OREANDA-NEWS. December 23, 2015. Fitch Ratings has downgraded UK-based pharmaceutical company AstraZeneca PLC's (AZ) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'A' from 'A+'. The Outlook on the IDR is Stable.

The downgrade reflects the acceleration of investments in AZ's science base by way of a series of acquisitions and R&D, as well as operational efficiencies at a time of growing near-term pressure on sales and profitability from loss of patent of key drugs As a result, Fitch observes an increase in business and financial risks and a profile more commensurate with an 'A' rating, compared with industry peers.

AZ continues its 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 a key prerequisite to improving debt coverage, which underpins the Stable Outlook. During this transitional period, we expect an increasing volatility in AZ's cash flow profile. However, the rating remains supported by the group's strong liquidity.

KEY RATING DRIVERS
M&A to Bolster Science Base
To strengthen its science base in its targeted therapeutic areas, AZ has announced a series of acquisitions, including ZS Pharma for USD2.7bn, strengthening the cardio-metabolic pipeline, respiratory assets from Takeda (USD575m), as well as a majority stake in Acerta adding scale to the oncology pipeline (USD4.0bn acquiring a 55% stake, of which USD1.5bn payment is deferred to 2018 at the latest). These debt-funded investments are in line with the group's strategic priorities and significantly enhance strategic options to achieve a return to profitable growth from 2018. However, they will add to near-term earnings erosion and stretch the financial profile.

Debt Protection Ratios in Line with 'A' Level
Incorporating the acquisition of the majority stake in Acerta, Fitch expects funds from operations (FFO) adjusted net leverage to peak at 2.8x, a level more commensurate with a 'A' rating compared with peers. We expect FFO fixed charge cover to remain at or just below 8.0x, which is still strong for the rating. Based on our conservative rating case assumptions (including elevated capex and restructuring costs) we do not project additional rating headroom for further material acquisitions. We also 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.

Patent Expiries Pressure Top Line
18% 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 sales at risk of 76.8%, 21.7%, 30.4% and 37%, respectively. However, AZ is most exposed among its 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 in R&D costs to 24% of total product sales as of 3Q15 (against a historical average close to 18%), in turn affecting profitability, despite AZ's focus on managing costs outside R&D.

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. It could also 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 has been implementing 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 plans in FY14 were USD1.6bn and USD662m during 9M15. Further anticipated cash restructuring charges have not yet been quantified.

Wide Geographical Diversification
AZ's rating is underpinned by wide geographical diversification, reducing the reliance on a single healthcare system. 40% 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 FY15 and FY16. AZ has also demonstrated continued good access to debt capital markets through its placement of USD6.0bn notes in November 2015, terming out short-term debt, securing financing for the recently announced ZS Pharma acquisition as well as covering general corporate purposes requirements over FY16 and FY17.

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 FY15-FY17, 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 FY15, gradually recovering to 33% over the four-year rating case. Profitability pressured by increased R&D expense, but mitigated by the company's focus on improving its cost base-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 FY15 before gradually reducing (associated with investment in manufacturing sites and development of the Cambridge headquarters); cash restructuring charges of up to USD2bn to FY16.
-Spike in FY15 working capital assumption to support product launches; normalisation thereafter.
- FX volatility (particularly emerging market and EUR exposure) resulting in continued FX translation risks.
-ZS Pharma acquisition (USD2.7bn) completed in 2015; Acerta majority stake cash outflow USD2.5bn in 2016 and USD1.5bn in 2018; at present we do not expect the additional option to acquire full control will be exercised in the next three years.
- 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 positive rating action 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 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 3.0x or FFO fixed charge cover of below 6x on a sustained basis.