OREANDA-NEWS. Fitch Ratings has affirmed Switzerland-based pharmaceutical company Novartis AG's (Novartis) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'AA' and its Short-term IDR at 'F1+'. The Outlook is Stable.

Fitch has also affirmed the unsecured rating of the notes issued by Novartis Finance S.A. and guaranteed by Novartis AG at 'AA'. In addition Fitch has assigned an unsecured rating of 'AA' to the notes issued by Novartis Capital Corporation and Novartis Securities Investment Ltd. These notes are also guaranteed by Novartis AG.

The rating affirmation reflects Novartis' strong competitive position as a leading player in the global pharmaceutical industry, underpinned by its wide product and geographical diversification. Rating headroom, however, has been reduced by cash outflows associated with a recent portfolio reorganisation and shareholder returns, in addition to lower profitability as a result of new drug launches and a weaker performance at Alcon, its eye-care business. Nevertheless, the ratings remain supported by strong cash flow generation and deleveraging ability.

Fitch expects Novartis to continue its cautious capital allocation, prioritising drug launches and restructuring over transformational acquisitions and/or accelerating shareholder returns in the near-term, which underpins the Stable Outlook.

KEY RATING DRIVERS

Rating Headroom Reduced
The completion of the group's share buyback programme (USD9bn over 2014/15) and the net cash outflows associated with the portfolio reorganisation (USD7.6bn) have increased financial leverage, leading to a reduction of rating headroom at the 'AA' level. As expected by Fitch funds from operations (FFO) adjusted net leverage at end-2015 increased to 1.4x (from 0.6x at end-2014) and our rating case expects it to remain close to the 1.5x downgrade sensitivity over the next 18 months before improving thereafter. However we project FFO fixed charge cover to remain healthy at more than 13x over the four-year rating horizon, which is comfortable for the rating.

Strong FFO; Conservative Capital Allocation
Fitch estimates an average annual FFO generation of more than USD13.5bn and a free cash flow (FCF) margin trending towards 7% over the next four years, supporting financial flexibility at the current rating level. Despite the currently elevated financial risk profile and reduced rating headroom, we believe Novartis will continue its cautious capital allocation prioritising the successful execution of drug launches and restructuring efforts. The Stable Outlook therefore assumes a continuation of a disciplined capital allocation approach in line with communicated financial policies.

Drug Launches Mitigate High Sales-At-Risk
Loss of exclusivity on two key blockbuster drugs pushed 'sales-at-risk' as defined by Fitch close to 20% of 2015 sales, which is high relative to peers and rating level. Such high sales-at-risk is, however, mitigated by two key drug launches, which we believe will achieve blockbuster sales within two to three years and compensate expected loss of revenue. During this transitional period, we expect soft pharmaceutical margins to persist, as mature, high-margin products are replaced with new drugs requiring upfront launch investment and dedicated marketing to achieve peak sale projections.

Accelerated Restructuring to Protect Margins
Fitch estimates group EBITDA margin to modestly improve from the current level of 29% by 2018. To protect profitability at group level and in view of the structural changes affecting the pharma division and softer Alcon performance, Novartis has launched an efficiency programme aimed at saving 3%-4% of costs each year or USD1bn per year by 2020.

Strong R&D Pipeline
The ratings are supported by Novartis' solid competitive position as a leading player in the global pharmaceuticals and consumer healthcare industry. We believe wide geographical and product diversification helps the company to mitigate the effect of the government's cost-containment measures and patent-expiry risk in individual countries.

Novartis has demonstrated sound R&D productivity, by obtaining regulatory approval for two potential blockbusters in 2015 in addition to being the first company to launch a biosimilar into the emerging US biosimilar market. Fitch, however, expects a slowdown in late-stage product pipeline until 2017 as the company focuses on projects in earlier development stages.

Positive Sector Trends
Fitch views fundamentals in the pharma- and healthcare sectors as positive, with growing access to healthcare globally, an ageing population, an increase of chronic diseases, as well as innovation in specialist treatments. Nevertheless, the focus on delivering value to patients and healthcare systems will accelerate the industry wide review of pricing models in favour of performance-based pay. Fitch believes Novartis is well-positioned to drive this industry trend towards outcome-based pricing models as seen in the recent Entresto pricing negotiations in the US or for its specialist drug Gilenya in the UK.

LIQUIDITY
Fitch assesses Novartis' liquidity as strong with cash and marketable securities at USD4.5bn at end-2015 (as defined by Fitch including current accounts and short-term investments of less than three months). Together with access to undrawn committed bank facilities of USD6bn, serving as commercial paper (CP) backup liquidity and maturing in 2020, this comfortably covers short-term debt maturities of USD5.6bn, of which around USD1.1bn is related to drawings under CP programmes. In addition the group's debt is not subject to financial covenants.

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 over the four year rating case are expected to grow by CAGR3.5%, with all three core divisions - Pharmaceuticals, Sandoz, and Alcon - contributing to projected growth.
-EBITDA margins to improve towards 31% (end-2015: 29%) as restructuring measures are implemented and recent product launches mature. Fitch currently sees more room for further margin advancement beyond these assumptions.
-R&D expense unchanged at 18% of sales
-Moderate working capital profile; however, potentially weakened in the short term by product launches.
-FCF margin trending towards 7% (end-2015: 4.1%) over the four-year rating horizon.
-FX volatility (CHF, EUR, and EM exposure) resulting in continued FX translation risks.
-An annual bolt-on acquisition basket of USD2.5bn with larger M&A treated as event risk; no material share buybacks other than allowing to compensate dilution (at USD500m p.a.), and a progressive dividend policy.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
-Further operating weaknesses reflected in sales or profit margin attrition post-2016, major debt-financed acquisitions or share buybacks resulting in FFO-adjusted net leverage greater than 1.5x or FCF margin below 6% on a sustained basis
-FFO net fixed charge cover below 13x on a sustained basis

Given Novartis' low rating headroom, Fitch views the possibility of a positive rating action as unlikely over the rating horizon. In future, we see potential upgrades capped at one notch, in line with Fitch's guidelines for the global pharmaceutical sector. Future developments that may, individually or collectively, lead to a positive rating action include:

-FFO-adjusted net leverage no greater than 0.5x on a sustained basis
-FFO net fixed charge cover of 20x or above on a sustained basis
-Further progress towards implementing the current strategic repositioning, translating into sustained profitability improvement