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)'.
In addition, Fitch has upgraded the debentures of the former Sul America S.A. to 'AAA(bra) from A+(bra), since Rede D'Or has become the successor of those issuances. The Rating Outlook is Stable.
Rede D'Or's ratings reflect the defensive nature of its business, solid competitive position in the fragmented hospital industry in Brazil, and a track record of adequate capital structure supported by a mix of internal cash flow, debt and equity, strong liquidity and FCF before capex.
The ratings also reflect the supply deficit for hospital services in Brazil and the company's solid portfolio of counterparties. Fitch expects Rede D'Or's adjusted net leverage (on a stand-alone basis) to peak in 2022 at 3.2x and to decline to 2.8x and 2.3x in 2023 and 2024. Considering the merger with former Sul America S.A. (SASA), those numbers are expected to be a benefit, given the latest's unleveraged capital structure.
Key Rating Drivers
Leading Business Position: Rede D'Or is the largest private hospital network in Brazil's fragmented and underserved hospital industry. The company owns 69 hospitals (11,046 total beds and 9,613 operating beds) as of Sept. 30, 2022. 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. This scale, in addition to a 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 services infrastructure in the public sector.
Merger with Sul America: The all-shares transaction is expected to enhance Rede D'Or's business position within the healthcare industry in Brazil, given SASA's strong brand and fourth largest position in the health insurance market. Following the completion of the transaction, Sul America was incorporated into Rede D'Or during late December 2022. The insurance activity will operate independently, given certain regulatory requirements. Main treasuries activities are expected to be managed by Rede D'Or, on a consolidated basis. Rede D'Or was approved as the successor of Sul America's previous public debentures (outstanding balance of around BRL3 billion as of Sept. 30 2022). This operation should bring opportunities to explore new services and products for the Rede D'Or group, while bringing relevant know-how in the insurance market. Rede D'Or has a good track record of execution in consolidating the hospital industry in Brazil.
Although Sul America is a new business, Fitch considers the execution risks manageable. Rede D'Or has a solid management team with ample experience in the healthcare industry, including insurance activities.
Country Ceiling Constrain: 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.
Withstanding Challenging Industry Scenario: The past years of industry consolidation and the increasing level of 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 all impacted Rede D'Or's 2022 performance.
Business scale, strong brand and medical recognition are essential competitive advantages that help to mitigate the 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.
Margins to Improve: Fitch expects Rede D'Or's adjusted EBITDA margins, on a stand-alone basis, to improve to around 23% in 2023 and 2024, which would be in line with 2019 pre-pandemic figures (23.4%), per Fitch's calculation. The company's margins compares well with global peers. The company has efficiently increased profitability through economies of scale and synergies from acquisitions. However, operating performance in 2022 was still impacted by the pandemic, fewer high-complexity hospitalizations and high inflation and interest rates and pressure on the payors side. Fitch forecasts adjusted EBITDA of around BRL4.9 billion in 2022 to grow to BRL6.2 billion in 2023 and BRL7.5 billion in 2024.
Strong Growth Strategy: Free cash flow (FCF) is expected to remain negative as Rede D'Or continues to pursue both organic and inorganic growth. The company seeks to diversify its service portfolio by expanding its ambulatory, oncology and opportunities to increase verticalization, i.e. the diagnostics market segment. Fitch expects this growth to be funded by a mix of internal cash flow generation, cash on hand and new local debt.
Leverage to Peak in 2022: Fitch projects Rede D'Or's leverage ratio to reach 3.2x in 2022, and 2.8x and 2.3x in 2023 and 2024, considering ongoing capex and/or acquisitions of up to BRL3.5 billion per year. These numbers do not include the likely benefit of the full integration of Sul America. Rede D'Or is expected to remain diligent in managing quite robust cash balances, a sign of positive synergies regarding the operational improvements in terms of SG&A savings and the rerouting of more patients to its network. The company has a positive track record of managing its capital structure, even raising equity when necessary to bring net leverage more in line within the 2.0x-2.5x range.
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 Brazilian Internal Revenue Service 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 to Auna S.A.A.(B+/Stable), Rede D'Or has stronger business scale and capital structure. 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), but Einstein has a track record of lower leverage.
Compared to 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 to 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
Fitch's Key Assumptions Within the Rating Case for the Issuer Include:
Revenue growth reflecting ongoing acquisitions and greenfield/brownfields projects;
EBITDA margins of around 23%-24%;
Working capital needs to remain on historical levels;
Average Capex and M&A disbursements of BRL3.5 billion annually;
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.
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 20%;
Total leverage consistently above 4.0x and net leverage consistently above 2.5x;
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.
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
Robust Liquidity: Rede D'Or has a track record of maintaining strong cash balances, while it navigates is aggressive growth strategy. The company had BRL28.9 billion of debt (net of derivatives and obligations with acquisitions), as of Sept. 30, 2022, of which BRL4,7 billion is due in the short term. Rede D'Or's BRL13.5 billion of cash on hand is sufficient to support debt amortization at least 2027. Around 20% of Rede D'Or debt, as of Sept. 30, 2022, was linked to the U.S. dollar, including BRL4.7 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 the local and cross- border capital markets. Fitch expects Rede D'Or will maintain a strong liquidity position and its proactive approach in liability management to avoid exposure to refinancing risks.
As of Sept. 30, 2022, the former Sul America entity reported BRL3.1 billion of debt (local debentures), cash of BRL709 million and marketable securities of BRL18.4 billion. At the same period, total technical provision was BRL15.9 billion and private pension reserves of BRL9.9 billion.
Issuer Profile
Rede D'Or is the largest private hospital player in Brazil, with 69 hospitals totaling 9.6 thousand operational beds and the country's largest integrated cancer treatment network as of Sept. 30, 2022.
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.
Unless otherwise disclosed in this section, the highest level of 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
REDE D'OR SÃO LUIZ S.A. 
