Fitch Ratings has affirmed Rede D'Or Sao Luiz S.A.'s Long-Term Foreign Currency Issuer Default Rating (IDR) at 'BB+', Long-Term Local Currency IDR at 'BBB-' and National Long-Term Rating at 'AAA(bra)'.

The Rating Outlook for the Long-Term Local Currency IDR was revised to Negative from Stable, and Outlooks for the Long-Term Foreign Currency and National Long-Term Rating remain Stable.

The Negative Outlook on the Long-Term Local Currency IDR reflects a lower than expected deleveraging trend after investment peaks and operating recovery post-pandemic. The high debt burden with interest expenses, as well as high working capital requirements following industry dynamics have further dented FCF generation. Fitch forecasts Rede D'Or's net leverage ratio will remain above rating triggers of 2.5x until 2025, per the agency's criteria.

The company's ratings reflect the defensive nature of its business, solid competitive position in the fragmented hospital industry in Brazil, strong portfolio of counterparties, track record of adequate capital structure supported by a mix of internal cash flow, debt and equity, and robust liquidity.

Key Rating Drivers

Deleverage Taking Longer: Rede D'Or's ability and willingness to effectively deleverage while managing aggressive business growth are key rating considerations. Considerations also include the company's ability to navigate a more challenging scenario in terms of higher operating costs and competitive environment.

The company has indicated it has passed its peak of organic and inorganic investments, which could alleviate pressure on free cash flow generation in the next two years. Fitch projects Rede D'Or's leverage ratio, per the agency's criteria, to reach 2.7x in 2023 and 2024 and 2.6x in 2025, without any extraordinary measure.

FCF to Remain Negative: The high debt burden and interest rates in Brazil, as well as working capital requirements have pressured Rede D'Or's operating cash flow generation. For 2023, Fitch estimates that Rede D'Or will pay around BRL1.9 billion of interest expenses (net of received interests) and consumed BRL2.4 billion in working capital, per Fitch's criteria.

Fitch forecasts adjusted EBITDA (excluding IFRS-16) of around BRL6.4 billion in 2023 to grow to BRL7.5 billion in 2024 and BRL8.5 billion in 2025. Fitch expects FCF to remain negative at around BRL1 billion during 2023, BRL1.8 billion in 2024 and BRL1.1 billion during 2025. Fitch's base case incorporates capex remaining elevated at BRL2.8 billion and BRL3 billion during 2024 and 2025, after BRL2.5 billion in 2023 and BRL2.3 billion in 2022, but no major M&A activity.

Margins to Improve: Fitch expects Rede D'Or's consolidated adjusted EBITDA margins to improve to around 13% and 14% in 2024 and 2025, from 12.3% in 2023; the first year of consolidating Sul America's results. The Hospital segment's operations are also expected to improve, moving closer to 26% during 2024 and 2025, after achieving 24% and 25% during 2022 and 2023, per the agency's calculation.

The company's margins compare well with global peers. The company has efficiently increased profitability through economies of scale and synergies from acquisitions. However, operating performance has been impacted by the pandemic, fewer high-complexity hospitalizations, high inflation and interest rates, and pressure from payors over the past two years. Fitch forecasts adjusted EBITDA (adjusted by IFRS-16) of around BRL6.4 billion in 2023 to grow to BRL7.3 billion in 2024 and BRL8.4 billion in 2025.

Leading Business Position: Rede D'Or is the largest private hospital network in Brazil's fragmented and underserved hospital industry. The company owns 73 hospitals, 11,512 total beds and 9,600 operating beds as of Sept. 30, 2023. Rede D'Or has a solid business position and large scale of operations in its key markets, which serves as a key competitive advantage, allowing for lower fixed costs and significant bargaining power with counterparties and the medical community.

The company's scale and strong brand act as strong barriers to entry over the medium term. The healthcare industry has positive long-term fundamentals, in light of the imbalance between supply and demand for hospital services in Brazil and lack of good healthcare service infrastructure in the public sector.

Withstanding a Challenging Industry: Industry consolidation and the increasing vertical integration among competitors has increased competition. Post-pandemic, increasing medical loss ratios within healthcare operators, insurances, logistic supply issues within the medical drugs and devices companies, have impacted all peers. Business scale, strong brand and medical recognition are essential competitive advantages that mitigate increasing pressure from healthcare plan providers in terms of contracts pricing and working capital management. Fitch believes Rede D'Or is well positioned to face the ongoing developments in industry dynamics.

Country Ceiling Constrains: Rede D'Or's Long-Term Foreign Currency IDR is constrained by Brazil's 'BB+' Country Ceiling because its operations are domiciled in Brazil. The investment-grade Long-Term Local Currency IDR reflects the resilience of Rede D'Or's business to economic downturns, and the positive prospects over the longer term, yet it is currently pressured by the company's aggressive financial strategy.

Legal Contingencies: Rede D'Or is exposed to tax litigation that could result in loss, as no provisions have been recorded. The most significant, BRL1.1 billion, refers to allegations by the Federal Revenue of Brazil (Brazil's federal taxation administrator) that certain doctors who render services in Rede D'Or's hospitals through legal entities should be considered company employees, which would require additional tax payments. Negative outcomes from this litigation could change the company's business model and affect its cost dynamics. However, Fitch has not incorporated this into its base case scenario at this time.

Derivation Summary

Rede D'Or's ratings reflect Brazil's private hospital industry's low business risk and its positive business fundamentals, adequate capital structure and strong financial flexibility. Compared with Auna S.A.A.(B+/Stable), Rede D'Or has stronger business scale, capital structure and financial flexibility in terms of liquidity and proven access to equity and credit markets. Rede D'Or compares well in terms of business scale and operating margins with the Brazilian non-for-profit hospital Sociedade Beneficente Israelita Brasileira Hospital Albert Einstein (Einstein; AAA(bra)/Stable). However, Einstein has a track record of lower leverage.

Compared with the Brazilian diagnostic and hospital competitor, Diagnostico da America S.A (Dasa; AAA(bra)/Negative), Rede D'Or has lower business risk, due to much lower competitive pressures. Both companies have aggressive growth strategies. From a financial risk perspective, Rede D'Or has lower leverage and greater financial flexibility following the IPO.

Rede D'Or, Auna, Einstein and Dasa all benefit from strong brands and reputation in the industry, which offer important competitive advantages and translate to strong relationships with counterparties. On a global scale, the dynamics of the Brazilian hospital industry and regulation are not directly comparable with other countries. Rede D'Or's operating margins and financial metrics are quite sound compared with other rated hospitals within Fitch's global universe.

Rede D'Or's Long-Term Foreign Currency IDR is constrained by Brazil's 'BB+' Country Ceiling since its operations are domiciled in Brazil. The investment-grade Long-Term Local Currency IDR reflects the resilience of Rede D'Or's business to economic downturns, and the positive prospects over the longer term.

Key Assumptions

Revenue growth reflecting ongoing acquisitions and greenfield/brownfields projects, with addition of around 400 operating beds during 2024 and around 1,000 during 2025;

Volume of daily-patients of 2.8 million in 2024 and 3.0 million in 2025;

Average hospital ticket (excluding oncology) at BRL9,8 thousand in 2024 and BRL10,5 thousand in 2025;

Hospital beds occupancy rate around 79,5% in 2024-2025;

Hospital EBITDA margins around 26% in 2024-2025;

SulAmerica's medical loss ratio (MLR) around 85%-86% in 2024-2025;

Capex at BRL2.8 billion in 2024 and BRL3 billion in 2025;

A 25% minimum dividend payout.

RATING SENSITIVITIES

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

Positive rating action for the Long-Term Foreign Currency IDR is limited by Brazil's 'BB+' Country ceiling;

Upward rating potential for Rede D'Or's 'BBB-' Long-Term Local Currency IDR is unlikely in the medium-term given the company's ongoing aggressive growth strategy, through both organic and M&A movements, and its lack of geographic diversification, which leads to large exposure to the local economy in Brazil.

A revision of the Outlook for the Local Currency IDR to Stable from Negative could occur if Fitch's forecasts indicates net leverage below 2.5x by 2025, due to strong than expected operating results, lower capex level and/or combination of non-core asset sales.

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

A change in management's strategy with regard to its conservative capital structure could also lead to a downgrade, as could a deterioration in the company's reputation and market position;

Hospital operation EBITDA margin declining to below 22%;

Total leverage consistently above 4.0x and net leverage consistently above 2.5x by 2025;

Deterioration of a sound liquidity position leading to refinancing risk exposure;

Major legal contingencies that represent a disruption in the company's operations or a significant impact to its credit profile.

Liquidity and Debt Structure

Robust Liquidity: Rede D'Or has a track record of maintaining strong cash balances, while it navigates its aggressive growth strategy. The company had BRL33.9 billion of debt (net of derivatives and obligations with acquisitions) as of Sept. 30, 2023, of which BRL2.7 billion is due in the short term. Rede D'Or's BRL17.5 billion of cash (net of technical provision) is sufficient to support debt amortization at least 2028.

Around 27% of Rede D'Or debt as of Sept. 30, 2023 was linked to the U.S. dollar, including BRL4.8 billion senior unsecured notes due 2028-2030. The company utilizes hedging instruments to moderate currency mismatch risks, since revenues are nearly 100% originated in Brazil. Rede D'Or does not have committed credit facilities.

The company's financial flexibility is solid, and the company has shown good access to local and cross-border capital markets. Fitch expects Rede D'Or will maintain a strong liquidity position and proactive approach in liability management to avoid exposure to refinancing risks.

As of Sept. 30, 2023, Rede D'Or reported BRL2.6 billion of local debentures related to the former SulAmerica. At the same period, total technical provision was BRL15.8 billion, with private pension reserves of BRL10.6 billion.

Issuer Profile

Rede D'Or Sao Luiz S.A. is the largest private hospital player in Brazil, with 73 hospitals totalling 9.6 thousand operational beds and the country's largest integrated cancer treatment network as of Sept. 30, 2023.

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

Rede D'Or Sao Luiz S.A. has an ESG Relevance Score of '4' for Labor Relations & Practices due to labor/tax litigation. The company registers their employees (mostly physicians) as service providers, not as Rede D'Or's employees. This has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' 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. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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