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Fitch Affirms Cardinal Health at 'BBB+'; Outlook Revised to Stable

CHICAGO--(BUSINESS WIRE)-- Fitch Ratings has affirmed the Issuer Default Rating (IDR) and other long-term ratings of Cardinal Health, Inc. (Cardinal) at 'BBB+'. The Rating Outlook has been revised to Stable from Positive. The ratings apply to approximately $2.9 billion of outstanding debt at Sept. 30, 2012.

KEY RATING DRIVERS

-- Steady pharmaceutical demand and oligopolistic market position support stable operating profile, profit margins, and core cash flows;

-- Drug distribution has slim profit margins, but profitability has benefited from the pharma patent cliff;

-- Cardinal has significantly less exposure to specialty pharmaceutical distribution than its peers, contributing to intermediate-term growth concerns;

-- Demonstrated commitment to maintaining a solid credit profile, but uncertainty related to intermediate-term cash generation in light of recently announced dividend payout increase;

-- Very strong liquidity profile supported by robust cash flows, though expected to be muted somewhat in 2013 due to one-time items;

-- Potential for indirect pricing pressure pertaining to generic profits within the drug channel and more direct pressure in connection with upcoming contract renewals with largest customers.

GUIDELINES FOR FUTURE RATING ACTIONS

Fitch believes Cardinal has significant flexibility at its current ratings to pursue targeted M&A and to fund expansionary initiatives in stated core areas of growth. Maintenance of a 'BBB+' IDR will require leverage (debt-to-EBITDA) generally maintained between 1.2x and 1.7x and annual funds from operations (FFO) in excess of $800 million.

An upgrade to 'A-' will require the company to demonstrate a commitment to operating with leverage below 1.2x-1.3x, combined with evidence of an intermediate-term growth driver. A sustained commitment to Cardinal's core distribution business, accompanied by strong cash flows and stable or improving profit margins will also be necessary to support the consideration of an upgrade.

A downgrade to 'BBB' could result from a large, leveraging acquisition that caused leverage to increase to above 1.7x for more than 12-18 months, or from debt-funded shareholder-friendly activities. Material margin pressure greater and more direct than expected, though unlikely, would also pressure ratings.

STEADY PHARMA DEMAND, OLIGOPOLY PROVIDE EXCEPTIONAL STABILITY

The oligopolistic nature of the U.S. drug distribution industry and steady pharmaceutical demand contributes to exceptionally stable operating profiles for Cardinal and its peers. The drug distribution industry has proven rather resilient in recent years, despite depressed patient and procedure volumes and elevated measures of unemployment. Longer-term organic top-line growth in traditional drug distribution is expected to be sustained in the low single-digits, driven by favorable demographics, population growth, and increased utilization as a result of the Affordable Care Act in the U.S. over the ratings horizon.

GENERIC WAVE DRIVING MARGIN EXPANSION, THOUGH LIMITING TOP-LINE GROWTH

Cardinal and its peers are benefitting from the unprecedented wave of branded drug patent expirations, especially in calendar 2012-2014. Most drug channel participants, including distributors, earn higher margins on the sale of lower-cost generic drugs. Generic conversions drove EBITDA margin expansion of 20 basis points (bps) in Cardinal's fiscal 2012. Fitch expects branded-to-generic conversions to contribute 10-15 bps of additional EBITDA margin expansion in fiscal 2013 and 2014. Fitch believes much of this margin expansion is durable as several of the most-prescribed medications in the U.S. have recently been or soon will be converted to generic. Fitch expects generic penetration in the U.S. to remain above 80% over the ratings horizon.

INTERMEDIATE-TERM GROWTH CONCERNS DUE TO WEAK POSITION IN SPECIALTY DISTRIBUTION

Cardinal significantly lags its two major competitors in its share of the higher-margin and faster-growing specialty drug distribution market. Market participants estimate that Cardinal's two primary competitors, AmerisourceBergen Corp. and McKesson Corp. (McKesson), together control approximately 80% of the specialty drug distribution market in the U.S. Fitch estimates that Cardinal holds less than 5%. Fitch sees Cardinal's significant underrepresentation in the important growth and profit area of specialty distribution as a key differentiator between the company and its competitors.

Furthermore, Fitch is not convinced that Cardinal's current strategy for its specialty distribution business will take significant market share over the ratings horizon. Cardinal's lack of a meaningful presence in specialty drug distribution leaves a potential hole in the company's intermediate-term growth prospects, particularly after the generic wave has washed through the channel in 2014-2015.

The company's growth potential in China, though robust, does not sufficiently offset this concern. There exist many opportunities for growth and expansion for Cardinal Health China. However, the overall impact from the company's China operations is expected to remain modest over the ratings horizon compared to Cardinal as a whole. Fitch believes it is important for Cardinal to focus on its core competency of healthcare distribution as it seeks to expand its presence in the rapidly evolving Chinese healthcare industry.

POTENTIAL FOR BOTH INDIRECT AND DIRECT PRICING PRESSURE

Fitch acknowledges the evolving landscape of the global healthcare markets. Legislated healthcare reform and government budget cuts in the U.S. have recently accelerated the push to moderate growth in healthcare spending. Additionally, ongoing consolidation among Cardinal's downstream customers contributes to some margin compression within the drug channel. Fitch believes distributors, while not immune, are well-insulated from these forces. However, especially in light of a growing pool of generic profits within the drug channel, distributors' generic profit margins could become a target for government and third-party payors' to moderate drug spend.

Cardinal's contracts with Walgreen Co. (Walgreens) and CVS Caremark Corp. (CVS) are both set to expire in the summer of 2013. Cardinal will likely be squeezed on pricing somewhat, but Fitch expects both the Walgreens and CVS contracts to be renewed. Contracts of this size are very sticky due to material investments in working capital and IT infrastructure.

SOLID CREDIT PROFILE, BUT STRENGTH OF INTERMEDIATE-TERM CASH FLOWS UNCERTAINTY

Fitch believes Cardinal is committed to maintaining strong credit metrics in line with Fitch's expectations for a 'BBB+' rating. The company has demonstrated this commitment by maintaining solid credit metrics while consummating nearly $2.5 billion in acquisitions in multiple areas of growth over the past two fiscal years. The company has also spent approximately $1.2 billion in the form of dividends and share repurchases over the same timeframe. Fitch expects acquisition activity to be considerably more modest in coming years, though the amount of cash returned to shareholders will likely continue to grow, as evidenced by Cardinal's recently announced dividend increase.

Fitch believes Cardinal's stated plan to increase dividends in line with earnings is consistent with the current 'BBB+' ratings. Near-term cash flows are forecasted to cover increases in near-term shareholder payouts. However, Fitch is less certain that intermediate-term growth will drive sufficient cash generation to support any further increased focus on shareholder returns.

Fitch expects free cash flow (FCF), not including one-time tax payouts and an unfavorable working capital swing due to the loss of the Express Scripts, Inc. contract, to approximate $800 million in each of fiscal 2013 and 2014. Fitch does not expect the loss of the Express Scripts contract or the suspension of Cardinal's license to distribute controlled substances out of one of its distribution centers, other than the aforementioned working capital swing, to materially impact cash flows.

STRONG LIQUIDITY PROFILE

Cardinal maintains a strong liquidity profile, consisting of $2.44 billion in cash and equivalents at Sept. 30, 2012 and a $1.5 billion revolver due May 2016. The revolver supports a $1.5 billion commercial paper program. The company also has an undrawn $950 million accounts receivable facility due November 2012.

Debt maturities are well-laddered and manageable for the firm. Debt maturities are as follows: $300 million in fiscal 2013, $500 million in 2015, $768 million in 2017, and $1.03 billion thereafter. Other than the $300 million due in 2013, which Cardinal pre-funded with notes issued in May 2012, debt will likely be refinanced with incrementally larger amounts consistent with EBITDA growth.

Fitch has affirmed Cardinal's ratings as follows:

-- Long-term IDR at 'BBB+';

-- Short-term IDR at 'F2';

-- Senior unsecured bank facility rating at 'BBB+';

-- Senior unsecured notes ratings at 'BBB+';

-- Commercial paper rating at 'F2'.

The Rating Outlook has been revised to Stable from Positive.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug. 8, 2012);

--'Short-Term Ratings Criteria for Non-Financial Corporates' (Aug. 9, 2012);

--'Navigating the Drug Channel - The ABCs (and Ds) of Drug Pricing' (July 25, 2012);

--'Navigating the Drug Channel - Drug Distributors: A Deeper Dive' (March 13, 2012).

Applicable Criteria and Related Research:

Corporate Rating Methodology

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684460

Short-Term Ratings Criteria for Non-Financial Corporates

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685553

Navigating the Drug Channel -- The ABCs (and Ds) of Drug Pricing

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685135

Navigating the Drug Channel -- Drug Distributors: A Deeper Dive

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=673889

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Fitch Ratings
Primary Analyst
Jacob Bostwick, CPA, +1-312-368-3169
Associate Director
Fitch, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Bob Kirby, CFA, +1-312-3698-3147
Director
or
Committee Chairperson
Michael Weaver, +1-312-368-3156
Managing Director
or
Media Relations
Brian Bertsch, New York, +1-212-908-0549
brian.bertsch@fitchratings.com

Source: Fitch Ratings