Fitch Affirms Cardinal Health at ‘BBB+’ Outlook Stable
By Business Wire News
Fitch Ratings has affirmed the ratings for Cardinal Health, Inc. (NYSE: CAH), including the Long-term Issuer Default Rating (IDR) at ‘BBB+’ and Short-term IDR at ‘F2’. The Rating Outlook is Stable.
A full list of rating actions, which apply to approximately $5.55 billion of debt outstanding at Sept. 30, 2015, follows at the end of this release.
KEY RATING DRIVERS
STABLE OPERATIONS, LOW MARGINS
The credit profiles of CAH and its peers benefit from stable operating profiles and consistent cash generation. Steady pharmaceutical demand, an oligopolistic drug distribution industry in the U.S., and relative insulation from most drug pricing and regulatory pressures, support strong ratings despite very low margins.
TEMPORARILY ELEVATED LEVERAGE
CAH’s gross debt/EBITDA at Sept. 30, 2015 was 1.9x, outside the 1.4x-1.7x range outlined for the firm’s ‘BBB+’ ratings. But Fitch expects this measure to moderate to around 1.5x by fiscal year-end 2017, owing to business growth, the recent win of key customer contracts (i.e. OptumRx and Fred’s grocery stores), and the addition of EBITDA from Cordis and the Harvard Drug Group.
SOLID LIQUIDITY, CASH GENERATION
Durable top-line growth with prospects of moderate margin expansion will drive growing cash generation, with annual FCF possibly approaching $2 billion over the ratings horizon. Sufficient internal liquidity and strong access to capital markets provide ample flexibility for the firm to fund significant working capital and other cash requirements.
LIMITED U.S. GROWTH, EVENT RISK
Fitch believes there are limited growth opportunities in the traditional U.S. drug distribution space. Growth opportunities are more robust for the Cordis and related medical segment platforms. As such, Fitch expects CAH to pursue small- to mid-sized M&A of additional low-tech medical-surgical product manufacturing or capabilities that help its strategy progress.
UNDERREPRESENTED IN SPECIALTY
Though CAH has grown its specialty business significantly in recent years, the firm remains underrepresented in the space relative to its peers, possibly hindering 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 incremental forms of operating (e.g. product liability, geographical) and execution risk.
Maintenance of a ‘BBB+’ IDR will require gross debt/EBITDA generally between 1.3x and 1.7x, accompanied by continued robust cash flows and stable or growing margins over the ratings horizon. Ratings flexibility is somewhat constrained following the partially debt-funded acquisitions of Cordis and the Harvard Drug Group. However, recent contract wins and expected strong EBITDA growth, with strong cash generation, are expected to improve Cardinal’s flexibility during fiscal 2016-2017.
An upgrade to ‘A-‘ is not anticipated in the 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 drug 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 the firm’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.
STRONG LIQUIDITY PROFILE
CAH’s strong liquidity profile at Sept. 30, 2015 comprised nearly $3 billion of cash ($480 million held outside the U.S.) and an undrawn $1.5 billion revolver, plus a $950 million A/R facility. The revolver backs up CAH’s $1.5 billion CP program. Cash generation is expected to be more than sufficient to address capex, dividends, and debt service over the ratings horizon.
Debt maturities are manageable and well-laddered. The next notable maturity is $250 million due in June 2017, with no more than $950 million (2018) due in any of the next 5 years. On balance, Fitch expects the firm to refinance maturities as they come due.
MEDICAL SEGMENT STRATEGY ADDS BUSINESS RISK, GROWTH OPPORTUNITIES
Cardinal accelerated its medical segment growth strategy after losing its drug distribution contracts with Express Scripts and Walgreens in 2012 and 2013, respectively. Including Cordis, the firm will have spent more than $4 billion on M&A in support of this strategy since 2012. Cardinal previously spun out its medical products and capital equipment business, CareFusion, Inc., in 2009, which was acquired by Becton, Dickinson & Co. in March 2015.
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 former risk is mitigated by Cordis’ already established products and channel presence. The latter should be muted in the near term, as Cardinal does not currently distribute the types of products manufactured by Cordis.
IMPROVED POSITION IN SPECIALTY STILL LAGS PEERS
Fitch remains concerned about Cardinal’s 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 competitive weakness. Cardinal’s lagging position in this important growth market could become more glaring now that the bulk of the generic wave has washed through the channel, as more specialty therapies are commercialized by pharma, and as biosimilars begin to gain market acceptance in 2016 and beyond.
In recent years, CAH won new business in specialty distribution and acquired Metro Medical, growing its specialty distribution business to an expected $8 billion of sales in 2016. Still, Fitch estimates that CAH commands only roughly 15% of the U.S. specialty distribution market, while its peers AmerisourceBergen Corp. (NYSE: ABC; ‘A-‘, Outlook Negative) and McKesson Corp. (NYSE: MCK; ‘BBB+’, Outlook Stable) control approximately 50% and 25%, respectively.
IMPACT OF CONSOLIDATING GENERIC DRUGMAKERS
Consolidation, while present in nearly every area of healthcare, is especially torrid among manufacturers of generic drugs. Most notably, Teva Pharmaceutical Industries Ltd., the world’s largest generic drugmaker, agreed in July 2015 to acquire the generic drug business of Allergan plc, also a top-4 global generic drugmaker. The effect of this very large-scale merger is at this time uncertain, as Fitch tends to think there is a point of diminishing returns as it pertains to generic drug pricing negotiations. However, the continued consolidation of mid-tier generic drug firms may incrementally push back on more favorable pricing and/or working capital terms achieved recently by the world’s largest buying consortiums.
–Strong top-line growth in 2016 (17%), owing to M&A and new customers, as well as growth at CVS Health, Inc. (NYSE: CVS). Core business growth around 4%.
–Moderate margin expansion in 2016-2017, primarily from SG&A rationalization, resulting in EBITDA of $3.3 billion and $3.6 billion, respectively.
— Capex and dividends of slightly more than $500 million each in 2016, with capex moderating and dividends growing in line with earning.
–FCF of approximately $1.6 billion in 2016 and 2017, approaching $2 billion over the forecast period.
–Refinancing of debt maturities; use of FCF for targeted M&A with the remainder for share repurchases.
Fitch affirms the following:
Cardinal Health, Inc.
–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’.
–Senior unsecured notes at ‘BBB+’.
The Rating Outlook is Stable.
Date of Relevant Rating Committee: 27 January 2016
Additional information is available on www.fitchratings.com.
Corporate Rating Methodology – Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
Dodd-Frank Rating Information Disclosure Form
Jacob Bostwick, +1-312-368-3169
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
Greg Dickerson, +1-212-908-0220
Michael Weaver, +1-312-368-3156
Alyssa Castelli, New York, +1 212-908-0540