Fitch Affirms Express Scripts at 'BBB'; Outlook Stable

CHICAGO--()--Fitch Ratings has affirmed the ratings of Express Scripts Holding Company (NYSE: ESRX) and its issuing subsidiaries, including the long-term Issuer Default Ratings, at 'BBB'. The Rating Outlook is Stable.

The rating action applies to approximately $13.8 billion of debt outstanding at Dec. 31, 2013. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

-- ESRX is the largest pharmacy benefit management (PBM) and third-largest pharmacy operator in the U.S. Fitch expects such scale to continue enabling ESRX to negotiate favorable purchasing discounts and pricing rebates and to leverage its fixed costs, especially associated with mail-order pharmacy.

-- ESRX achieved its leverage target of 2x subsequent to its merger with Medco Health Solutions, Inc., using nearly $4.2 billion of cash flows for debt repayment in the second half of 2012 (2H'12) and fiscal year 2013 (FY13). Fitch-calculated debt leverage was 2.05x at Dec. 31, 2013. Management says the bulk of core integration tasks are largely complete; though some additional capacity and cost rationalization is planned for 2014.

-- Stable and robust cash flows are driven by strong working capital management and efficient operations, despite relatively low margins. Fitch forecasts free cash flow (FCF) of approximately $4.4 billion in 2014. Strong cash flows and a solid liquidity profile afford incremental ratings flexibility in light of debt leverage toward the upper end of the current 'BBB' range.

-- ESRX has been an active acquirer over the past decade, often employing large debt balances to fund deals. The possibility for large-scale M&A and accompanying leverage spikes, albeit lower now given ESRX's very large size, pressure the ratings somewhat. Notably, the firm has routinely executed on its outlined de-leveraging plans, reducing leverage appropriately within 12-18 months of each deal.

-- Some pricing pressure is possible from consolidating clients over the ratings horizon. Current trends support increasing consolidation in many areas of healthcare, including among health insurers. Increasing competition and an apparent willingness to experiment with new models on the part of PBM clients creates opportunities for both risk and reward to ESRX's growth prospects over the medium term.

-- ESRX's public guidance for total adjusted script declines of 2%-6% implies weaker utilization and possibly more client losses than Fitch had initially expected. Though 2014 and possibly 2015 may be somewhat weak, Fitch believes ESRX's longer-term growth will fare more positively as tailwinds from healthcare reform, specialty market growth, demographics, and ongoing cost containment efforts by payers drive PBM volumes and utilization of more value-add services.

RATING SENSITIVITIES

Maintenance of the current 'BBB' ratings will require debt-to-EBITDA of 2x or below, accompanied by continued robust cash flows and steady longer-term script growth in the low- to mid-single digits. Completion of final Medco integration and cost rationalization efforts in 2014, with evidence of better underlying growth drivers in 2015+, could support incremental flexibility at the 'BBB' ratings and possibly positive ratings momentum in the medium term. Fitch notes that the firm's strong cash flow profile provides significant de-leveraging capabilities in the event of debt-funded mergers and acquisitions (M&A).

Fitch thinks ESRX will generate cash flows sufficient to repay debt in a potential stress scenario or in the event of a leveraging M&A deal. Fitch believes it is unlikely that broader industry dynamics alone will contribute to significant ratings pressure over the ratings horizon. But the prioritization of cash flows for shareholder-friendly activities over debt repayment in such a case, resulting in debt leverage materially and durably above 2x, could drive a negative rating action. A possible stress scenario envisions the possibility of prolonged negative underlying script growth, possibly due to customer losses more severe than Fitch currently expects and/or the loss of the Department of Defense (DoD) contract.

HIGHER DEBT LEVERAGE TARGET POST-ACQUISITION

Fitch expects ESRX to operate with debt leverage around 2x going forward. This target is currently toward the upper end of the 'BBB' ratings. But the firm's newfound scale and consistently strong cash generation could support incremental flexibility upon the completion of integration and cost rationalization efforts over 2014.

Despite somewhat limited leverage flexibility in the near term, ESRX remains committed to a solid investment grade (IG) rating, and Fitch does not expect the firm to engage in activities that jeopardize the current 'BBB' ratings. Large M&A transactions are possible; though targets requiring debt-funding are not likely to be PBMs, due in part to ESRX's significant market position and the general non-existence of such targets. Importantly, ESRX has a history of delivering on committed de-leveraging plans following large deals.

NEGATIVE SCRIPT GROWTH FORECASTED FOR 2014 A MODERATE CONCERN

ESRX is expecting organic adjusted prescriptions to decline 2%-6% in 2014, despite another wave of generic conversions and an increase, albeit more moderate than originally expected, in covered lives from the coverage expansion provisions of the ACA. Fitch estimates negative revenue growth in the mid-single digits for 2014.

Concerns center on the possibility that the negative script growth encompasses greater contract losses than Fitch had previously expected subsequent to the Medco deal and associated platform migrations. Furthermore, Fitch acknowledges the growing competitive threat of ESRX's much-smaller peers, especially the fast-growing Catamaran.

In general, Fitch believes ESRX's competitive strengths remain ahead of these players due to its much greater scale - leading to lower drug acquisition costs and greater rebates - and the combination of legacy ESI's focus on behavioral consumer science and legacy Medco's forte in clinical expertise. Some share loss is possible over the ratings horizon, but Fitch expects ESRX to grow more or less in line with the industry as a whole in the low single digits.

DEPARTMENT OF DEFENSE CONTRACT UP FOR RENEWAL

The DoD launched a request for proposal process in Summer 2013 for bids on its PBM contract, currently held by ESRX. The current contract is set to expire in Fall 2014. ESRX sourced about 10% of its 2013 revenues providing certain PBM services, including mail-order drug dispensing and pharmacy network access, to the DoD.

The loss of the DoD contract would not likely result in a downward rating action, so long as ESRX adjusted its cash deployment according to the resulting decrease in cash generation. The DoD book of business is lower-margin than ESRX's overall client base. But the loss of such a large client could negatively impact ESRX's purchasing and rebate power and reduce operational efficiency, especially associated with mail-order pharmacy services.

CASH GENERATION, LIQUIDITY IS VERY STRONG RELATIVE TO KNOWN CASH NEEDS

Fitch forecasts FCF of at least $4 billion in 2014, despite the expectation for remaining integration and other cost structure rationalization efforts to remain elevated in 2014. Strong and steady cash generation is driven by strong working capital management, steady demand, and strong operational efficiency. In lieu of strategic M&A, Fitch expects the majority of excess cash flows to be used for share repurchases. ESRX management has stated publicly that it intends to return over half of FCF to shareholders.

ESRX maintains a solid liquidity profile, comprised of nearly $2 billion of cash and full availability under the $1.5 billion revolver due 2016, as of Dec. 31, 2013. Debt maturities are well-laddered, estimated as follows: $1.6 billion in 2014; $2.6 billion in 2015; $3 billion in 2016; $1.5 billion in 2017; $1.2 billion in 2018; and $4 billion thereafter.

SPECIALTY, GENERICS OFFER STRONG GROWTH; MAIL STILL A PLATEAU

Another wave of generic conversions in 2014-2015 and the continued rapid growth of specialty drugs, including the possibility for biosimilars in 2015-2016, provide compelling drivers of overall growth and margin expansion over the ratings horizon. Though not as large as 2012, 2014 and 2015 are expected to be significant years for branded drug patent expiries, with the patents of blockbusters like Cymbalta, Nexium, Diovan, Abilify, and possibly Celebrex having just expired or set to expire over this timeframe. The rapid growth of the specialty drug market will also provide a significant area of growth for ESRX and its peers, especially as clients continue to increase their focus on controlling the spending growth associated with that drug class.

Fitch believes that mail-order pharmacy services could provide upside to current forecasts over the medium-to-longer term. Though currently plateaued at around 30%, home delivery utilization could rise as the growing numbers of retirees, who usually take a larger number of maintenance medicines, increasingly represent more tech-savvy individuals. Mail-order services offer significant costs savings to PBMs and their clients, supporting the view that mail-order penetration will rise over time.

Fitch has affirmed the following ratings:

Express Scripts Holding Company

-- Long-term IDR at 'BBB';

-- Unsecured bank facility at 'BBB';

-- Unsecured notes at 'BBB'.

The Rating Outlook is Stable.

Express Scripts, Inc.

-- Long-term IDR at 'BBB';

-- Unsecured notes at 'BBB'.

The Rating Outlook is Stable.

Medco Health Solutions, Inc.

-- Long-term IDR at 'BBB';

-- Unsecured notes at 'BBB'.

The Rating Outlook is Stable.

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' (Aug. 5, 2013);

--'U.S. Healthcare Stats Quarterly - Third-Quarter 2013' (Jan 2, 2014);

--'2014 Outlook: U.S. Healthcare - Secular Challenges Require a Compelling Value Proposition' (Nov. 25, 2013);

--'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 - PBMs: In Flux (March 27, 2012).

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

U.S. Healthcare Stats Quarterly -- Third-Quarter 2013

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726356

2014 Outlook: U.S. Healthcare -- Secular Challenges Require a Compelling Value Proposition

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724141

Trekking the Path to Biosimilars -- The Destination

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=719802

Vital Signs -- Currents in the Drug Channel

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=707243

Navigating the Drug Channel: Pharmacy Benefit Managers (PBMs) in Flux

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=674982

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=825004

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Contacts

Fitch Ratings
Primary Analyst
Jacob Bostwick, CPA, +1-312-369-3169
Director
Fitch Ratings, Inc.
70 W Madison Street
Chicago, IL 60602
or
Secondary Analyst
Bob Kirby, CFA, +1-312-368-3147
Director
or
Committee Chairperson
Sean Sexton, +1-312-368-3130
Managing Director
or
Media Relations
Brian Bertsch, +1-212-908-0549 (New York)
brian.bertsch@fitchratings.com

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Contacts

Fitch Ratings
Primary Analyst
Jacob Bostwick, CPA, +1-312-369-3169
Director
Fitch Ratings, Inc.
70 W Madison Street
Chicago, IL 60602
or
Secondary Analyst
Bob Kirby, CFA, +1-312-368-3147
Director
or
Committee Chairperson
Sean Sexton, +1-312-368-3130
Managing Director
or
Media Relations
Brian Bertsch, +1-212-908-0549 (New York)
brian.bertsch@fitchratings.com