Fitch Affirms McKesson's Ratings at 'BBB+'; Outlook Revised to Stable
A full list of rating actions, which apply to approximately \$10.6 billion of debt at Sept. 30, 2014, follows at the end of this release.
KEY RATING DRIVERS
-- Fitch forecasts debt leverage to be above 2x at fiscal year-end 2015, slightly above the target for the 'BBB+' ratings. But debt repayment plans and solid EBITDA growth in fiscal 2016 should drive debt-to-EBITDA of 1.7x or lower by the end of fiscal 2016.
-- The credit profiles of MCK and its peers benefit from stable operating profiles and consistent cash generation. Steady pharmaceutical demand and an oligopolistic drug distribution industry in the U.S. and, for the most part in Western Europe, support strong ratings despite slim margins.
-- Fitch generally sees the drug channel outside the U.S. as less stable and higher risk, especially given the diversity of regulatory and reimbursement systems. But inorganic growth opportunities are more prevalent in markets outside the U.S., so McKesson's presence there is important for long-term growth prospects.
-- Robust cash flows and solid capital market access contribute to a strong liquidity profile and should enable MCK to de-lever in the intermediate term. Cash flows are enhanced with the addition of Celesio and expanded distribution agreements with Rite Aid Corp. and Omnicare Inc. as the benefits of increased scale, especially in generic drug purchasing, are realized over the next several years.
-- Global drug channel participants, including pharmaceutical wholesalers, have benefited much from the unprecedented branded-to-generic wave in 2011-2014. Growth of specialty drugs should also provide profitability support beyond the generic wave, though the most expensive therapies will be largely dilutive to margins. Pricing pressure, especially in Europe, could offset some growth.
-- MCK holds top U.S. market positions in specialty drug distribution, medical-surgical distribution, and healthcare IT, as well as drug distribution in Canada. These businesses will support intermediate-term growth and profitability and, in addition to measured expansion in other non-U.S. markets, are likely to represent areas in which MCK will pursue future growth opportunities over the ratings horizon.
RATING SENSITIVITIES
The 'BBB+' IDR incorporates the expectation that the firm will direct cash flows to debt repayment such that debt-to-EBITDA of around 2x or below is achieved by the end of fiscal 2016 (March 2016). Continued strong and steady cash flows, accompanied by expected margin expansion driven by the generally favorable industry tailwinds (i.e. generic conversions, growth in specialty pharma) and improving purchasing scale are also expected at the current ratings.
Ratings flexibility will be limited during this time of integration and de-leveraging. A downgrade to 'BBB' could be driven by material debt-funded acquisitions or the resumption of large-scale share repurchases over the next couple of years, resulting in debt leverage sustained at or above 2x. Fitch believes liquidity is adequate for McKesson to purchase the remaining 24% of Celesio it does not own, if it so chooses, at the current 'BBB+' ratings.
A positive rating action is not anticipated in the near term. An upgrade to 'A-' will require a commitment to sustaining debt-to-EBITDA around 1.4x or below. Depending on management's capital deployment strategy, this target is probably achievable in the years that follow the currently contemplated de-leveraging horizon (e.g. fiscal 2017-2018).
FOCUS ON DEBT REPAYMENT IN FISCAL 2015-2017
Fitch expects MCK to limit share repurchase activity as it repays virtually all debt maturities during fiscal 2015-2017, totaling up to \$3.8 billion (including the Celesio bonds due April 2017). Repaying this full amount would likely drive McKesson's debt leverage back into a range indicating positive rating momentum toward 'A-'. Fitch expects cash generation and current liquidity will be more than ample to accommodate such repayment.
However, a return to regular share repurchases and/or the refinancing of debt post-2016 will likely be amenable at current ratings. The firm's commitment to maintaining leverage at or below 1.4x such that an 'A-' rating is attainable is at this time unknown.
INCREASING GENERICS SCALE, PROFITS FROM EXPANDED DISTRIBUTION AGREEMENTS
With the addition of the generic volumes from Rite Aid and Omnicare, Fitch views McKesson as very strongly positioned among drug channel participants to drive cost savings related to generic drug procurement. The addition of Rite Aid and Omnicare generic drug volumes to McKesson's purchasing arm should enhance the \$275 million to \$325 million synergy number outlined publicly by management that refers to better generic drug pricing available from the acquisition of Celesio. Incremental product cost savings could drive material margin expansion and cash generation over the next few years, particularly if additional large customers that currently source and distribute the majority of their own generic drug volumes.
These agreements have furthermore strengthened McKesson's leadership position in North American drug distribution. Fitch forecasts revenues for the North America pharmaceutical distribution business of \$140 billion in fiscal 2015, rising to nearly \$150 billion in 2016. Strong growth is driven by a favorable drug pricing environment and improved penetration with key customers. Growing generic drug volumes impacts profitability more keenly than the top-line, however, and also contributes to McKesson's ability to garner lower net product acquisition costs going forward.
COST TO ACQUIRE REMAINING 24% OF CELESIO
The driver of the Negative Rating Outlook assigned in February 2014 was the risk that McKesson would require additional debt funding to acquire the remaining 25% of Celesio stock it did not acquire from Franz Haniel & Cie GmbH (Haniel) and Elliott Fund Management (Elliott). At the time, Fitch estimated the cost of this transaction at approximately \$1.7 billion and were not sure when this cost may come to bear.
Pursuant to a subsequent tender offer early in 2014, McKesson reports that it currently owns approximately 76% of the outstanding stock of Celesio AG. Although not a 100% owner, McKesson achieved operational control of Celesio under German law in December 2014. Acquiring the remaining 24% does not impact McKesson's ability to direct the operations and, more importantly, the cash flows of Celesio. The firm has combined purchasing functions and begun to drive the targeted \$275 million to \$325 million of synergies over the next few years. Therefore, it is not imperative that McKesson act quickly to purchase the Celesio stock it does not currently own. Fitch does note, however, that non-controlling owners have the right to put their Celesio stock to McKesson at EUR22.99.
Although this risk remains, it is mitigated by McKesson's re-built liquidity position, including \$1.7 billion of U.S. cash and \$2.1 billion of cash held overseas at Sept. 30, 2014. Furthermore, the weakening Euro and relatively stable stock price of Celesio has reduced Fitch's estimated cost for McKesson to acquire the remaining portion of Celesio stock to \$1.3 billion. Celesio's stock has not traded below the EUR22.99 put option price since MCK announced its new deals with Haniel and Elliot in January 2014.
STRONG MARGIN EXPANSION DRIVEN BY GENERIC WAVE, PRICING PRESSURE POSSIBLE
MCK and its peers continue to benefit from the unprecedented wave of branded drug patent expirations in calendar 2011-2014. Most drug channel participants, including distributors, earn higher margins - though less revenues - on the sale of lower-cost generic drugs. Fitch believes much of the margin expansion MCK and its peers have achieved from generic conversions in recent years is durable, as generic penetration in the U.S. is likely to remain above 80% (based on volumes) for many years to come. Generic utilization is expected to improve in most non-U.S. markets over the longer term.
Increasing pricing pressure within the drug channel is possible, however, over the next couple of years. Especially in light of legislated healthcare reform, it is possible that third-party payers will begin focus more intently on profits associated with specialty and, to a lesser extent, generic drugs. Drug distributors, while not immune, are well-insulated from these types of pressures. Furthermore, distributors' and pharmacies improving purchasing position with generic drugmakers should help to strengthen their position as market-makers, thereby supporting margins for the foreseeable future.
ROBUST CASH FLOWS AND SOLID LIQUIDITY; BUT UNKNOWN CAPITAL DEPLOYMENT POST-2017
MCK's stable margins and good asset management contribute to stable and strong cash generation measures. Funds from operations (FFO) for the latest 12 month (LTM) period ended Sept. 30, 2014 was a robust \$3.16 billion. Free cash flow (FCF; cash from operations less dividends and capital expenditures) for the same period was \$1.77 billion. Fitch forecasts FFO and FCF of \$2.8 billion and \$2.7 billion in 2015, respectively, and \$3.3 billion and \$3.1 billion in 2016, respectively. Possible upside could come from more rapid pacing of purchasing synergy capture from the addition of Celesio, Rite Aid, and Omnicare volumes.
Cash generation is expected to outpace debt maturities, and Fitch expects all debt maturities in fiscal 2016 and 2017 to be repaid. Long-term debt maturities are estimated as follows: \$1.5 billion in 2016; \$1.7 billion in 2017; \$1.2 billion in 2018, and \$5.4 billion thereafter.
The company maintains a strong liquidity profile. At Sept. 30, 2014, MCK had \$3.8 billion of cash on hand (\$2.1 billion OUS), as well as full availability of its \$1.3 billion revolver due September 2016 and its \$1.35 billion accounts receivable facility. Appropriate availability under Celesio facilities is also maintained.
SOLID PRESENCE IN SPECIALTY, MED-SURG, AND HIT
Traditional drug distribution in the U.S. is an industry mostly consolidated and characterized by steady growth in the low-single digits. This activity accounts for roughly 80% of MCK's overall revenues. The remaining 20% comes from the company's leading market positions in the distribution of specialty pharmaceuticals and of med-surg supplies, and in healthcare information technology (HIT). MCK is one of only a handful of companies with a significant share of these relatively fragmented markets.
As a result, Fitch believes MCK is uniquely positioned to benefit from growth opportunities related to its ancillary businesses as those markets grow and consolidate over time. To that end, Fitch expects MCK to continue consummating small, tuck-in acquisitions in especially the med-surg and HIT spaces. In general, the company approaches M&A opportunistically and responsibly.
Fitch has affirmed the ratings of MCK as follows:
-- Long-term IDR at 'BBB+';
-- Senior unsecured bank facility at 'BBB+';
-- Senior unsecured notes at 'BBB+';
-- Short-term IDR at 'F2';
-- Commercial paper at 'F2'.
The Rating Outlook is revised to Stable from Negative.
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