Fitch Rates Merck's EUR Debt Offering 'A+'; Outlook Negative

CHICAGO--()--Fitch Ratings has assigned an 'A+' rating Merck & Co.'s (Merck) Euro denominated senior unsecured notes offering. Merck intends to use all or a substantial portion of the net proceeds from the offering to refinance existing debt.

The Rating Outlook is Negative and applies to approximately $23.1 billion in outstanding debt. A full list of Merck's ratings follows near the end of this release.

KEY RATING DRIVERS

--The Negative Outlook mainly reflects that leverage (total debt/EBITDA) has remained above 1.5 times (x) since Merck's $5 billion, largely debt-funded share repurchases in second-quarter 2013 (2Q'13). While leverage has declined to 1.52x from its peak of 1.92x at June 30, 2013, the Oct. 1, 2014 sale of its consumer business to Bayer will modestly weigh on EBITDA and leverage.

--Fitch expects that Merck will continue to favor share repurchases over deleveraging, acknowledging the possibility of further debt-funded stock buybacks. Notably, the company has roughly $7 billion remaining on its existing repurchase authorization.

--Sales at-risk to patent expiries have declined to roughly 20% of total firm sales. Roughly one-third of those sales are generated by biologics, which tend to have significantly less market share erosion in the face of generic (biosimilar) than do traditional small molecule drugs.

--Merck has made progress in building its late-stage pipeline. The company has approximately 20 new molecular entities (NMEs) in phase 3 development or registration.

--Merck initiated a restructuring program in October 2013, which Fitch expects will be supportive to margins during the intermediate term. Merck will focus on costs in a number of areas including manufacturing, general administration and research & development.

--Fitch believes the sale of Merck's consumer business was strategically sound, as it increases the company's focus on its core mission of developing and marketing innovative medicines. However, the sale incremental decreases the diversification of the company's business model.

--Fitch expects modest growth for Merck's Januvia/Janumet franchise, as the market becomes increasingly crowded with new entrants. Although, the growth in the number of diabetic patients and some share gains from older generic treatment modalities should offset the competitive headwinds.

--Fitch forecasts that Merck will generate $5.8 billion - $6.1 billion in FCF during 2014 as improving margins offset soft revenue.

Debt Financed Share Repurchases

Fitch expects that Merck will continue with shareholder friendly actions during the near term, some of which may be funded by debt. Merck purchased $2.3 billion (net of issuances) of its common stock during the first six months of 2014. The repurchases were executed under a $15 billion program authorized in May 2013 and a previously authorized program. Merck has approximately $7 billion remaining under the May 2013 share repurchase program.

Patent Exposure Easing

Merck faces a significant number of patent expiries during the next two years. However, roughly only 20% of total firm sales are at risk. In addition, Remicade and PEG-Intron (accounting for about 6.2% of total firm) are biologics and tend not to experience the rapid sales loss to generic competition as do traditional small molecule pharmaceuticals.

Expanding Late Stage Pipeline

Fitch expects Merck to continue to build its late-stage pipeline, despite the company's intention to narrow its focus its focus on R&D projects. Merck's late stage pipeline is broad with new molecular entities (NMEs) to treat cancer, bacterial and viral infections, diabetes, cardiovascular disease, central nervous system disorders, osteoporosis, allergies and other maladies. The September 2014 FDA approval of Keytruda was a significant milestone in Merck's development of cancer treatments.

While the majority of these projects are internally developed, Merck has partnered with other innovator firms to take advantage of technological advancements that were discovered externally. The landscape for drug development is expanding, particularly as more is learned about how genetics influence the development, prevention and treatment of disease.

Cost Cutting Continues

In October 2013, Merck initiated a new global restructuring program, in an effort to sharpen its global commercial and research & development focus. Merck is working on reducing costs in the areas of sales, administration and research & development. Merck continues to work towards improving the efficiency of its manufacturing and supply network. The restructuring program is expected to be substantially completed by the end of 2015. Estimated pre-tax restructuring costs are approximately $2.5 billion - $3 billion, of which two-thirds will be cash-related.

Consumer Business Sale

Fitch believes the sale of Merck's consumer products business is a modest negative for its credit profile, with the expectation that the proceeds of the sales would not be used for debt reduction. While the consumer business accounted for roughly 4% of total firm sales, Fitch estimates the segment's contribution to Merck's total EBITDA is less than that. Regardless, Fitch believes the negative effects of an incrementally less diversified product portfolio and a lower base of profitability will more than offset the benefits to the firm from increasing its focus on its core competency of drug development and marketing in the near term.

More Competition for Januvia/Janumet

Fitch expects that the growing number of diabetic patients and continued market share gains from some older generic diabetes treatments will more than offset the increasing number of competitors in the diabetes treatment market. This will result in relatively soft sales growth for Januvia/Janumet, Merck's largest selling franchise. Growth has slowed in recent years due to competition (DPP-4 inhibitors, SGLT2 inhibitors, GLP-1 agonists) entering the diabetes market. In addition, concerns over the safety of these drugs(DPP-4 inhibitors) have been a headwind to growth. However, the FDA recently reaffirmed their safety regarding pancreatitis and pancreatic cancer.

Solid Free Cash Flow Expected

Fitch forecasts that Merck will continue to generate significantly positive free cash flow generate, including expected 2014 FCF of $5.8 billion - $6.1 in FCF during 2014. Improving margins driven by an improving sales mix and strong cost control should more than offset the negative effect that expected soft top-line growth will have on cash generation.

Adequate Liquidity

Fitch looks for Merck to maintain adequate liquidity through strong FCF generation and ample access to the credit markets. FCF for the LTM ending June 30, 2014 was $5.1 billion. At the end of the period, Merck had approximately $13.4 billion in cash plus short-term investments and full availability on its $4 billion revolver, maturing in May 2017.

At June 30, 2014, Merck had roughly $24.1 billion in debt outstanding. Fitch expects near- to mid-term maturities will be satisfied primarily through refinancing in the public debt markets.

RATING SENSITIVITIES

Fitch would consider revising the Rating Outlook to Stable if Merck pursued a capital deployment strategy that maintained gross debt leverage below 1.5X during the long term, including managing through operational stress such as patent expiries and clearly taking a more conservative approach to its use of debt. In addition, Merck must demonstrate long-term positive sales growth through demand for core drug products and uptake of new medicines.

Rating pressure would stem from total debt leverage remaining above 1.5x in the intermediate term. The high leverage would likely be driven by incremental borrowing to fund acquisitions or share repurchases. Leverage pressure could also result from operational weakness due to an inability to achieve in achieving cost containment targets or generating sales growth despite is improving patent risk profile and expanding late-stage pipeline. In addition, Fitch anticipates that FCF would be constrained in this scenario.

Fitch currently rates Merck as follows:

--Long-term IDR 'A+';

--Senior unsecured debt rating 'A+';

--Bank loan rating 'A+';

--Short-term IDR 'F1';

--Commercial paper rating 'F1'.

The Rating Outlook on the long-term ratings is Negative.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (May 28, 2014);

--'Rating Pharmaceutical Companies - Sector Credit Factors' (Aug. 9, 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=749393

Rating Pharmaceutical Companies

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684459

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=891055

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Contacts

Fitch Ratings
Primary Analyst:
Bob Kirby, CFA, +1-312-368-3147
Director
Fitch Ratings, Inc.
70 West Madison Street
Chicago, IL 60602
or
Secondary Analyst:
Michael Zbinovec, +1-312-368-3164
Senior 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

Contacts

Fitch Ratings
Primary Analyst:
Bob Kirby, CFA, +1-312-368-3147
Director
Fitch Ratings, Inc.
70 West Madison Street
Chicago, IL 60602
or
Secondary Analyst:
Michael Zbinovec, +1-312-368-3164
Senior 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