Fitch Ratings has affirmed Gainwell Acquisition Corp's Long-Term Issuer Default Rating (IDR) at 'B'.

The Rating Outlook has been revised to Negative from Stable. Fitch has also affirmed the senior secured first-lien term loan rating at 'BB-' and has maintained the recovery rating at 'RR2'. Fitch's actions affect approximately $4.2 billion of outstanding debt.

The Negative Outlook reflects the recent operational underperformance against expectations in the current year as Gainwell increased investments in product management and engineering capabilities, along with higher than expected nonrecurring costs related to integration and separation costs. This has resulted in weakened credit protection metrics for the company. Fitch believes that despite short-term pressure on Gainwell's profitability, the investments would strengthen competitive positioning in the Medicaid industry, and margins would become stronger once synergies are achieved.

Key Rating Drivers

Recent Performance: Pro forma revenue growth for the LTM ended Sept. 30, 2022 was 9%, with the September quarter representing 6% pro forma adjusted revenue growth. Growth rates have been moderately below Fitch's expectations for mid-to-high single digits at the time of Fitch's last-year estimates. The company has benefited from Medicaid enrollment growth, new program implementations and new logos. This is partially limited by a few client signature delays on awarded contracts and decreased COVID-19 related volumes.

From a profitability perspective, management continues to pursue its margin expansion strategy and has executed on $166 million of cost reductions and synergies out of the total target of $222 million. However, Gainwell is undergoing an investment phase to deploy a new cloud-based modular Medicaid platform. The results are also affected by continued high nonrecurring transaction and integration costs, resulting in short-term depressed profitability. As a result, Gainwell generated Fitch calculated pro forma EBITDA margins in 1H23 of 26%. Fitch continues to forecast margin expansion in the low 30% range as cost saving synergies are achieved and the modular platform contributes to long-term competitiveness.

Evolving Marketplace: Gainwell faces risks in the evolving MMIS marketplace. Fitch believes CMS's efforts stimulate increased competition by reducing switching costs and providing opportunities for new entrants seeking to develop niche solutions, which may lead to share erosion over time. However, despite the potential for increased competition, Fitch believes the risk of lost wallet share is moderated by Gainwell's large installed base and undertaken investments, which position it as an entrenched provider of the core underlying platform.

Market Position: Gainwell is the primary MMIS vendor in 32 states/territories, serving 51 in total when including adjacent or modular offerings. The company covers approximately 60 million beneficiaries across its portfolio of offerings, out of the 91 million under Medicaid and Human Health Services. The company is gaining market share, having added eight new logos in the past year.

Increased competition from CMS's drive toward modularity and interoperability has increased competitive intensity and moderated Gainwell's growth rate. However, Fitch expects the company's leadership position, long-term contracts and high retention rates to provide support during re-determination of contracts.

Cyclicality: Fitch expects Gainwell, which has generated accelerated growth though the pandemic, to continue to exhibit low cyclicality for the foreseeable future. Fitch believes the company will exhibit a correlation with Medicaid spending and enrollment, supported by the non-discretionary nature of health expenditures. In addition, Medicaid enrollment exhibits countercyclicality, which experiences elevated growth during economic downturns as job losses increase the pool of eligible beneficiaries, resulting in increased demand for the company's offerings.

However, with the upcoming end of the PHE in May 2023, enrollment is forecast to decline by 0.4%, according to the Kaiser Family Foundation. Moreover, declining COVID-19-related volumes represents additional growth headwinds for 2023. As such, Fitch expects Gainwell's fiscal 2024 pro forma growth to be slower from recent high-single digit levels. Over the longer term, as the COVID-19-related distortions are lapped, Fitch expects the company will return to its characteristic low cyclicality and to demonstrate a stable credit profile with little sensitivity to macroeconomic cycles.

High Leverage: Gainwell's acquisition of the HMS carve-out in a deal valued at $2.4 billion was financed with incremental term loans that increased leverage to a Fitch-forecast pro forma fiscal 2022 level of 9.1x. Due to the margin pressures noted above, Fitch is currently forecasting fiscal 2023 leverage of 9.4x. Fitch believes liquidity remains sufficient and leverage is supported by the company's dependable growth prospects over the longer term, strong market position, low capital intensity and low cyclicality, with leverage moderating toward 6.5x over the end of the rating horizon.

Beneficial Tailwinds: Fitch expects Gainwell to benefit from strong secular trends propelling growth in Medicaid expenditures. The Centers for Medicare and Medicaid Services (CMS) forecasts Medicaid expenditure growth of 5.6% per annum, approaching $1 trillion with 82 million beneficiaries by 2026, due to long-standing trends in medical procedure/drug cost inflation and utilization, program expansions among states, and increased share of the aged and disabled beneficiaries served.

In addition, CMS estimates $80.6 billion of improper payments by Medicaid and $4.3 billion under CHIP in 2022 due eligibility and claims processing complexity, lack of sufficient documentation, shifting regulatory requirements, fraud and waste. States suffering from constrained budgets are strongly incentivized to adopt Gainwell's software and data offerings in order to contain such costs. Fitch believes the secular tailwinds provide for a dependable growth trajectory, benefiting the credit profile.

Derivation Summary

Fitch evaluates Gainwell following its 2021 acquisition of the HMS carve-out that consists of the products that address administration of state Medicaid programs in a transaction backed by private equity sponsor, Veritas Capital.

Fitch believes the company benefits from favorable tailwinds as the underlying growth of Medicaid, constrained state budgets, constructive regulatory environment and long-standing trends in U.S. healthcare including, an aging demographic, medical procedure/drug cost inflation and utilization growth are supportive of adoption of the company's software and services.

The combination with HMS bolstered the company's modular offerings to generate significant cross-selling opportunities in the existing client base. Fitch believes growth is further ensured by the company's leading share, strong client retention rates, high switching costs and continued Medicaid program expansions among states.

Finally, as the country laps the distortions caused by the pandemic and related government policies, Fitch expects Gainwell to demonstrate minimal cyclicality and durable resistance to economic cycles due to the counter cyclical aspects of Medicaid enrollment. While Fitch views the high visibility into long-term revenue growth positively, the company faces risks from an evolving marketplace and the potential for future regulatory changes that may increase competition or reduce growth in Medicaid expenditures and enrollment over time.

The company's profitability metrics, though strong, scores below peers, with Fitch forecasting EBITDA margins in low 30% range over the rating horizon, compared with the 46% average for Fitch-rated healthcare IT peers. However, Gainwell's margins are still above average of Fitch-rated software peers in the B-category. Fitch also expects consistent FCF margins to be constrained in the near term due to increasing interest rates, similar to PE-sponsored peers. Fitch believes FCF will improve gradually as growth and margin expansion returns, and will be sustainable due the low cyclicality and a supportive regulatory environment in the medium term.

Despite these favorable characteristics, Fitch forecast fiscal 2023 leverage of 9.4x is near the upper 6.0x-11.5x range for Fitch-rated health care IT issuers in the 'B' rating category. However, Fitch expects gradual reduction in leverage to 6.5x by fiscal 2026 due to achievement of already actioned cost reduction programs in Gainwell and synergy opportunities from the acquisition of HMS.

While the company clearly benefits from beneficial secular tailwinds, a leading, defensible market position, and low cyclicality, Fitch views sustained elevated leverage as the primary determinant of the 'B' rating. No Country Ceiling, parent/subsidiary or operating environment aspects had an impact on the rating.

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer:

Organic revenue growth in the mid-to-high single digits in fiscal 2023 and mid-single digits thereafter, due to decreased Medicaid enrolments and reduced COVID-related volumes, consistent with Medicaid enrolment forecasts;

EBITDA margins depressed in fiscal 2023, then expand to early 30% over the rating horizon, reflecting actioned margin improvement initiatives at Gainwell and achievement of synergies at HMS;

Capital intensity of 3%, due to cloud migration efforts, decreasing to 2.5% by fiscal 2025 and thereafter;

Bolt-on acquisitions of total $150 million fiscal years 2025 and 2026.

KEY RECOVERY RATING ASSUMPTIONS

The recovery analysis assumes that Gainwell would be reorganized as a going-concern in bankruptcy rather than liquidated;

A 10% administrative claim.

Going-Concern (GC) Approach

The GC EBITDA estimate reflects Fitch's view of a sustainable, post-reorganization EBITDA level upon which Fitch bases the enterprise valuation (EV). Fitch contemplates a scenario in which the increasing modularization of MMIS offerings results in elevated competition and loss of share for Gainwell, leading to decreased revenue growth and higher investment into sales and R&D to address the challenges.

As a result, Fitch expects Gainwell would likely be reorganized with a similar product strategy and higher than planned levels of operating expenses as the company reinvests to develop competing products, ensure customer retention and defend against competition.

Under this scenario, Fitch believes EBITDA margins would decline such that the resulting GC EBITDA is approximately 4% below fiscal 2022 EBITDA. Fitch believes GC EBITDA will be above future results as much of the company's recent margin pressures are viewed as transitory.

An EV multiple of 7.0x EBITDA is applied to the GC EBITDA to calculate a post-reorganization enterprise value.

The choice of this multiple considered the following factors:

Comparable Reorganizations: The historical bankruptcy case study exit multiples for technology companies ranged from 2.6x to 10.8x. Of these companies, only three were in the software sector: Allen Systems Group, Inc; Avaya, Inc.; and Aspect Software Parent, Inc., which received recovery multiples of 8.4x, 8.1x, and 5.5x, respectively. Long-term contracts ranging from 6-10 years, average client relationship of 20 years, with low customer concentration, and mission critical nature of Gainwell's solutions support the high-end of the range.

M&A Multiples: A study of 273 precedent transactions in the healthcare IT industry during 2015-2020 established median EV/EBITDA transaction multiples ranging 9x to 18x, depending on the specific product area. In addition, HMS was acquired at a 15.5x multiple, excluding synergies.

Fitch evaluated a number of qualitative and quantitative factors that are likely to influence the GC valuation:

Secular trends and regulatory environment are highly supportive with Medicaid enrollment and expenditure growth resulting from program expansions, looser eligibility standards leading to a higher share of the aged and disabled beneficiaries served, and increased claims processing complexity. In addition, constrained state budgets encourage adoption of the company's products that reduce improper Medicaid spend;

Barriers to entry are high relative to software issuers, as deep domain and regulatory expertise are required to develop necessary solutions;

Gainwell is the leading commercial provider of MMIS services;

Revenue and cash flow outlooks are favorable as long-standing secular trends are supportive of revenue growth, while moderate margin expansion and low capital intensity promote FCF margins in the low teens;

Revenue certainty is high as a result of the 92% recurring revenue profile, typical contract duration of 6 to 10 years, 100% client retention and the countercyclicality of Medicaid;

Operating leverage is durable given a highly variable cost structure typical of software developers.

Fitch believes these factors reflect a particularly attractive business model that is likely to generate significant interest, resulting in a recovery multiple at the high-end of Fitch's range.

The recovery model implies a 'BB-' and 'RR2' Recovery Rating for the company's first-lien senior secured facilities, reflecting Fitch's belief that lenders should expect to recover 82% or greater in a restructuring scenario.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

--(Cash flow from operations-capex)/total debt sustaining above 6.5%;

EBITDA leverage sustaining below 5.5x;

Organic growth sustaining above high-single digits.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

EBITDA Interest Coverage sustained below 1.5x;

EBITDA leverage sustaining above 7.5x;

--(Cash flow from operations-capex)/total debt sustaining below 3%;

Erosion of the company's competitive advantage or market position.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Declining Liquidity: As of 2Q23, total cash has declined to $61 million from nearly $190 million one year prior. EBITDA margin compression, integration and carve-out costs, and rising interest rates have pressured FCF and credit protection metrics with coverage ratios now below 1.5x. However, the $400 million RCF remains undrawn. Fitch forecasts steady growth in liquidity to over $700 million by fiscal 2024 due to accumulation of FCF after the transaction and carve-out costs are absorbed and the expectation for the RCF to remain undrawn. While liquidity has come under some pressure, Fitch believes it remains more than sufficient to fund operating costs.

Issuer Profile

Gainwell is a software and solutions provider that supports the administration and operation of government Medicaid programs and other Health & Human Services initiatives through a Medicaid Management Information System.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of Environmental, Social and Corporate Governance (ESG) Credit Relevance is a Score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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