OREANDA-NEWS.  Fitch Ratings has affirmed German healthcare and chemical conglomerate Bayer AG's (Bayer) Long-term Issuer Default Rating at 'A' with Negative Outlook. The Short-term IDR has been affirmed at 'F1'

The agency has also assigned a 'BBB+' subordinated rating to Bayer's EUR1.3bn hybrid issue maturing 2075 and a 50% equity credit to this instrument. The new debt replaces the previous EUR1.3bn 2105 issue at its call date in July 2015. The structure of the new hybrid bond is consistent with that of its two 2014 hybrid issues and hence Fitch has aligned all three ratings at 'BBB+' with 50% equity credits for these subordinated instruments.

Bayer's IDR remains constrained by the recent Merck & Co. Inc. (Merck)'s consumer healthcare acquisition and its integration, which stretches its near-term financial metrics, in particular its funds from operations (FFO) adjusted net leverage. We expect leverage to remain above 2.0x up to 2016 (2014: 2.7x) under the current business setup, which is reflected in the Negative Outlook.

Bayer is, however, in the process of adjusting its long-term capital structure post acquisition, with a focus on integrating the recent acquisition, growing organically and using hybrid capital. It is also accelerating non-core asset disposals in order to focus on the life science sector, which offers long-term growth potential. We expect deleveraging to accelerate upon completion of the disposal of the MaterialScience division (BMS), expected by mid-2016. Such a disposal, based on our conservative assumptions, will likely restore financial flexibility and return the capital structure comfortably within the 'A' rating level and could result in the Outlook being revised to Stable provided that the proceeds are not used for shareholder distributions.

KEY RATING DRIVERS

Strengthening Business Risk Profile
Bayer's rating remains underpinned by strong market positions in the healthcare, animal health, and crop science markets. The repositioning of its business model towards the life science sector should offer sound organic growth, which Fitch has incorporated into its rating case. All of these sectors share a strong focus on R&D and benefit from long-term positive economic and demographic trends.

While not reflected in today's rating action, Fitch views the planned disposal of the BMS division, as positive for the business risk profile with the loss of diversification offset by structurally enhanced profitability and the removal of cyclicality. The transaction would also free up capital to accelerate investment and growth in select life science markets, allowing Bayer to build on its strong market positions, product and geographic diversification, all of which will underpin the company's strong operational profile post BMS disposal.

Elevated Financial Leverage
Bayer's FFO adjusted net leverage peaked at 2.7x (albeit EBITDA contribution not annualised) in 2014 on the back of the debt-funded consumer health acquisition. However, we expect leverage to decline to our sensitivity guidance of 2.0x within the next three years, assuming no further asset disposals (the announced divestment of the Diabetes Care business has been factored into the rating case). The deleveraging path is accelerated by the issue of hybrid debt, whose 50% equity credit reduces 2015 leverage by an estimated 0.3x.

Strategy Execution Key to Outlook
Fitch assumes a continued and strong focus on executing strategic changes including the integration of the consumer health acquisition as well as the disposal of BMS as key to revising the Outlook to Stable. Bayer has demonstrated a sound track record in managing such transitions, which we have factored into the rating.

Narrow Pharma R&D
Following recent product launches, Fitch views Bayer's late-stage pipeline as somewhat weaker compared with pharma peers and expects a concentration of research efforts to accelerate promising Phase 2 developments, particularly in the field of cardiology. Bayer's patent protection profile is, however, satisfactory with sales at risk from US patent expiry to 2016 at less than 4%.

Fitch's Hybrid Treatments
Fitch views hybrid debt now as a permanent feature of Bayer's capital structure to optimise investor reach as well as funding mix and costs. Fitch rates the hybrid notes two notches below Bayer's IDR given their long-dated maturity (more than 60 years), contractual subordination to senior debt and senior ranking only to common equity, reflecting their consequently lower recovery prospects in a bankruptcy or liquidation scenario relative to senior obligations.

The issues qualify for 50% equity credit as they meet Fitch's criteria with regard to deep subordination, remaining effective maturity of at least five years (including coupon step up of less than 1% and replacement language) and deferrable interest coupon payments at the option of the issuer. All these features offer sufficient financial flexibility to protect the capital structure in our view.

ADEQUATE LIQUIDITY

Bayer has access to a range of funding sources spanning bonds, bank debt and commercial paper. The group has a EUR3.5bn syndicated credit facility, which was undrawn at end-2014. Bayer's cash position amounted to EUR1.6bn at 31 March 2015 and the agency assumes minimum free cash flow (FCF) generation of EUR1.7bn p.a. over the four-year rating case horizon. Fitch assumes EUR200m as non-readily available cash in its rating calculation to allow for intra-year working capital swings.

KEY ASSUMPTIONS

Fitch's expectations are based on the agency's internally produced, conservative rating case forecasts. They do not represent the forecasts of rated issuers individually or in aggregate. Key Fitch forecast assumptions include:
-Disposal of BMS not incorporated into the rating case due to execution risks and uncertainties around valuation and separation strategy
-Satisfactory organic growth profile driven by new product launches in the pharma business and revenue synergies resulting from the increasing scale of the Consumer Health division
-EBITDA margin stable at around 21%
-R&D spend rising towards the higher end of management guidance (15%-18%) with key focus on accelerating pharma R&D
-Integration and separation costs in line with management guidance at EUR700m
-FX volatility (particularly EM and USD exposure) resulting in continued FX translation risks.
-Annual bolt-on acquisition of EUR800m in addition to capex assumed at 5% of sales

RATING SENSITIVITIES

A revision of the Outlook to Stable is contingent on a return to an improved financial leverage profile with FFO adjusted net leverage below 2.0x on a sustained basis, resulting from evidence of a smooth integration of Merck's consumer healthcare acquisition supported by other cash preservation measures, along with sustained positive FCF and FFO fixed charge cover of above 8.0x (2014: 10.5x) within the next 12 to 18 months.

Sustained financial ratios worse than above indicated levels -i.e. as a result of lower-than- expected cost savings and/or revenue uplift or a permanently higher debt burden could result in a downgrade. At present, a potential downgrade remains limited to one notch.

FULL LIST OF RATING ACTIONS

Bayer AG
Long-term IDR: affirmed at 'A', Outlook Negative
Short term IDR: affirmed at 'F1'
Senior unsecured debt: affirmed at 'A'
Subordinated debt: affirmed at 'BBB+'
EUR1.3bn hybrid bond due 2075 (DE000A146JN) assigned 'BBB+'