Fitch Affirms Cardinal Health at ‘BBB+’ on Cordis Acquisition; Outlook Stable
By Business Wire News
By Business Wire News
Fitch Ratings has affirmed the ratings of Cardinal Health, Inc. (Cardinal; NYSE: CAH), including the long-term Issuer Default Rating (IDR), at ‘BBB+’. The Rating Outlook is Stable.
The rating action accompanies Cardinal’s intention to acquire the Cordis business of Johnson & Johnson (NYSE: JNJ; ‘AAA’, Outlook Stable) for approximately $1.9 billion). The deal is expected to close in calendar fourth-quarter 2015 and to be funded with the proceeds of $1 billion of new bonds and cash on hand.
A full list of rating actions, which apply to approximately $3.97 billion of debt at Dec. 31, 2014, follows at the end of this release.
KEY RATING DRIVERS
–The oligopolistic nature of the U.S. drug distribution industry and steady pharmaceutical demand contribute to exceptionally stable operating profiles for Cardinal and its peers. Drug distribution, though low margin, is relatively insulated from pricing and regulatory pressures faced by other areas of healthcare in the U.S.
–Fitch thinks Cardinal’s financing plans for the purchase of Cordis are responsible at the current ‘BBB+’ ratings. However, there will be limited room for more long-term debt over the next couple fiscal years. Fitch forecasts gross debt/EBITDA to approximate 1.7x, pro forma for the Cordis acquisition. De-leveraging is expected to occur primarily through EBITDA growth.
–Margins and cash flows continue to benefit from the mostly durable effects of the generic wave, albeit offset more recently by margin-dilutive Hepatitis C therapies. The addition of Cordis, along with Cardinal’s generic drug procurement joint venture (JV) with CVS Caremark Corp. (NYSE: CVS) and the anticipated introduction of biosimilars to the U.S. drug channel should support margins in fiscal 2015-2016.
–Fitch remains concerned that Cardinal’s material underrepresentation in the specialty drug distribution space relative to its peers could hinder future growth and profitability. Cardinal’s presence in China and recent moves in its medical business, including the Cordis acquisition, could offset this concern somewhat. But these areas also represent forms of operating (e.g. product liability, geographical) and execution risk.
–Generic conversions, favorable drug pricing, new customer wins, and base business growth are offsetting the now-annualized lost contracts with Express Scripts, Inc. (NASDAQ: ESRX; ‘BBB’, Outlook Stable) and Walgreens Boots Alliance, Inc. (NASDAQ: WBA). Strong top-line growth with prospects of moderate margin expansion will drive growing cash generation over the ratings horizon.
–Solid liquidity is supported by relatively large available cash balances and an undrawn $1.5 billion revolver. Annual free cash flow (FCF) is expected to exceed $1 billion. The firm’s recent refinancing activity resulted in no more than $400 million of debt due in any of the next four fiscal years.
Maintenance of a ‘BBB+’ IDR will require debt leverage generally maintained below 1.7x, accompanied by continued robust cash flows and stable or growing margins over the ratings horizon.
Liquidity should be adequate to fund targeted M&A and the firm’s shareholder payouts. But, given the Cordis deal funding, there will be limited room for additional long-term debt at the ‘BBB+’ ratings for the next 12-18 months.
An upgrade to ‘A-‘ is not anticipated in the near-to-intermediate term. Upward ratings migration could result from a demonstration of and commitment to operating with debt leverage below 1.2x-1.3x, combined with responsible M&A activity that contributes to an overall improved intermediate-term growth outlook. A sustained commitment to Cardinal’s core distribution business will also be necessary to support the consideration of an upgrade.
A downgrade to ‘BBB’ could result from an additional leveraging transaction that causes debt leverage to be sustained above 1.7x for more than 12-18 months. Debt-funded shareholder-friendly activities or material operational snafus, particularly related to Cardinal’s Medical segment strategy, could also precipitate a negative rating action. Evidence or anticipation of material pricing pressure greater and more direct than currently expected could also pressure ratings.
MEDICAL SEGMENT STRATEGY COULD DRIVE INTERMEDIATE-TERM GROWTH, ADDS BUSINESS RISK
, Cardinal’s accelerated medical segment growth strategy has helped to offset the recently lost drug distribution contracts with Express Scripts and Walgreens. Including Cordis, the firm will have spent more than $4.3 billion on M&A in support of this strategy since 2012. Cardinal previously spun out its medical products and capital equipment business, CareFusion, Inc. (NYSE: CFN; ‘BBB’, Rating Watch Positive), in 2009.
Fitch views this shift in strategy as appropriate, albeit with the potential for a longer-term payback, so long as it is pursued in a measured and responsible manner. Recent deals for small firms that manufacture cardiovascular surgery supplies, vacuum-assisted closure (wound care) devices, and orthopedic materials fit this description.
On balance, Fitch expects it will take some time for broad acceptance of Cardinal’s lower-cost product offerings. However, the execution of this strategy with an established product portfolio such as Cordis could accelerate such acceptance. Upside potential related to growth of lower-cost, lower-tech physician preference items could be significant over the ratings horizon.
The acquisition of manufacturing assets brings with it some incremental risks related to product liability, new geographic exposure, and potential channel conflicts with other suppliers. The latter should be muted in the near term, as Cardinal does not currently distribute the types of products manufactured by Cordis.
Though potentially aided by the growing medical segment, Fitch remains concerned about Cardinal’s significant under-representation in specialty drug distribution. Specialty drug distribution in generally the highest-growth and highest-margin segment of drug distribution, so CAH’s small presence therein represents a significant competitive weakness. Cardinal’s lagging position in this important growth market could become more glaring after the bulk of the generic wave has washed through the channel and biosimilars begin to gain market acceptance in 2016 and beyond.
Fitch estimates AmerisourceBergen Corp. (NYSE: ABC; ‘A-‘, Outlook Negative), McKesson Corp. (NYSE: MCK; ‘BBB+’, Outlook Stable), and Cardinal control approximately 55%, 25%, and 5%, respectively, of the specialty drug distribution (primarily to physicians and other care providers) market in the U.S.
–Pharmaceutical segment growth of 10% in fiscal 2015 and upper-single digits in 2016, driven by continued growth in high-cost Hepatitis C therapies, strong overall drug pricing, and new customer wins, including Catamaran Corp. (NASDAQ: CTRX), Fred’s, Inc. (NASDAQ: FRED) and PharMerica Corp. (NYSE: PMC).
–Medical segment growth of 5% in 2015 and mid- to upper-single digits in 2016, including the impact from Cordis, in 2016.
–Some EBITDA margin compression in fiscal 2015, mostly due to lower-margin Hepatitis C. Modest margin expansion in 2016, mostly from better generic purchasing dynamics and a positive impact from Cordis.
–$1 billion of incremental senior notes to fund the Cordis deal, with no material debt repayment over the ratings horizon. EBITDA growth drives de-leveraging to 1.4x-1.5x by fiscal year-end 2017.
–Moderate dividend increases, up to 10% per year.
–Elevated capital expenditures in 2015 (approximately $350 million), moderating in 2016 pending Cordis-related spending.
–FCF of $1.1 billion and $1.3 billion in 2015 and 2016, respectively. Share repurchase activity accounting for $400 million to $800 million annually, depending on cash needed for M&A.
Fitch has affirmed Cardinal’s ratings as follows:
— Long-term IDR at ‘BBB+’;
— Short-term IDR at ‘F2’;
— Senior unsecured bank facility at ‘BBB+’;
— Senior unsecured notes at ‘BBB+’;
— Commercial paper at ‘F2’.
The Rating Outlook is Stable.
Fitch has also taken the following rating actions at Allegiance Inc., a wholly-owned issuing subsidiary of Cardinal:
— Long-term IDR of ‘BBB+’ withdrawn;
— Senior unsecured notes affirmed at ‘BBB+’.
Additional information is available at ‘www.fitchratings.com‘.
Applicable Criteria and Related Research:
–‘Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage’ (May 28, 2014);
–‘Fitch Rates New Cardinal Bonds ‘BBB+’; Outlook Stable’ (Nov. 7, 2014);
–‘Fitch Affirms Cardinal Health at ‘BBB+’; Outlook Stable’ (Feb. 12, 2014);
–‘2015 Outlook: U.S. Healthcare – The Value Debate Intensifies While Aggressive M&A Continues’ (Dec. 4, 2014);
–‘Trekking the Path to Biosimilars – The Destination’ (Oct. 4, 2013);
–‘Vital Signs – Currents in the Drug Channel’ (Podcast) (April 25, 2013);
–‘Navigating the Drug Channel – Drug Distributors: A Deeper Dive’ (April 24, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology – Including Short-Term Ratings and Parent and Subsidiary Linkage
2015 Outlook: U.S. Healthcare (The Value Debate Intensifies While Aggressive M&A Continues)
Trekking the Path to Biosimilars — The Destination
Vital Signs — Currents in the Drug Channel
Navigating the Drug Channel — Drug Distributors: A Deeper Dive
Jacob Bostwick, CPA
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
Alyssa Castelli, New York, +1 212-908-0540
Elizabeth Fogerty, New York, +1 212-908-0526