OREANDA-NEWS. December 16, 2015. Fitch Ratings has revised UK-based pharmaceutical company AstraZeneca PLC's (AZ) Outlook to Negative from Stable, while affirming its Long-term Issuer Default Rating (IDR) at 'A+'. The senior unsecured rating is affirmed at 'A+'.

The change in Outlook reflects growing near-term pressure on sales and profitability from patent expiries of key drugs, at a time when the company is accelerating investments in R&D, and efficiencies as well as strengthening its science base through bolt-on transactions. As a result, Fitch sees a near-term reduction of rating headroom during this transitional period, characterised by greater cash flow volatility and weakening debt coverage ratios over the next two years which, if maintained, could result in a downgrade of one notch.

AZ is making efforts to focus the business on core therapeutic areas, making sound progress in accelerating developments in its promising late-stage pipeline. Accordingly, Fitch views a successful launch of new products, supporting an expected return to profitable growth from 2017, as key prerequisite to improving debt coverage ratios and stabilising the rating. The current rating also does not allow for further material acquisitions. During this transitional period, the rating is supported by the group's strong liquidity.

KEY RATING DRIVERS
Patent Expiries Pressure Top Line
Eighteen per cent of AZ's 2014 sales are at risk from US patent expiries over the three-year period to end-2017 (down from around 28% of 2013 sales following the loss of patent protection for Nexium in 2015). The company is less affected by patent expiry than some of its US peers - AbbVie Inc, Amgen, BMS or Eli Lilly, with respective sales at risk of 76.8%, 21.7%, 30.4% and 37%. However, AZ is most exposed among European peers.

Accelerating Investments
AZ's cash flow performance is being affected by significant upfront investment in the business to achieve the company's growth path. Accelerating innovation has led to an increase of R&D costs to 24% of total product sales per 3Q15 (against a historical average close to 18%), in turn affecting profitability, despite AZ's focus on managing costs outside R&D (particularly SG&A).

In addition AZ's capex remains elevated (peaking at 12.5% of total product sales in 2015) as it continues to invest in its Cambridge headquarter and modernising its manufacturing sites. To strengthen its science base in its core cardio-metabolic therapeutic area, AZ has also announced a bolt-on acquisition (ZS Pharma), which is expected to improve the long-term strategic development of the group but will be eroding earnings further in the near-term and lead to a debt-funded USD2.7bn cash outflow.

Weakening Debt Protection Ratios
Funds from operations (FFO) adjusted net leverage as a result of accelerated capex is trending towards the 2.5x negative guidance over the next two years, breaching thereafter if no new products are introduced in the meantime. FFO fixed charge cover is expected to remain between 8.0x-9.0x, which would be still consistent with the current rating. Based on our conservative rating case assumptions (as outlined below and including elevated capex and restructuring costs), we do not project additional rating headroom for further material acquisitions and expect AZ to generate negative free cash flow (FCF) over the next 12-18 months, before returning to positive FCF once revenue growth is restored.

Uncertainty around Upcoming Drug Launches
Some of AZ's chosen areas of R&D and expected drug launches are subject to growing competition, particularly in the field of oncology, respiratory and cardio-metabolism. This may lead to additional clinical trial requirements, increasing the cost of development and may limit future pricing power as the industry moves from volume-based to value-based reimbursement models and increases sensitivity around drug pricing.

Restructuring to Ease Margin Pressures
During 9M15, the company continued expanding its restructuring initiatives (Phase 4) that it implemented since March 2013. The Phase 4 restructuring includes R&D site footprint changes to align with globally recognised bio-science clusters and further restructuring of SG&A activities. Total cash restructuring costs in 2014 were USD1.6bn and in 9M15 USD662m; further expected cash restructuring charges have not yet been quantified by the company.

Wide Geographical Diversification
AZ's rating is underpinned by wide geographical diversification, reducing the reliance on a single healthcare system. Forty per cent of 9M15 group sales originated from the US, 22% from Europe, 13% from the rest of the developed world, and 25% from emerging markets.

STRONG LIQUIDITY
Fitch assesses AZ's liquidity as strong with readily available cash at USD3.6bn as of end-3Q15 (as defined by Fitch adjusting for assumed USD500m restricted/non readily available cash) and undrawn committed term bank facilities totalling USD3bn, maturing in 2020 and not subject to financial covenants. This amount is more than sufficient to cover near-term maturities of USD2.7bn in 2015 and 2016. AZ has also demonstrated continued good access to debt capital markets through its placement of USD6bn notes in November 2015, terming out short-term debt, securing financing for the recently announced ZS Pharma acquisition as well as covering GCP requirements over 2016 and 2017.

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:

- Sales decline of CAGR -3% between 2015-2017, driven by sales decline in three key drugs (Nexium, Crestor, and Seroquel XR) as a result of generic competition, exacerbated by FX headwinds
-EBITDA margin decline to have bottomed out at 29% in 2015, gradually recovering to 33% over the four-year rating case. Profitability pressured by increased R&D expense, but to a degree mitigated by the company's focus on improving COGS and SG&A.
-R&D peaking at 24% of sales in 2015, before gradually easing towards 20% over the four- year rating horizon.
-Investment in the business characterised by capex/sales peaking at 12.5% in 2015 before gradually reducing (associated with investment in manufacturing sites and development of the Cambridge headquarter); cash restructuring charges of up to USD2bn to 2016.
-Spike in 2015 working capital assumption to support product launches; normalisation thereafter
- FX volatility (particularly emerging market and EUR exposure) resulting in continued FX translation risks.
-No further acquisitions; dividend cover of around 2.0x and no share buybacks over the four-year rating horizon.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, could lead to a positive
rating action or lead to the Outlook being revised to Stable include:
-Successful product launches supporting revenue growth and restoring EBITDA margin comfortably above 30%, supporting positive FCF generation.
-FFO adjusted net leverage trending around 2.0x and FFO fixed charge cover comfortably above 8x on a sustained basis.

Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
-Failure to mitigate near-term top-line erosion with new product developments and to return to growth path as per guidance, leading to further pressure on the business risk profile.
-Major debt-financed acquisitions or higher-than-expected shareholder distributions resulting in FFO adjusted net leverage above 2.5x or FFO fixed charge cover of below 8x on a sustained basis.