(The following statement was released by the rating agency)
Oct 5 - Fitch Ratings has affirmed Merck & Co.'s (Merck) ratings as follows:
--Long-term Issuer Default Rating (IDR) at 'A+'; --Senior unsecured debt rating at 'A+'; --Bank loan rating at 'A+'; --Short-term IDR at 'F1'; --Commercial paper rating at 'F1'.
The ratings apply to approximately $21.5 billion in outstanding debt including the recent $2.5 billion debt issuance. The Rating Outlook is revised to Positive from Stable.
Margins Steady Through Patent Cliff:
Merck has successfully managed through a very long period of key drug patent expirations that will ease over the next year after annualizing the loss of market exclusivity for its bestseller Singulair that started in August. Cost savings programs initiated since 2008 have supported margins in light of a patent cliff dating back to 2006. Since 2006, three of Merck's top-5 selling pharmaceuticals - Zocor, Fosamax, and Cozaar/Hyzaar - each of which generated at least $3 billion in annual sales - have lost market exclusivity.
Merck maintained EBITDA margin above 30% during this period, with the exception of 2010, when there were cost pressures related to the integration of Schering-Plough. In the first half of 2012, the EBITDA margin rose to 39.3%, from 37% in the same period in 2011, driven primarily by the savings initiatives that lowered SG&A by 5.5% and cost of goods sold by 1.2%. Fitch sees EBITDA margin compressing in the second half of 2012 due to pressure on gross profit as high-margin Singulair sales dramatically decline, outweighing the company's recent success in its cost reduction program. However, Fitch expects EBITDA margin to be maintained above 30% at the end of 2012 supported by restructuring actions that will continue through 2013.
Revenue Pressures Easing:
Fitch believes that Merck's revenue decline due to expiring drug patents will peak in 2013 driven by rapidly eroding sales of its bestseller Singulair following the commercialization of multiple generic drugs in August. Excluding the loss of Singulair, Merck is subject to patent lapses that represent 16.9% of overall revenues over the next three-year horizon, including the potential expiration of Remicade internationally. The figure shows a moderation from 30% exposure at the end of 2009. Pressure on top-line performance also arises from the anticipated dissolution of Merck's commercialization agreement with AstraZeneca that will erase over $1 billion in annual sales in 2012 to 2013, in Fitch's estimation.
An upgrade is contingent on Merck's ability to generate sales growth after reaching a projected floor in 2013. Fitch recognizes that demand for the current diversified product portfolio, and commercialization of a broad late-stage research program could offset the pressures from drug patent expirations over the long term.
Fitch presently anticipates compound annual growth (CAGR) in 2012-2016 for the overall company of 0.99%. Key growth drivers are the Januvia franchise, Isentress, Zetia, and the vaccine portfolio. Fitch sees much improved CAGR of 2.26% during 2013-2016, once the company has lapped the patent loss of Singulair. Uptake of new drug approvals from the late-stage R&D program are anticipated to contribute around 1% growth annually in 2014-2016, depending on Merck's success in filing seven potential therapeutics with drug regulators by the end of 2013.
Leverage Improvement From EBITDA Expansion:
Strong EBITDA growth bolstered by the contribution from Schering-Plough and restructuring programs has led to a reduction in debt leverage since the end of 2009. Gross debt leverage and adjusted debt leverage have fallen to 1.1 times (x) and 1.3x, respectively, for the latest 12 months (LTM) ending June 30, 2012 from 2.1x and 2.2x, respectively, in 2009 following the merger with Schering Plough. The drop in leverage resulted mostly from EBITDA growth rather than a reduction in outstanding debt. EBITDA more than doubled to $17.4 billion from $8.5 billion, strongly driven by margins expansion to 36.1% from 31%, during that time frame.
Fitch currently sees total debt leverage staying below 1.3x (pro forma for the recent issuance of $2.5 billion), which, if sustained, could support a one-notch upgrade of the IDR to 'AA-'. Fitch's total debt leverage forecast assumes that the company will refinance $6 billion of debt maturing in 2013-2015 given the absence of a commitment to deploy capital toward debt reduction.
Steady Free Cash Flow:
Merck generated free cash flow of $6.1 billion in the LTM period ending June 30, 2012, in line with Fitch's expectation of annual free cash flow in excess of $5 billion. Restructuring costs, higher capital spending, and pressured earnings from rapidly declining Singulair revenues will dampen cash flow in 2012 leading to free cash flow of $5 billion (yielding free cash flow margin of 10.7%) this year. Free cash flow will remain above $5 billion annually with free cash flow margin sustained above 10% through 2014. The free cash flow forecast includes an expectation of an increasing dividend and higher capital spending.
Merck's strong liquidity is supported by cash and short-term investments of $17.5 billion and $4.1 billion of long-term investments on June 30, 2012. In addition, Merck had full capacity under a five-year $4 billion revolving credit facility due May 2017. The company has ample liquidity to address upcoming debt maturities of $1.8 billion in 2013, $2.1 billion in 2014, and $2.1 billion in 2015.
What Could Trigger A Rating Action:
Positive rating action would follow sustained gross debt leverage in the range of 1.0x to 1.3x over the next 12-18 months, which indicates that Merck successfully traversed its long-running patent expiration period. In addition, Merck must demonstate positive sales growth, through demand for core drug products and uptake of new medicines, subsequent to a trough in 2013.
Rating pressure would stem from a rise in total debt leverage above 1.5x in the intermediate term. The increase in total debt leverage could result from operational weakness due to inability in achieving cost containment targets or generating sales growth despite the imminent end of the company's patent cliff. A leveraging transaction could lead to higher leverage prompting negative rating action.
(Caryn Trokie, New York Ratings Unit)