HR And Payroll Software Company NGA UK Downgraded Over Weaker Cash Flows And Higher Debt Levels

  • Colour Bidco Ltd. (NGA UK) has increased the amount of debt on its balance sheet due to higher costs than initially expected during the carve out from its parent Northgate Information Solutions and the acquisition of Benefex.
  • The increase in debt, combined with weaker-than-expected operating performance, has caused forecast leverage (excluding carve-out costs) to increase to more than 8x in the financial year (FY) ending April 2019.
  • We are therefore lowering to 'B-' from 'B' our long-term issuer credit rating on NGA UK and our issue rating on its £260 million term loan.
  • The stable outlook reflects our expectation that the company's cash flow generation will improve over the next 12 months as it increases sales and reduces deal-related exceptional costs. Nevertheless, we expect leverage to remain above 7.5x.
LONDON (S&P Global Ratings) Dec. 11, 2018--S&P Global Ratings today lowered to 
'B-' from 'B' its long-term issuer credit rating on Colour Bidco Ltd., the 
parent company of U.K.-based human resources and payroll provider NGA UK.

At the same time, we lowered to 'B-' from 'B' our issue rating on NGA UK's 
£260 million senior secured term loan. The recovery rating is unchanged at 
'3', indicated our expectation of meaningful recovery (50%-70%; rounded 
estimate 55%) in the event of default.

The downgrade primarily reflects the higher-than-anticipated increase in debt 
following the completion of NGA UK's carve out from parent Northgate 
Information Solutions in February 2018 and the mainly debt-financed 
acquisition of Benefex completed in September 2018. Total carve-out costs were 
estimated at £30 million during the fourth fiscal quarter of 2018 and first 
fiscal quarter of 2019, and were almost entirely financed by drawings on the 
company's revolving credit facility (RCF). We also estimate that the 
acquisition of HR software provider Benefex will add an additional £20 million 
of debt, and that Benefex will make limited EBITDA contributions over the 
short term. 

The downgrade also partly reflects a weaker-than-expected operating 
performance during 2018. Reported sales declined by 4.9% during the year due 
to weaker-than-expected new license sales of the company's core HR software, 
Resourcelink, during the carve-out period. This also cut into implementation 

As a result, we now expect NGA UK's gross debt to EBITDA to increase to about 
15x (8.0x, excluding carve-out and transformation-related costs) in FY2019, 
from about 7.6x for FY2018. It should remain above 7.5x in FY2020. This 
compares with our previous base case of 6.8x in FY2019.

In addition, we forecast annual free operating cash flow (FOCF) generation of 
only about £10 million-£15 million in FY2019 (excluding exceptional carve out 
and transformation costs), suggesting a S&P Global Ratings-adjusted 
FOCF-to-debt ratio of about 3%-5% over the same period. Our previous forecast 
stood at £20 million-£25 million (corresponding to adjusted FOCF to debt of 
6%-8%). In preparing this forecast, we excluded about £4.9 million in annual 
contributions to the company's pension plan, which we consider as part of the 
company's debt repayment.

That said, NGA UK benefits from relatively good cash conversion thanks to low 
capital expenditure (capex) requirements, excluding capitalized expenses for 
research and development (R&D), and limited working capital requirements due 
to a large recurring revenue base with upfront annual billing. 

Our view of the company's business risk profile continues to be constrained by 
NGA UK's small scale and limited geographic diversity compared with most of 
its rated peers in the software sector. In FY2018, NGA UK generated about £131 
million of revenues and about £47 million of EBITDA, and operated entirely in 
the U.K. and Ireland. 

NGA UK's business risk profile is further constrained by its narrow 
specialization on HR and payroll products, where the market is very 
competitive and fragmented and there are only modest entry barriers, in our 
view. Although NGA UK's payroll software solutions are critical to customers' 
operations, we do not consider that they are as embedded in customers' IT 
strategy as software that supports revenue generation, for instance. NGA UK's 
customer base also exhibits some customer concentration because the 10 largest 
customers account for about a quarter of total revenues.

This is partly offset by NGA UK's good profitability--it reported EBITDA 
margins of 32.5% in FY2018 and solid cash conversion of about 30% of EBITDA 
(both excluding carve-out costs). The business risk profile further benefits 
from the company's leading position in the HR and payroll services in the U.K. 
According to management, NGA UK held approximately 19% market share for HR 
software in the mid-market enterprise segment, which is roughly twice the 
market share of the second player in this segment. The company also holds 
roughly 8% for the market in HR software for small and midsize businesses. 

Furthermore, NGA UK's relatively high proportion of recurring revenues 
provides good visibility on future earnings. In FY2017, 85% of NGA UK's 
revenues were recurring. The company has achieved meaningful software as a 
service (SaaS) penetration among its existing client base, and expects to 
increase this further as it transitions its customers from on-premises to 
cloud-based solutions.

Our financial risk profile assessment still reflects NGA UK's highly leveraged 
pro forma capital structure and our expectation that Bain Capital will likely 
pursue an aggressive financial policy.

We calculate NGA UK's leverage on a gross debt basis. We have added to our 
debt calculation for NGA UK about £37 million unfunded pension obligations in 
FY2018 and adjusted EBITDA for capitalized development costs (about £8 million 
in FY2018). 

The stable outlook reflects our expectation that NGA UK will successfully 
increase revenues in 2019 by delivering on various sales growth initiatives 
including investment in its current sales force and pushing more aggressive 
price increases. We anticipate that this will lead to sales growth of 2%-3% 
and reported FOCF generation of at least £10 million over the next 12 months, 
with leverage remaining above 7.5x.

We could raise the rating if reported FOCF of £15 million-£20 million and 
adjusted debt-to-EBITDA decreased below 7.5x.
We think this could be achieved through better-than-expected operating 
performance, including a faster-than-expected transition to Saas and an 
acceleration in payroll outsourcing of existing ResourceLink users. This could 
also be achieved through higher-than-expected new client wins or realization 
of cost benefits from various off-shoring and automation initiatives, which 
would lead to EBITDA margin improving to above 35%.

Although unlikely in the next 12 months, we could lower the rating if NGA UK 
generated breakeven FOCF, causing its liquidity to deteriorate materially. 
This could be the result of operating performance deterioration from intense 
competition, higher customer churn, or loss of market share.

  • Colour Bidco's £260 million senior secured term loan is rated 'B-', with a recovery rating of '3'. The recovery rating indicates our expectation of meaningful (50%-70%; rounded estimate 55%) recovery in the event of a payment default.
  • Our default scenario envisages, among other things, a weaker operating environment, significant deterioration in demand, coupled with a prolonged economic recession and overexpansion that causes material pricing pressure and increased customer churn. In addition, we envisage that technology risks from the company's product offering could lead to customer defections.
  • We value Colour Bidco as a going concern given the long-term nature of its customer contracts and some switching costs for existing customers to replace its software solutions.

  • Year of default: 2020
  • Minimum capex (% of sales): 1%
  • Miscellaneous items: £4.9 million for annual pension deficit funding payments
  • Cyclicality adjustment factor: +5% (standard sector assumption)
  • Operational adjustment: +5% (reflecting our assumption that long-term contracts with clients would provide for some limit/protection to EBITDA decline)
  • Emergence EBITDA after recovery adjustments: about £31.9 million
  • Implied enterprise value multiple: 6x
  • Jurisdiction: U.K.

  • Gross enterprise value at default: about £191.7 million
  • Administrative costs: 5%
  • Net value available to debtors: £182.1 million
  • Prior-ranking claims: nil
  • Secured debt claims: about £330 million*
  • Recovery expectation: 55% (Recovery rating: 3)
*All debt amounts include six months of prepetition interest. Assumes RCF 85% 

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