UPDATE: Fitch Affirms Ratings on Merck; Outlook Lowered from Positive to Negative
Fitch Ratings has affirmed Merck & Co.'s (NYSE: MRK) ratings, including the Issuer Default Rating (IDR) at 'A+'. The Rating Outlook is revised to Negative from Positive. A full list of ratings affirmed is listed below.
The ratings apply to approximately $20.5 billion in outstanding debt.
KEY RATING DRIVERS
Leveraging Share-Buybacks Pressure Credit Profile
On April 1, Merck announced the expansion of its share repurchase program by $15 billion to $16.1 billion. The company intends to use debt issuances, in part, to repurchase $7.5 billion worth of shares over the next 12 months with the timing of the remaining buybacks to be open-ended. Merck has ample liquidity via cash on hand and operating cash flow generation to complete the repurchasing activity without harm to the credit profile. However, the plan to partially fund the program through debt financing will halt positive momentum the company gained through solid operational performance through its long patent cliff period.
Leverage Improvement to Reverse
The Negative Outlook reflects Fitch's concern that the pacing and financing of the share repurchase program could drive debt leverage to a level that is no longer reflective of the 'A+' IDR. If the company were to fund two-thirds, or $10 billion, of the planned share repurchases through debt issuance, Fitch sees an increase in total debt leverage (gross debt to EBITDA) to greater than 1.5x in 2014. This would likely result in a one-notch downgrade of the IDR, to 'A'. In addition, Merck faces $6 billion of debt maturing in 2013-2015, which Fitch expects the company to refinance.
Solid EBITDA growth following the 2009 merger with Schering Plough has driven improvement in gross debt leverage and adjusted debt leverage to 1.2x and 1.3x, respectively, at the end of 2012 from 2.1x and 2.2x in 2009. However, further leverage improvement is not expected given the potential for incremental debt to fund accelerated share repurchases over the ratings horizon.
Patent Expiration Pressures Subsiding
Merck is approaching the end of a long-standing patent expiration period following annualizing the patent lapse of the once top-selling drug Singulair in August 2013. Company sales fell by 1.6% and 9.0% in 2012 and the first quarter of 2013 (1Q'13), respectively, due in part to rapidly declining Singulair revenues. Merck's exposure to drug patent expiring over the next three-year horizon ending 2015, excluding Singulair, is more manageable at 15.9% of revenues.
Fitch anticipates the revenue decrease due to expiring drug patents will peak in 2013 led by the sales erosion of Singulair. Easing pressure from the Singulair patent loss in the second half of the year, a return to growth of the Januvia franchise, and continued demand for the vaccine portfolio and core drug products may lessen the revenue decline experienced in 1Q'13.
Fitch believes Merck can mitigate the present patent risk through demand for its current diversified product portfolio, and commercialization of a broad late-stage research program over the long term. Accordingly, Fitch expects compound annual growth (CAGR) in 2012-2016 for the overall company of 0.1%, and improved growth during a recovery phase in 2013-2016 of 1.65%.
Ample Liquidity Available
Merck's sustained strong free cash flow (FCF)generation and large cash and short-term investments provide liquidity to address upcoming maturities totaling nearly $6 billion in 2013-2015. The company generated free cash flow of $2.8 billion in 2012, down from $5.8 billion in 2011, due to a $960 million legal settlement and $1.3 billion in pension contributions.
Fitch still expects that FCF will remain above $5 billion annually and FCF margin sustained above 10% through 2016 despite an increasing dividend, higher capital spending, and pressure from declining Singulair revenues in the first half of 2013.
Merck's strong liquidity is supported by cash and short-term investments of $16.1 billion and $7.3 billion of long-term investments at the end of 2012. In addition, Merck had full capacity under a five-year $4 billion revolving credit facility due May 2017.
Positive rating action is unlikely given the expanded share repurchase program. An upgrade to 'AA-' would require sustained gross debt leverage in the range of 1.0x to 1.3x. Leverage in this range is possible if Merck is able to couple operational improvement with financially-disciplined share repurchasing. Operational improvement would be demonstrated by sustained positive sales growth, through demand for core drug products and uptake of new medicines, subsequent to a trough in 2013.
A downgrade of the ratings would result from a rise in total debt leverage above 1.5x in the intermediate term. The increase in total debt leverage would likely result from incremental borrowing for funding the expanded share repurchase program. Leverage pressure could also result from operational weakness due to inability to achieve cost-containment targets, or ongoing negative sales growth despite the imminent end of the company's patent cliff.
Fitch affirms the following ratings:
--Long-term IDR at 'A+';
--Senior unsecured debt rating at 'A+';
--Bank loan rating at 'A+';
--Short-term IDR at 'F1';
---Commercial paper rating at 'F1'.
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