CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings of Express Scripts Holding Company (NYSE: ESRX) and its issuing subsidiaries at 'BBB'. The Rating Outlook is Stable.
A full list of rating actions, which apply to approximately $16.2 billion of debt outstanding at Sept. 30, 2016, follows at the end of this release.
KEY RATING DRIVERS
ESRX is the largest pharmacy benefit manager (PBM) and third-largest dispenser of prescription drugs 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 associated especially with mail-order pharmacy.
Robust Cash Flows
Stable and robust cash flows are driven by excellent working capital management and efficient operations, despite relatively low margins. Strong cash flows and a solid liquidity profile provide flexibility at current ratings in the event of leveraging M&A or major contract losses. Fitch forecasts about $4 billion of free cash flow (FCF) in both 2016 and 2017 and, absent material M&A, expects the vast majority to be used for share repurchase activities.
Managing to Moderate Leverage
ESRX manages its capital structure to a gross debt/EBITDA target of around 2x. Fitch expects this practice to persist, though acknowledges that ESRX has the financial flexibility to reduce leverage rather than pay shareholders if management made the unlikely decision to shift its capital deployment priorities.
Growth Re-Aligned with Industry
Fitch believes ESRX's underlying growth will fare more positively as the firm's leading scale benefits from specialty market growth, demographics, and ongoing cost containment efforts by payors leading to growing PBM volumes and the utilization of more value-add services. Recent performance is improved and expected to keep step with the overall industry in 2017 and beyond.
Industry Evolution, Anthem Dispute
Underlying growth and margin dynamics are at risk of pricing pressures and possible large customer losses in light of pending large-scale payor consolidation. Furthermore, the future of ESRX's contract with Anthem, Inc. ('BBB+'/Rating Watch Negative; NYSE: ANTM), its largest customer, is at this time unknown given Anthem's currently pending acquisition of Cigna and filed litigation against ESRX. The deal could produce the largest health insurer in the U.S., possibly with the scale supportive of a strategy to bring its PBM functions in-house.
Top-line is relatively flat in 2016, as increasing prevalence of higher-revenue specialty products is offset by roll-off from Coventry contract losses. The continuing growth of specialty products and high renewal rates drive low single-digit revenue growth throughout the forecast period.
Growth in higher-margin specialty products and the improving profitability of late-stage contracts drive slight margin expansion throughout the forecast period. This effect is slightly offset in 2016 by the Coventry roll-off.
Cash Flows & Capital Deployment
Cash flows are expected to remain strong, with FCF of more than $4 billion in both 2016 and 2017. Most FCF is expected to be used for share repurchases, with ESRX maintaining a cash balance between $1 billion and $2 billion.
Very modest deleveraging is expected, as EBITDA grows while the company refinances maturing debt and deploys most FCF for share repurchases rather than debt pay down. Fitch expects ESRX to continue managing its balance sheet with gross debt/EBITDA around 2x.
No material change to the current relationship is contemplated in Fitch's base case forecast for 2016-2018.
ESRX has decent flexibility at its current 'BBB' ratings, which contemplate gross debt/EBITDA of around 2x. Flexibility is afforded by robust cash flows, market share leadership, and steady industry demand. Concerns include strained relations with its largest customer and increasing calls for reformation of the drug pricing systems in the U.S.
Positive rating actions could accompany a shift in Fitch's expectations that ESRX would use its ample FCF to repay debt, rather than for shareholder payments, such that run-rate gross debt/EBITDA was maintained around 1.5x. Current cash generation is more than sufficient to operate with debt leverage even lower than this target over the ratings horizon.
Negative rating actions could be driven by the prioritization of cash flows for shareholder-friendly activities over debt repayment in the event of large-scale M&A, debt-funded share repurchase, or operational stress, resulting in debt leverage materially and durably above 2x. A possible stress scenario envisions customer losses more severe than Fitch currently expects (i.e. Anthem earlier than 2020) without a corresponding reduction in absolute debt balances.
ESRX maintains a solid liquidity profile, supported by $2.3 billion of cash and equivalents and full availability under a $2 billion revolver at Sept. 30, 2016. Fitch considers all cash readily available due to ESRX's revolver availability and its negative cash conversion cycle.
Strong Cash Flows
FCF on an LTM basis exceeded $5 billion. Strong cash flows are driven by excellent working capital management and steady and efficient operations.
Well-Laddered, Manageable Maturities
The firm's debt maturity schedule is well-laddered and manageable, especially given its strong cash flow profile. No more than $2.5 billion is due in any one year (2019). Nevertheless, Fitch expects ESRX to refinance most debt maturities, thereby growing absolute debt balances with EBITDA, in favor of directing FCF toward M&A and shareholders.
ANTHEM RELATIONSHIP, LITIGATION
Fitch is not able to forecast the outcome of pending litigation between ESRX and Anthem, but thinks it is unlikely that ESRX will be required to provide the scope of pricing concessions put forward by Anthem in its filed suit. Though ESRX management has stated publicly that it hopes to continue servicing the Anthem business, even beyond the current contract's expiration at the end of 2019, Fitch thinks the most likely outcome is no material change to the current agreement except the possibility for early termination and the switching of Anthem to a different PBM. In any case, Fitch at this time does not expect further developments to occur for at least the bulk of 2017 as the case moves through the discovery phase. Furthermore, we believe cash generation would still be robust and sufficient to repay debt in order to maintain gross debt/EBITDA around 2x in the event of an early contract termination.
Anthem accounted for 16.3% of ESRX's 2015 revenues and an estimated 14% of total claims processed. Margins could see moderate pressure due to lower overall rebates earned and reduced operating efficiency. However, calculating a percentage of EBITDA attributable to Anthem is difficult given the lack of information provided and the accounting treatment employed related to rebates received by ESRX and passed on to Anthem. In general, we expect that larger customers are lower-margin for ESRX, but note that language in ESRX's response to Anthem's lawsuit seems to oppose this view somewhat.
By way of context, ESRX disclosed that Anthem and the U.S. Department of Defense, its second-largest customer, together accounted for 29.4% and 25.9% of 2015 and 2014 revenues, respectively.
POSSIBLE PBM INDUSTRY EVOLUTION IN 2017-2019
Rising scrutiny of the drug pricing systems in the U.S., some evidence of weak client satisfaction with major PBMs, pending large-scale health insurance mergers, and the upcoming expiration of many of the largest PBM contracts could provide opportunities for significant shifts in the industry. On balance, profitability could be pressured and some market share could change hands, but Fitch thinks PBMs will retain their important role in the U.S. drug channel as valuable agents of moderating drug spend for payors.
As more and more healthcare costs are shifted to consumers through the rise of high deductible and/or co-insurance health plans, Fitch expects increased calls for reformation of the drug pricing systems, of which PBMs are generally the gatekeepers. Lower list prices and reduced reliance on rebates negotiated by PBMs may weaken the industry's value proposition, albeit only modestly. Though details are uncertain, Fitch expects a Trump administration will push for greater price transparency, possibly pressuring PBM profitability.
Pending large-scale consolidation among health insurers announced in 2015 (Aetna-Humana; Anthem-Cigna) and the upcoming expiration of related contracts may shake up PBM market shares over the medium- to longer-term. Anthem's proposed acquisition of Cigna creates uncertainty with respect to the contract between ESRX and Anthem, due to expire at the end of 2019. The combined Anthem-Cigna firm could have the optionality to move its full PBM business, which Fitch estimates would become the #1 or #2 largest book of business in the U.S., to a single PBM, or to take the business in-house. Humana already operates its own in-house PBM, which could be leveraged by a combined Aetna-Humana. No decision or indication has been given to-date, and both transactions are currently facing pushback from U.S. regulators.
DISTRIBUTION CONTRACT EXPIRES SEPTEMBER 2017
ESRX's distribution contract with AmerisourceBergen Corp. ('A-'/Outlook Negative; NYSE: ABC) will be expiring in September 2017, following a second one-year extension under the same terms as the previous contract (which expired in September 2015). In 2015, ABC supplied ESRX with 65.7% of its pharmaceutical purchases. Notably, following the merger of legacy Express Scripts and Medco, the combined company adopted Medco's IT platform in part because it was already integrated into ABC's platform. After that rocky transition, which resulted in material customer losses, Fitch thinks ESRX management will be hesitant to undertake another sizeable platform migration.
Given ESRX's customer losses over the past few years, and particularly in light of the possible loss of its contract with Anthem, it is possible that a new contract with ABC (or another distributor) will have terms less favorable to ESRX. It is uncertain to what degree ESRX will choose to use incremental distribution services, such as generic sourcing, as relative purchasing scale is difficult to determine. Though the three recently formed major generic drug purchasing organizations are larger than ESRX in absolute terms, Fitch believes ESRX still has significant purchasing scale in the majority of the generic drugs it sells through its mail-order pharmacy. Notably, management's public commentary has recently seemed more open to the possibility of joining one of these purchasing organizations.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
Express Scripts Holding Company
--Long-Term Issuer Default Rating at 'BBB';
--Senior unsecured bank facility at 'BBB'.
--Senior unsecured notes at 'BBB'.
Express Scripts, Inc.
--Senior unsecured notes at 'BBB'.
Medco Health Solutions, Inc.
--Senior unsecured notes at 'BBB'.
The Rating Outlook is Stable.
Date of Relevant Rating Committee: Nov. 16, 2016
There were no adjustments made to published financial statements that were material to the rating rationale.
Additional information is available on www.fitchratings.com.
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
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