OREANDA-NEWS. Fitch Ratings has affirmed Germany-based pharmaceuticals wholesaler Phoenix Pharmahandel GmbH & Co. KG's (Phoenix) Long-term Issuer Default Rating (IDR) at 'BB'. The Outlook is Stable. Fitch has also affirmed the instrument ratings on the bonds issued by Dutch finance company, Phoenix PIB Dutch Finance B.V., at 'BB'.

The ratings are underpinned by Phoenix's leading market position in the European pharmaceutical wholesale and distribution (W&D) market, supplemented by a growing presence in the higher margin pharmaceutical retail channel. The affirmation reflects Fitch's expectation that despite being stretched for the next two years, Phoenix's financial metrics should gradually return to being in line with the agency's leverage guidance. The Stable Outlook assumes that there will be further gradual improvements in profitability, driven by a gradual improvement of the German operations coupled with a greater share of retail contributions and a more normalised working capital position. We assume that acquisitions such as Mediq, which are larger than those it has historically made, will not be repeated.

KEY RATING DRIVERS
Elevated Leverage Restrains Rating Headroom
The recent difficult trading environment in Germany, which required investment in working capital, as well as the potentially debt-funded Mediq acquisition have stretched debt protection ratios. We now forecast funds from operations (FFO) adjusted net leverage peaking at 4.7x in FY15 and static in FY16 (FY14: 4.4x). This temporarily breaches the 4.5x downgrade sensitivity, removing headroom under the 'BB' rating. Fitch calculates leverage by applying a EUR125m adjustment for restricted cash and intra-year working capital swings as per its criteria).

Stable Outlook Reflects Expected Deleveraging
The Stable Outlook reflects our assumption that there will be further improvements in profitability in the German market, more normalised working capital as well as a return to bolt-on acquisitions. This should allow for satisfactory deleveraging in the later years of Fitch's four-year rating case. As a result, we assume FFO-adjusted net leverage will return to well below the 4.5x sensitivity from FY17, a level more commensurate with the 'BB' rating. The rating is also underpinned by satisfactory FFO fixed charge cover (FCC) at around 2.5x throughout the four-year rating case, which has been improving as the group has refinanced higher yielding debt over the past two years.

Structurally Weak Profitability in Pharma Wholesale
Pharmaceutical wholesale is the company's core business. However, compared with pharmaceuticals manufacturers, the profitability of wholesalers is very limited, despite the oligopolistic structure of the industry. Fitch expects Phoenix's wholesale and distribution margin to remain aligned with its wholesale sector peers in our four-year rating case. This reflects intense competitive and regulatory pressures and we do not expect scope for margin expansion in the industry.

Continued Expansion in Retail Markets
Fitch expects Phoenix to conduct further investment to increase its vertical diversification in retail channels and views the announced acquisition of Mediq's Dutch wholesale and retail assets as a good strategic opportunity to create a leading market position in the competitive developed Western European markets. Besides Mediq, we expect further acquisition of retail chains, but spending will be subject to opportunities arising and we assume it will be of smaller, bolt-on nature as emerging European economies liberalise. Fitch's rating case budgets for around EUR25m additional bolt-ons per year.

Integrated Business Model Improves Risk Profile
Phoenix's strategy is to continue developing its geographic presence in Europe, focussing on opportunities to build an integrated business model spanning wholesale and retail , to maximise margins across the value chain as the retail channels have a structurally higher margin compared with W&D and supports Fitch's assumptions of a gradually improving group EBITDA margin trending towards 2.5%.

Core German Wholesaling Margin to Recover
Phoenix also continues to repair profitability in its German wholesale market, which suffered a significant drop in profitability following an unsustainable price competition initiated following regulatory changes in 2011.
Fitch assumes the German W&D margins will gradually improve supported by ongoing restructuring and despite some headwinds associated with the introduction of the minimum wage in Germany. Due to regulation, Phoenix is not able to develop a retail channel in the German market and only operates a wholesale and distribution business.

Wholesale Pharmaceuticals Leader
Phoenix is one of the largest European players in the pharmaceuticals wholesale market. The rating reflects its geographical diversification, which helps strengthen its market position with pharmaceutical manufacturers and makes it fairly resilient to healthcare policy changes in countries. However, the pharmaceutical wholesale sector is subject to comprehensive regulation, affecting major aspects of the underlying business model, especially the distribution chain, reimbursement and pricing levels, including margin structures of pharmaceutical distribution and related services. Regulatory intervention tends to recognise pharmaceutical distribution as a key cost in national healthcare systems and to target it as one of many possible items where to identify savings.

European Industry Structure Constrains Consolidation
Fitch views buying power and scale as key drivers for industry consolidation, as with increasing purchasing volume, players have the ability to extract extra value from suppliers. However, due to existing regulation in individual markets the European distribution landscape lacks the same scope for concentration experienced in the US.

Three pan-European wholesalers have so far emerged through consolidation: Alliance Boots, Celesio, and Phoenix Group, the first two now part of larger US distributors. Beyond these leading three players, there are numerous full-line and short-line wholesalers in operation, also reflecting the less concentrated and more fragmented retail channels in many EU countries.

Instrument Rating
Fitch rates Phoenix's bonds and bank debt (which both rank pari passu) at the same level as the IDR, reflecting only limited subordination from the group's prior ranking on-balance sheet ABS and factoring lines and Italian credit lines representing around EUR506m outstanding at end-FY14 (January).

Accordingly prior ranking debt compared with EBITDA in FY14 was 1.1x (reducing from 1.3x compared to prior year given) and the agency expects this to remain below 1.5x going forward, which is comfortably below the 2.0x-2.5x threshold that Fitch typically applies in its recovery analysis to assess subordination issues for unsecured bond holders. In addition, subordination is also mitigated by the upstream guarantee network capturing minimum 70% of turnover and EBITDA.

LIQUIDITY
Fitch views Phoenix's funding structure as diversified and liquidity as satisfactory. At end-FY15, Phoenix had headroom of around EUR1.5bn under its committed facilities and an unrestricted cash position of EUR442m, which was more than sufficient to cover its short-term financial liabilities of EUR760m (including ABS/factoring).

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:

-Moderate sales growth over the four-year rating case (1.0%-2.0% per year);
-EBITDA margins projected to trend towards 2.5%.
-Mediq acquisition expected to complete in FY16, which Fitch conservatively assumes will be debt-funded together with Celesio as JV partner.
-Working capital outflow of EUR225m in FY15/16, followed by a normalising working capital position thereafter.
-Capex constant at 0.6% of sales, cash tax rate at 27%, bolt-on acquisition basket of EUR25m per year.
-No dividends projected.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-Continued and/or increasing competitive pressures in key geographies leading to permanent pressure on profitability. Higher than anticipated debt funded investment levels, leading to:
-Net (lease, factoring and ABS) adjusted FFO adjusted net leverage above 4.5x on a sustained basis (FY14: 4.4x).
-FFO fixed charge coverage below 2.2x (FY14: 2.6x).
-FCF/EBITDAR falling below 25% on sustained basis (FY14: 36%).

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
-Stabilisation of operating performance and conservative financial policy driving FFO-adjusted net leverage to below 3.5x.
-FFO fixed charge coverage above 3x.
-FCF/EBITDAR sustainably above 40%.
-Slowing competitive pressure in Phoenix's major markets and sustainable improvement in the group-wide profitability.