DME Market: While Drive DeVilbiss Healthcare (DDV) has a leading market position in many of its product lines, the Durable Medical Equipment (DME) market is highly competitive, including a large number of competitors of similar or greater size that compete directly with DDV with similar products. Despite these competitive pressures, the company has consistently generated double digit organic growth supplemented with targeted acquistions since 2009.

High Post-LBO Leverage: Leverage will be high following the Clayton, Dubilier & Rice (CD&R) transaction and DDV's capital deployment strategy has historically been fairly aggressive, specifically with respect to M&A. Over the next 12-24 months, however, Fitch expects management to focus on de-levering and realizing operational efficiencies and projects that debt reduction and EBITDA growth will reduce leverage below 6.0x by the end of 2017. Post initial leverage reduction, Fitch expects debt-funded acquisitions to remain a key component of the company's business development strategy.

Historically Challenged Cash Generation: DDV's historically weak cash flows are a constraint to the ratings. Operational and supply chain initiatives instituted over the past 12 months, as well as the addition of new sponsor CD&R's resources, suggest that margin expansion, improved inventory management, and accompanying cash generation are possible. DDV's future ability to generate at least breakeven free cash flow (FCF) is important to maintain ratings at the current 'B' level.

Favorable Secular Trends: The aging of the global population will generate increased demand for DDV's product offerings, which are predominantly mobility aids, beds, respiratory aids, and bath and safety devices. Each of these products is most often used by patients aged 65 and older. Fitch expects the aging of the global population to provide a tailwind to revenues. Growth prospects should be further bolstered by on ongoing shift toward value-based products and services and a shift in care toward lower cost settings, including home health services.

Moderate Reimbursement Risk: A relatively small percentage of DDV's revenues are indirectly exposed to Medicare reimbursement levels. DDV's market position as a low cost, "value" provider could further insulate the company from potential reimbursement cuts and pricing pressure from private payers.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for DDV include:

--Revenues grow by a 14.9% compound annual growth rate (CAGR) from 2016-2019, aided by acquisitions completed in 2015 and 2016 in addition to market share gains and favorable secular and demographic trends;

--EBITDA margins expand by over 400 basis points (bps) over the forecast period, reflecting significant expense savings stemming from various operational efficiency initiatives started in late 2015;

--Gross debt leverage declines to 4.5x by the end of 2019, reflecting term loan amortization and EBITDA growth and no debt repayment other than term loan amortization;

--No acquisitions or shareholder payouts over the forecast period;

--Capital expenditures average roughly 1.5% of revenues;

--Operating cash flows (OCF) and FCF (defined as OCF minus CAPEX and shareholder dividends) turn positive in 2017 and remain so throughout the remainder of the forecast period.

RATING SENSITIVITIES

--Maintenance of DDV's 'B' IDR considers gross debt/EBITDA in the range of 5.0x-6.0x with positive FCF sufficient to fund term loan amortization.

--An upgrade to 'B+' could be warranted by earnings growth and debt reduction leading to gross debt leverage durably below 5.0x and EBITDA margins of 12% or higher, accompanied by positive FCF and expectations of these trends continuing.

--A downgrade would likely be tied to execution problems, lost market share or significant pricing erosion, leading to meaningful earnings declines. A shift in strategy leading to debt leverage expected to be maintained above 6.0x and/or the expectation for ongoing negative FCF could also contribute to negative ratings pressure.

SOLID PERFORMANCE DESPITE MEDICARE REIMBURSEMENT PRESSURES

DDV has consistently generated robust organic revenue growth in a highly competitive industry in which companies often compete with largely undifferentiated products. Importantly, this growth came during a period when pricing in the broader DME business has come under increased pressure, due in part to the roll out of CMS' competitive bidding program. DDV's strong growth in the face of this potential headwind is supportive of Fitch's view that the company's exposure to Medicare reimbursement pressure is moderate, and also that DDV's position as a low cost supplier allows the company to benefit from a shift to value-based payment that is occurring across the healthcare sector.

HISTORICALLY WEAK CASH GENERATION

DDV's history of negative FCF is an important constraint on the ratings. The company has not been solidly cash generative despite strong top line growth, generally expanding margins, and light CAPEX requirements. In recent years cash generation has been hampered by non-recurring expenses related to acquisitions and restructuring initiatives. Over a longer period, management's historical emphasis on growth more-so than operational efficiency improvement, has led to cost inefficiencies and suboptimal working capital management.

The company began to address this weakness in late 2015 when it hired external consultants to analyse its supply chain. The consultants' recommendations led DDV to upgrade its operations capabilities and implement a number of initiatives aimed at realizing expense efficiencies and improving working capital management. Along with the dissipation of non-recurring expenses, Fitch expects that the majority of the benefits from these efforts will begin to flow through results in 2017 and carry forward though the remainder of the forecast period.

HIGH POST-LBO LEVERAGE

Fitch anticipates that the company will prioritize de-levering through debt reduction and earnings growth over the next 12-24 months, and that gross debt leverage will fall below 6.0x by the end of 2017. Longer term, CD&R's concentrated ownership stake does raise the possibility of aggressive or shareholder friendly financial policy.

Fitch notes that DDV's approach to capital deployment for business development purposes has historically been fairly aggressive. DDV has completed 25 acquisitions over its 16-year operating history, many of which were debt funded. Fitch expects targeted acquisitions to remain a part of the company's growth strategy and notes that the credit facility does provide flexibility to incur additional debt to fund transaction. However, maintenance of the 'B' rating will require the company to prioritize leverage reduction in the near term.

LIQUIDITY

Adequate Liquidity: The company has historically maintained fairly modest cash balances. Additional liquidity will be provided by a company's five-year $100 million revolving credit facility that Fitch expects to be undrawn when the company's planned refinancing transaction closes.

Cash Flow Generation Poised to Improve: DDV's cash generation has been pressured in recent years by negative working capital swings and non-recurring expenses, largely related to acquisition costs and restructuring and efficiency efforts. Fitch projects DDV's OCF and FCF to turn positive in 2017, due to margin expansion, absence of non-recurring expenses, and improved working capital management.

No Near-Term Debt Maturities: DDV's planned capital structure calls for only term loan amortization of 1% ($4.1 million) per year until 2023 when the remainder of first lien term Loan is scheduled to mature.

FULL LIST OF RATING ACTIONS

Fitch has assigned the following ratings with a Stable Rating Outlook:

Medical Depot Holdings, Inc. (dba Drive DeVilbiss Healthcare)

--Long-Term IDR 'B';

--Senior 1st lien secured revolving credit facility 'BB-/RR2';

--Senior 1st lien secured term loan 'BB-/RR2';

--Senior 2nd lien secured term loan 'CCC+/RR6'.

The 'BB-/RR2' rating for DDV's 1st lien secured debt reflects Fitch's expectations for 83% recovery under a hypothetical bankruptcy scenario. The 'CCC+/RR6' rating on DDV's 2nd lien secured debt reflects Fitch's expectations for principal recovery of 0%.

In the U.S. healthcare sector, Fitch consistently uses a going-concern approach to valuation as opposed to assuming a liquidation value; intrinsic value is assumed to be greater than liquidation value for these companies, implying that the most likely outcome post-default would be reorganization rather than liquidation.

The going-concern cash flow (measured by EBITDA) estimate assumes an initial deterioration that provokes a default which is somewhat offset by corrective actions that would take place during restructuring. Fitch applied a 7.5x multiple to DDV's post-default cash flow estimate to estimate a going concern enterprise value (EV). The 7.5x multiple is based on observation of both recent transactions/takeout and public market multiples in the durable medical equipment industry.

Administrative claims are assumed to consume 10%, of going concern EV, which is a standard assumption in Fitch's recovery analysis. Also standard in its analysis, Fitch assumes that DDV would fully draw the $100 million available balance on its bank credit revolver in a bankruptcy scenario and includes that amount in the claims waterfall.

Date of Relevant Rating Committee: Nov. 9, 2016

Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor include:

Fitch excludes the following expenses from EBITDA calculations:

--Stock-based compensation.

--Non-recurring expenses related to refinancing and corporate restructuring.

--Certain other non-recurring expenses related to operational efficiency initiatives.

Additional information is available on www.fitchratings.com

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 05 Apr 2016)

https://www.fitchratings.com/site/re/879564

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1014720

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1014720

Endorsement Policy

https://www.fitchratings.com/regulatory

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Source: Fitch Ratings

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