While the operating environment for the U.K. pub sector has improved significantly following the unprecedented stress faced during the pandemic, earnings have yet to fully recover, and issuers face ongoing inflationary pressure, especially with respect to labor costs. To assess the effect of a lower-than-expected EBITDA recovery in the long term, for U.K. pub corporate securitizations rated by S&P Global Ratings, we conducted a scenario analysis assuming EBITDA declines by an additional 10%-25% below our current long-term forecasts. Notwithstanding the various challenges faced by the sector, the results of our scenario analysis demonstrate the resilience of our credit ratings to a reduction in the borrower's S&P Global Ratings-adjusted long-term forecasted EBITDA. We observed that a 10% reduction to our long-term forecasted EBITDA would generally not affect our current ratings on U.K. pub corporate securitizations. On the other hand, possible rating movements for more extreme scenarios of a 25% reduction in long-term forecasted EBITDA could result in an up to a four-notch downgrade on some tranches.

From COVID-19 To The Cost Of Living Crisis

Lockdowns and the trading restrictions during the pandemic severely affected the U.K. pub sector, with companies generating very minimal revenue in 2020. When lockdown restrictions were gradually lifted, the sector started to recover with a sudden jump in post-pandemic consumer discretionary spending as a result of high levels of savings and pent-up demand that boosted revenues. However, lower discretionary spending and cost inflation from various sources, including wages, energy, and food and drink prices, has dented the rate of recovery and slowed potential improvement in EBITDA margins. Companies in the sector passed on some of these costs by raising prices to limit the impact on recovery and some operators did not feel the full extent of the increases in these costs as they had short-term energy hedges in place. Nevertheless, elevated costs continued to leave EBITDA margins depressed through 2022 compared with pre-pandemic levels. While inflation, especially on energy and food prices, is beginning to moderate and cost reductions are supported by more flexible labor arrangements and rationalizing opening hours, we believe that the sector's recovery in general will likely be delayed until about 2025. At the same time, EBITDA margins may likely not recover completely, sitting slightly below pre-pandemic levels by 2025-2026.

EBITDA And Revenue Gradually Return After A Protracted Recovery

We recently completed full reviews of Unique Pub Finance Co. PLC, Marston's Issuer PLC, Greene King Finance PLC, and Mitchells & Butlers Finance PLC (see "Related Research"). Following these reviews, for Marston's, Greene King, and Mitchell's & Butlers, we affirmed our ratings on all classes of notes. For Unique, we lowered our ratings on the class A4 notes, primarily attributed to near-term liquidity concerns as opposed to reductions in our EBITDA forecast, while affirming our ratings on the class M and N notes.

Cost inflation headwinds continue to pose a major challenge to the hospitality sector as a whole, most notably in wages, even as energy and food prices ease. We believe that the extraordinary levels of inflation in the U.K. will decline to just above 4% toward the end of 2023, continue to normalize to about 2.4% in 2024, and will remain below 2.0% in 2025-2026. While companies within the sector have increased prices and passed through some of the cost inflation, weaker consumer confidence and pressure on discretionary spending may limit the pace of earnings recovery. Although some of the resilience in consumer spending in the first quarter of 2023 was underpinned by rising employment, several quarters of high spending to maintain consumption levels in an inflationary environment have strained savings and increased the use of credit, especially at the lower end of the household income distribution. Even if real income growth turns positive again early next year, we expect these households will continue to struggle for some time (see "Economic Outlook U.K. Q3 2023: Higher Rates Start To Bite," published June 26, 2023). As the cost-of-living crisis and higher mortgage payments continue to constrain customers' disposable incomes, we think that pressures on profitability margins for the pub sector will remain elevated compared with historical levels, and we expect the observed recovery in earnings and cash generation to be delayed and only return gradually for the overall industry.

At the same time, we noted differences in the rate of recovery between managed models and the leased and tenanted (L&T) models. Under the L&T model, based on a lease agreement, the lessee or publican assumes the right to occupy the pub for a pre-determined 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, are less directly exposed to increasing inflationary costs as these are borne to a greater extent by the publicans (i.e., the lessees). Importantly, some L&T publicans have effectively managed to overcome the fast-paced growth in hospitality sector wages, using flexible opening hours and resorting to the services of family members or local members of the community. Further, while there is a possibility publicans may activate break clauses to terminate their leases, if macroeconomic conditions turn challenging, the diversification across the leases may cushion the effect. We therefore observed the EBITDA margins of operators under the L&T model recovering to pre-pandemic levels more rapidly than for the managed model. This is because, under the latter, the pub is directly exposed to increasing costs, which creates higher pressure and volatility on earnings.

Among the U.K. pub corporate securitizations we rate, Marston's, Green King, and Mitchells & Butlers, operate either a fully managed or a hybrid (i.e., a mix of managed and L&T pubs) model. On the other hand, Unique's revenues are based on retail price index-linked rental income from leased estate. We observed that while revenues remain comparatively lower for Unique as compared with pre-pandemic levels, due to fewer pubs in the estate, its EBITDA margins have reached our long-term forecasts in 2022. At the same time, the EBITDA margins for Marston's, Green King, and Mitchells & Butlers would likely take longer to recover, sitting slightly below pre-pandemic levels by 2025-2026 (see charts 1 and 2).

Chart 1

Chart 2

As the L&T model leads to a faster recovery in earnings and cash generation, the EBITDA margins for Unique have already reached close to the pre-pandemic levels, implying full recovery. Therefore, we have not applied any considerations for delayed EBITDA recovery in our analysis for Unique. Consequently, we have excluded this transaction from our scenario analysis. Our analysis therefore focuses on U.K. pub corporate securitizations from Marston's, Greene King, and Mitchells & Butlers, where we expect delayed recoveries in EBITDA, due to them being fully managed or hybrid-model pub cos.

Strong Or Watered Down: Assessing Resilience To A Lower EBITDA Recovery

During our recent full reviews of Marston's, Greene King, and Mitchells & Butlers, we assessed whether the borrower's generated operating cash flows, derived based on our base-case operating cash flow projections and our assessment of its business risk profile (BRP) determined under our corporate methodology, would be sufficient to make timely interest and principal payments on the notes by using a debt service coverage ratio (DSCR) analysis under both a base-case and a downside scenario (see "Related Criteria").

Short term: strong liquidity support bodes well

Under our DSCR analysis, we first determine a base-case anchor for each tranche within a structure. We constructed a base-case projection that considers operating-level cash flows but does not consider issuer-level structural features, such as external credit support from liquidity or liquidity reserve accounts. Once we establish this base-case anchor, we typically derive the downside scenario from this base-case anchor to determine the resilience-adjusted anchor for each tranche. Our downside analysis is intended to refine our base-case anchor depending on the resilience of the tranche to downside conditions. These conditions stem from declines in revenues or EBITDA due to stress factors such as market or competitive developments in the industry, demand fluctuations, or operating cost changes, etc. We therefore give benefit to structural forms of support, generally in the form of liquidity support, in our downside analysis. We factored in that the high level of inflation has severely strained the hospitality sector, which has delayed cash flow recovery and caused EBITDA and consequently the cash flow available to service debt (CFADS) to remain below pre-pandemic levels for these three transactions. The consequent effect on operational costs, in our view, already reflects a certain level of stress we would typically apply under our downside scenario analysis. Therefore, we currently do not determine a base-case anchor for these transactions as the base-case anchor does not reflect the issuer's liquidity support (see paragraph 46 of our corporate securitization criteria). We see the issuer's available liquidity support as a mitigating factor to what we believe is a temporary liquidity stress from exceptionally high levels of inflation and challenging macroeconomic conditions (see chart 3). We therefore focused directly on the resilience-adjusted anchor. The available liquidity in these three transactions has improved post-pandemic.

Chart 3

While the prevailing inflationary pressures on pubs in the U.K. have delayed their recovery, we forecast the sector for pure managed and hybrid models will recover to slightly below 2019 levels around 2025-2026. We anticipate that the stabilization of the macroeconomic environment will support the creditworthiness of companies in the sector. Therefore, while we typically do not give credit to growth in EBITDA after the first two years of our forecasts in corporate securitizations, during our recent surveillance review for the three issuers, we considered the growth period to continue for three years to accommodate both the duration of inflationary pressures and the subsequent recovery. We expect earnings and cash flow recovery to pre-pandemic levels will take longer than we initially anticipated, due to cost inflation and pressures on discretionary spending.

For our short-term analysis, i.e., until 2025, we reviewed if the available liquidity would be sufficient to maintain timely payments on the rated notes until full recovery to our long-term forecasted EBITDA levels. Based on our downside analysis, we observed strong liquidity support in all three structures. Consequently, we believe the above-mentioned three issuers are currently well-positioned to tide over temporary reductions in EBITDA until the industry recovers to near pre-pandemic levels.

Long term: how little is too little?

While the short-term resiliency of the issuers remains strong, our forecasted long-term operating cash flows, post 2025, incorporate our forward-looking view on the effect from the macroeconomic environment on the U.K. pub sector once it recovers to near pre-pandemic levels.

To test the stability of our credit ratings, we conducted a long-term sensitivity analysis to assess, all else being equal, the effect on recovery of lower levels of long-term EBITDA than we currently forecast in each transaction. Unlike our analysis for the short term, where we focused on just the resilience-adjusted anchor, in our long-term sensitivity analysis, we focused both on the base-case anchor as well as the resilience-adjusted anchor, as we expect EBITDA recovery to have materialized by this time.

Under each scenario, we therefore first determined the base-case anchor for each tranche within the structure by applying hypothetical reductions to the borrower's S&P Global Ratings-adjusted long-term forecasted EBITDA. These hypothetical reductions reflect the potential impact on the borrower's S&P Global Ratings-adjusted long-term forecasted EBITDA from a combination of two possible scenarios: (i) the future revenue generated by the borrower, post full recovery in the sector, is lower than our current long-term forecasts due to the borrower being unable to fully pass on any further price increases or recover their customer base to pre-pandemic levels; or (ii) the operating costs of the pubs remain elevated in the long term and do not normalize to pre-pandemic levels.

As both these scenarios--independently as well as in aggregate--would ultimately affect EBITDA, we considered it appropriate to perform our long-term sensitivity analysis by applying reductions directly to the overall EBITDA, rather than assess changes to these factors individually. Further, a reduction in overall EBITDA directly reduces the available CFADS that we consider for our cash flow analysis to determine the base-case and downside analysis.

Scenario Analysis

In our long-term sensitivity analysis, we focused on four scenarios by reducing the level of each borrower's S&P Global Ratings-adjusted long-term forecasted EBITDA (i.e., post-2025) by 10%, 15%, 20%, and 25% (see table 1). We first performed our base-case analysis to determine the effect on the base-case anchor, followed by our downside analysis to determine the cumulative rating impact based on the resilience-adjusted anchor.

Table 1

Assessment of base-case anchor

In line with our assessment in the recent full reviews, we determined a business volatility score of 4 based on our fair BRP assessment for all three borrowers, which is supported by each group's current position in the sector in the U.K. and their well-invested estates. We then determined the base-case anchor for each tranche under each of these four scenarios, based on the minimum DSCR and the volatility scores. For each of the four scenarios, we then compared the base-case anchor for the respective scenario for each tranche with the base-case anchor of the respective tranche determined before we applied paragraph 46 of our criteria in our recent surveillance review (i.e., unstressed base-case anchor), to assess the potential ratings impact from a change in the base-case anchor (see table 2).

Table 2

For example, the minimum DSCR for a tranche under scenario 1 (10% reduction in EBITDA) is less than 1.30x and applying a volatility score of 4 would give a base-case anchor in the 'b' category. We would then adjust this anchor by one notch higher or lower, i.e., 'b+' or 'b-', if the minimum DSCR lies toward one of the endpoints in this DSCR range. If, for example, the scenario 1 base-case anchor is 'b+' and if the unstressed base-case anchor for this tranche is also 'b+', we would likely determine that a 10% reduction in the borrower's S&P Global Ratings-adjusted long-term forecasted EBITDA does not have any potential impact on the base-case anchor for this tranche.

Assessment of resilience-adjusted anchor

Next, we performed our downside analysis, where we considered other structural support, such as the available liquidity, to determine the resilience of the tranche to downside conditions in the long-term. From this, we determined a resilience score for each tranche ranging from excellent to vulnerable, under each of the four scenarios. We then combined the resilience score with the base-case anchor to determine the resilience-adjusted anchor. Finally, we compared this resilience-adjusted anchor (which is prior to incorporating our modifier and comparable ratings analysis) with the current rating on the tranche to assess the potential ratings impact from a change in the resilience-adjusted anchor (see table 3).

Table 3

For example, under scenario 1 in our downside analysis the tranche we discussed above achieves a resilience score of strong. When we combine this resilience score with our base-case anchor of 'b+' on this tranche, we determine the resilience-adjusted anchor at 'bb'. If the current rating on these notes is 'BB+', we can observe that there is a deterioration by one notch from the 'bb' resilience-adjusted anchor. It is important to note that the effect assessed based on the change in the resilience score reflects the combined impact of our base-case and downside analysis.

Therefore, based on combining the impact assessed in tables 2 and 3 above, we observe that under scenario 1, where we reduce the level of borrower's S&P Global Ratings-adjusted long-term forecasted EBITDA by 10%, the current rating on a tranche could potentially be lowered by one notch, based on the analysis presented above.

Our analysis also includes qualitative considerations depending on our assessment of the structural package, including repayment structures, leverage, and weak financial covenant packages (modifier analysis), and holistic comparable analysis and our assessment of the issuer's credit characteristics and performance in aggregate, both in absolute terms and relative to peers (comparable ratings analysis). The outcome of this step could either (i) mitigate any ratings impact we have determined based on our base-case and downside analysis if the outcome of our assessment in this step is positive; or (ii) cause a further deterioration in the ratings (determined through our base-case and downside analysis) if we assess the overall impact of qualitative factors to be negative. We did not conduct these two steps, i.e., modifier analysis and comparable ratings analysis, in our long-term sensitivity analysis, as these are qualitative and driven by the prevailing circumstances at the time we perform our surveillance reviews.

Rating Implications

We may revise our base-case assumptions if we expect a deterioration in performance within the sector or for the entities themselves, including revisions to our economic outlook, whereby long-term EBITDA for these securitizations does not reach the long-term forecasts we currently expect. The results of our long-term sensitivity analysis indicate that the potential ratings migration could range from no impact to up to four notches, depending on three aspects:

• The level of reduction in EBITDA,
• Whether the tranches are currently investment-grade or speculative-grade, and
• The effect on the resilience-adjusted anchor in our downside analysis.

Level of reduction in EBITDA

Table 3 shows that the ratings impact based on the resilience-adjusted anchor worsens as long-term EBITDA within these securitizations reaches a lower level than we currently forecast. For example, a reduction of 10% in long-term EBITDA would generally not affect our current ratings, whereas if they are 25% below our current forecast (scenario 4), the effect could potentially reach four notches, prior to qualitative adjustments.

Current rating on the tranches: investment-grade versus speculative-grade

We observed that investment-grade tranches showed a stronger resiliency to the reduction in EBITDA, due to strong structural enhancement, being senior in the capital structure, and having access to the available liquidity. On the other hand, tranches that we currently rate below investment-grade could potentially start to deteriorate even with a 10% reduction in our long-term forecasted EBITDA.

Resilience-adjusted anchor in our downside analysis

The resilience-adjusted anchor deteriorates faster when the base-case anchor is set higher, compared with when base-case anchor is set at lower levels. For example, when the base-case anchor is set at 'bbb-', the resilience-adjusted anchor drops to 'bbb-' from 'bbb+', should the resilience score from our downside analysis deteriorate to satisfactory from strong. However, at a lower base-case anchor, such as 'b', the resilience-adjusted anchor remains stable at 'bb-' across resilience scores excellent through fair and deteriorates to 'b+' only once the resilience score drops to weak. Therefore, the distance to a potential ratings impact is much greater when the base-case anchor is already close to or at the borrower's stand-alone credit profile. This is because, under our criteria, we consider factors such as a rating floor, based on the borrower's creditworthiness, and access to liquidity at lower rating levels.

In our base-case analysis, if the minimum DSCR is below 1.0x, and (i) such a DSCR is not in a period affected by a one-off event that is highly unlikely to occur, (ii) will result in a breach of any financial covenant, or (iii) the transaction does not have sufficient liquidity to preserve through the period even under stressed conditions, we would determine our base-case anchor based on the application of our 'CCC' criteria, in conjunction with consideration of available liquidity support and, where appropriate, any floors implied by the credit quality of the borrower (see "Related Criteria").

At the same time, prior to any potential downgrade and rating action, we would also incorporate adjustments based on our modifier analysis and comparable rating analysis. The maximum reduction in our ratings would therefore incorporate these additional considerations, along with qualitative factors as applicable, and would be subject to the decision of an S&P Global Ratings' rating committee.

Limitations And Caveats

• The EBITDA 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 credit and cash flow analysis only. 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 information available in the most recent investor reports available for these issuers, our long-term credit forecasts applied in our recent full review analysis, 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 different rating than the largely quantitative analysis undertaken herein.

Related Criteria

• Global Methodology And Assumptions For Corporate Securitizations, June 22, 2017
• Corporate Methodology, Nov. 19, 2013
• Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings, Oct. 1, 2012

Related Research

• Unique Pub Finance Co. PLC Class A4 U.K. Corporate Securitization Notes Rating Lowered; Class M and N Ratings Affirmed, Aug. 23, 2023
• Industry Top Trends Update Europe: Retail And Restaurants, July 18, 2023
• Global Credit Conditions Q3 2023: Higher For Longer Will Fuel Ratings Divergence, June 29, 2023
• Economic Outlook U.K. Q3 2023: Higher Rates Start To Bite, June 26, 2023
• Mitchells & Butlers Finance PLC U.K. Corporate Securitization Ratings Affirmed, May 30, 2023
• Marston's Issuer PLC Class A And B U.K. Corporate Securitization Notes Ratings Affirmed, May 30, 2023
• Greene King Finance Class A, AB, And B U.K. Corporate Securitization Notes Ratings Affirmed, May 30, 2023
• Period of Maximum Liquidity Stress May Have Passed For U.K. Pub Corporate Securitizations, May 24, 2021
• U.K. Pubs, Shaken And Stirred, Look To Recover After A Cocktail Of Headwinds, April 8, 2021