Fitch Affirms AmerisourceBergen at 'A-'; Outlook Stable

CHICAGO--()--Fitch Ratings has affirmed the long-term ratings of AmerisourceBergen Corp. (NYSE: ABC) at 'A-' and the short-term ratings at 'F2'. The Rating Outlook is Stable.

The rating actions apply to approximately $2 billion of debt at June 30, 2014. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

-- U.S. drug distributors maintain stable operating profiles due to the industry's oligopolistic nature and steady pharmaceutical demand. Drug distribution, though low margin, is relatively insulated from pricing and regulatory pressures faced by other areas of healthcare in the U.S.

-- ABC maintains strong credit metrics through its consistently strong core cash generation, efficient operations, and commitment to operating with low debt leverage. The May 2014 debt issuance, which Fitch expects to be repaid upon maturity in 2017, pushed leverage toward the upper end of the 'A-' ratings. But de-leveraging is expected owing to growth from ramping Walgreen & Co (Walgreens) generic drug volumes over the next few quarters.

-- Fitch views favorably ABC's alignment with Walgreens and Alliance Boots GmbH (AB), and the process to align the firms seems to have gone well so far. Fitch expects the relationship will drive increased top-line growth, stronger cash flows, improved stability, and incremental margin expansion opportunities over the ratings horizon, despite the significant drop in profit margins and material cash outflows for working capital initially.

-- The ultimate effectiveness of ABC's strategy to offset stock dilution associated with the pending warrant exercises by Walgreens in 2016-2017 is at this time uncertain, as an increasing stock price may result in the need for additional cash outflows. The firm's solid liquidity position and strong operational cash generation provide an offset to this risk.

-- Fitch believes there are limited growth opportunities in the traditional U.S. drug distribution space. As a result, and now more so considering ABC's alignment with WAG-AB, Fitch expects ABC to responsibly pursue growth in service-related and non-U.S. markets (e.g. its minority investment in Profarma Distribuidora) over the intermediate- to longer-term.

RATING SENSITIVITIES

ABC currently has somewhat limited flexibility at its present ratings. Maintenance of its 'A-' long-term ratings will generally require ABC to operate with gross debt leverage at or below 1.3x, accompanied by steady funds from operations (FFO) in excess of $800 million annually. EBITDA margins, which declined significantly in fiscal 2013 and 2014 due to the onboarding of the new Express Scripts Holding Co. (Express Scripts) and Walgreens distribution contracts, should show some improvement going forward, in support of the firm's current ratings.

An upgrade to 'A' is not expected over the ratings horizon. Because of the business's low margins, Fitch believes ABC's management would need to commit to operating with gross debt leverage below 0.75x to achieve an upgrade to 'A'. Fitch does not expect ABC to commit to operating with such low leverage in the near- to intermediate-term.

Negative ratings momentum could be caused by greater and more direct pricing pressures than Fitch currently expects and/or by a transaction which drives leverage sustainably above 1.3x or that illustrates a departure from ABC's traditional commitment to its core drug distribution business. Fitch notes the risks associated with ABC's recently announced alignment with Walgreens-AB, including possible cash outflows associated with working capital or hedging/anti-dilution transactions. But Fitch does not expect these risks to precipitate a negative rating action over the ratings horizon.

COMMITMENT TO STRONG CREDIT PROFILE

Steady demand for pharmaceuticals contributes to an exceptionally stable operating profile for U.S. drug distributors. The industry has proven rather resilient to persistently depressed patient volumes, elevated levels of unemployment, and constrained healthcare reimbursement in recent years. Appropriately low EBITDA margins have grown steadily in recent years, owing primarily to brand-to-generic conversions, efficiency improvements, and growth in higher-margin businesses (i.e. specialty distribution, consulting services).

ABC's credit profile also benefits from management's demonstrated commitment to conservative financial management. Fitch expects the firm to remain committed to operating with debt leverage, as adjusted for operating leases, below 1.5x. (This figure implies Fitch-calculated unadjusted leverage of 1.2x-1.3x.) Fitch generally views event risk associated with M&A to be limited given ABC's history of sticking to its core competencies and management's demonstrated financial discipline.

TEMPORARILY LIMITED FINANCIAL FLEXIBILITY

Unadjusted debt leverage of 1.6x at June 30, 2014 currently affords ABC limited flexibility to issue additional debt, if necessary, to help fund cash outflows associated with working capital and/or additional share repurchases meant to offset dilution. However, ramping EBITDA contributions from the onboarding of generic drug distribution volumes to Walgreens should help to moderate debt leverage to below 1.3x during fiscal 2015. Fitch expects ABC to repay its $600 million of 2017 notes upon maturity, which is ABC's only debt due until 2019. Furthermore, Fitch believes ABC's contract with Walgreens contributes to improved operational efficiency and business stability, plus expected cost savings and working capital improvement, offsetting the risk associated with temporarily elevated debt leverage metrics.

ALIGNMENT WITH WALGREENS A NET POSITIVE

The unique 10-year, comprehensive distribution contract with Walgreens, which began Sept. 1, 2013, will add materially to ABC's top-line and cash flows over the next couple of years. Gross margins have declined in ABC's fiscal 2014 due to the low-margin nature of distributing to a customer as large as Walgreens. But Fitch expects the new Walgreens business will contribute to ABC's already stable and highly efficient operations by allowing the firm to leverage the fixed costs associated with drug distribution.

Fitch forecasts EBITDA margins of approximately 1.3%-1.4% in ABC's fiscal 2014 and 2015, compared to 1.84% in fiscal 2012. Higher margins could be achieved depending on the success of the generics procurement joint venture (JV) among Walgreens, AB, and ABC. Expansion opportunities in adjacent businesses (i.e. World Courier and consulting services) and in non-U.S. markets - especially in partnership with AB - and growth in specialty and generics could also provide margin upside over the ratings horizon.

ADDITIONAL CASH MAY BE NEEDED TO SUPPLEMENT HEDGING STRATEGY

Significant cash outflows for working capital needed to onboard the Walgreens business are now beginning to normalize, but cash needed to fund ABC's strategy to offset dilution resulting from the expected warrants exercise by Walgreens in 2016 and 2017 may continue to pressure ABC's overall cash generation in fiscal 2014-2015. Fitch estimates that total cash outflows to accomplish the firm's hedging strategy will exceed $1 billion, including around $370 million for the capped call options ($163 million in 2013, $205 million in 2014) and $650 million to complete the firm's special share repurchase program ($142 million in first nine months of 2014). According to ABC, these transactions are meant to offset approximately 80% of the firm's exposure to warrant-related dilution.

In the event ABC's share price exceeds the "cap" price of a portion of the call options contracts, additional cash may be needed to supplement the hedging strategy. The firm may have some flexibility at 'A-' in 2016-2017 to use debt to fund additional special share repurchases, as necessary. But Fitch forecasts free cash flow (FCF; cash from operations minus capital expenditures minus dividends) to approach $1 billion in 2015 and beyond, providing ample cash flows to fund possible supplemental share repurchases. ABC's liquidity profile is also solid, comprising an undrawn $1.4 billion revolver and $1.26 billion of cash on hand at June 30, 2014.

In general, Fitch believes ABC will address these risks, including the issuance of any possible incremental debt, in a manner appropriate at ABC's current ratings of 'A-'. Furthermore, Fitch expects that working capital benefits and cost savings related to the increased purchasing scale of the procurement JV will more than offset these costs over the next few years.

HIGHER CUSTOMER CONCENTRATION NOT A MATERIAL CONCERN

Fitch acknowledges the risks generally associated with increased revenue concentration, as represented by ABC's new contracts with Express Scripts and Walgreens. But these risks are mitigated by the long-term and comprehensive nature of the Walgreens distribution contract, as well as the costs that are required to switch drug distributors, especially those related to technological integration. Furthermore, Fitch believes ABC will benefit from the long-term market growth connected with serving two of the largest pharmacy companies in the U.S. Fitch estimates these two customers will account for roughly 45% of ABC's revenues going forward.

Notably, ABC's distribution contract with Express Scripts is set to expire in September 2015. Although representing more than $20 billion in revenues, the contract carries very low profit margins; thus, a negative rating action would not likely occur in the event ABC lost this contract.

TAILWINDS INCLUDE SPECIALTY, GENERICS, AND PROSPECT OF BIOSIMILARS

ABC's incumbent leadership in the higher-growth and higher-margin specialty drug distribution business is a material competitive advantage. Fitch expects ABC will continue to grow other areas of its specialty business, including more nascent therapeutic classes and non-U.S. markets (i.e. Brazil) in the longer term, providing growth and margin support over the rating horizon.

Brand-to-generic conversions will also continue to support profit margins. ABC and its peers have benefited materially from the unprecedented wave of generic launches in recent years. A few large branded products' expirations should provide some margin support in calendar 2014-2015. While Fitch believes much of the margin expansion achieved by drug distributors as a result of generic conversions is durable, it will be harder to identify for ABC going forward due to the impact of the lower-margin Express Scripts and Walgreens business. Generic pricing as a whole has also been favorable to drug distributors in recent quarters, but generic pricing deflation is expected to resume over the longer term.

The introduction of biosimilars to the U.S. drug channel - possibly as early as 2015 - will provide another area of potential margin growth for drug distributors. ABC is uniquely positioned among its peers to benefit from biosimilars, given its leadership position in specialty drug distribution and its relationships with Walgreens and Express Scripts, which currently control sizeable shares of the specialty pharmacy market.

Fitch has affirmed ABC's ratings as follows:

--Long-term Issuer Default Rating (IDR) at 'A-';

--Short-term IDR at 'F2';

--Senior unsecured bank facility at 'A-';

--Senior unsecured notes at 'A-';

--Commercial paper at 'F2'.

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' (May 28, 2014);

--'U.S. Healthcare Stats Quarterly - First-Quarter 2014' (July 7, 2014);

--'Fitch Rates AmerisourceBergen's Proposed $1B Bond Offering 'A-'; Outlook Stable (May 19, 2014);

--'Trekking the Path to Biosimilars - The Destination' (Oct. 4, 2013);

--'Trekking the Path to Biosimilars - Forging Ahead' (Aug. 5, 2013);

--'Vital Signs - Currents in the Drug Channel' (Podcast) (April 25, 2013);

--'Navigating the Drug Channel - Drug Distributors: A Deeper Dive' (April 24, 2013).

Applicable Criteria and Related Research:

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

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=706690

Vital Signs -- Currents in the Drug Channel

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

Trekking the Path to Biosimilars -- Forging Ahead

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=714715

Trekking the Path to Biosimilars -- The Destination

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

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

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=710713

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

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=869555

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Contacts

Fitch Ratings
Primary Analyst
Jacob Bostwick, CPA, +1 312-368-3169
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
Michael Weaver, +1 312-368-3156
Managing Director
or
Media Relations, New York
Brian Bertsch, +1 212-908-0549
brian.bertsch@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Jacob Bostwick, CPA, +1 312-368-3169
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
Michael Weaver, +1 312-368-3156
Managing Director
or
Media Relations, New York
Brian Bertsch, +1 212-908-0549
brian.bertsch@fitchratings.com