Fitch Downgrades Merck's L-T IDR to 'A'; Outlook Revised to Stable

CHICAGO--()--Fitch Ratings has downgraded Merck & Co.'s (Merck) long-term Issuer Default Rating (IDR) by one notch to 'A' and revised the Rating Outlook to Stable from Negative. In addition, the company's short-term IDR has been affirmed at 'F1'.

Merck had $21.7 billion in outstanding debt at Dec. 31, 2014. A full list of Fitch's ratings actions follows at the end of this release.

KEY RATING DRIVERS

--Fitch expects MRK's leverage (total debt/EBITDA) to remain above 1.7x for the next several years, a level consistent with an 'A' rating given the company's scale and strong industry position.

--Fitch believes Merck will pursue targeted acquisitions as opposed to large transformative ones. An improving pipeline and narrowing strategic focus reduces the need to do big deals, as evidenced by the recent acquisition of Cubicin Pharmaceuticals (Cubist).

--Fitch expects Merck will continue to favor share repurchases over deleveraging, with the possibility of further debt-funded stock buybacks being an overhang on the credit profile. The company has roughly $11.7 billion remaining on its existing repurchase authorizations as of March 24, 2015.

--Sales at risk to patent expiries through 2017 are roughly 23% of 2014 revenues. About one-quarter of those sales are generated by biologics, which tend have significantly less market share erosion upon patent expiration than do traditional small-molecule drugs.

--Merck continues to make progress in building its late-stage pipeline, with approximately 17 new molecular entities (NMEs) in phase 3 development or registration.

--Januvia/Janumet, Merck's largest prescription drug franchise, continued to post low single-digit growth during 2014, despite ongoing competitive headwinds in the diabetes treatment market.

--Fitch forecasts that Merck will generate $3.7 billion-$3.8 billion in free cash flow (FCF)/(cash flow from operations minus capital expenditures minus dividends) during 2015 as improving margins offset soft revenue.

Aggressive Capital Deployment Drives Downgrade: Fitch believes that Merck's operating outlook is favorable. This includes an improving drug development pipeline, recently good results in securing FDA approvals for new therapeutic products, and a manageable percentage of sales at risk to near-term patent expiration.

Higher leverage (total debt-to-EBITDA of 1.8x pro forma for the Cubist acquisition versus 1x in 2011) is partly the result of the effects of the U.S. branded-drug patent cliff on the company's top line and EBITDA in 2012-2013. However, the company has not prioritized deleveraging as the business profile has recovered, instead choosing to be aggressive in returning cash to shareholders.

Cubist Acquisition Expands Presence in Hospital Setting: Merck's January 2015 $8.4 billion acquisition of Cubist plus roughly $1.1 billion in net debt expands its presence in the anti-infective market, particularly in the hospital setting. The transaction also adds two of Cubist's pipeline products, bevenopran (opioid-induced constipation) and surotomycin (clostridium difficile), to Merck's drug development efforts. The acquisition was largely funded with $8 billion in new debt, which Merck issued in February 2015.

The Cubist acquisition is an example of the types of targeted acquisitions that Fitch believes Merck will continue to pursue. A large, transformational type of transaction is relatively less likely given the company's favorable operating outlook.

Diabetes Franchise Growth Continues: Combined sales of Januvia and Janumet continued to grow during 2014 by roughly 3% year-over-year. Favorable clinical data, a growing number of diabetic patients, and investment in the franchise has helped to support the underlying growth in sales. The positive trend has occurred despite increasing competition from other recently introduced branded pharmaceuticals within the diabetes market.

Patent Exposure Manageable: The company faces a significant number of patent expiries during the next two years, but Fitch views the risk as manageable as roughly only 23% of total firm sales are at risk. In addition, Remicade, which accounts for about 5.6% of total firm sales, is a biologic that will probably experience less rapid sales losses to generic competition compared to traditional small-molecule pharmaceuticals.

Expanding Late-Stage Pipeline: Fitch expects Merck to continue to build its late-stage pipeline with NMEs to treat cancers, bacterial and viral infections, diabetes, cardiovascular disorders, central nervous afflictions, osteoporosis and allergies.

While most of these projects are internally developed, Merck has partnered with other innovator firms to take advantage of technological advancements that were discovered and cultivated externally. The landscape for drug development is expanding, particularly as more is learned about how genetics influence the development, prevention and treatment of disease. As such, Fitch believes that it is a responsibility, and strategically advantageous, for firms to look externally as well as internally regarding new drug development.

Share Repurchases to Continue: Fitch forecasts continued shareholder-friendly actions during the near term, some of which may be funded by debt. Merck has occasionally funded its share repurchases with debt. During 2014, the company purchased a net $6.1 billion of its common stock, compared to $5.3 billion during the prior LTM period.

On March 24, 2015, Merck announced its board authorized an additional $10 billion share repurchase program and stated that it had $1.7 billion remaining on a May 2013 program.

Positive FCF Expected: Fitch forecasts that Merck will continue to generate $3.7 billion-$3.8 billion in FCF (cash flow from operations of $10.3 billion minus capital expenditures of $1.2 billion minus dividends of $5.4 billion) during 2015. Improving margins driven by sales mix and strong cost control efforts should more than offset expected soft top-line growth.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Merck include:

-- Declining revenue, driven by weak utilization in developed markets, the divestiture of the consumer business and foreign exchange headwinds. Somewhat offsetting the decline are relatively stronger demand in emerging markets, a moderating patent cliff and incremental revenue from pipeline commercialization.

--Margin improvement driven by a focus on costs and an improving sales mix benefiting from the divestiture of the lower margin consumer health business.

--Annual FCF (cash flow from operations minus capital expenditures minus dividends) of $3.7 billion to $3.8 billion during 2015.

--Targeted acquisitions with no strategic, transformative transactions.

--Continued significant capital deployment to share repurchases.

--Leverage to range between 1.8x-2x during the next two years driven by an additional $8 billion in debt issued in February 2015 to fund the Cubist acquisition.

LIQUIDITY

Fitch expects Merck to maintain adequate liquidity through strong FCF generation and ample access to the credit markets. FCF for the LTM ending Dec. 31, 2014 was $1.3 billion. At the end of the period, Merck had approximately $15.7 billion in cash/short-term investments (U.S.: 10%-20% of total balances/OUS: 80%-90% of total balances) and full availability on its $6 billion revolver, maturing in August 2019.

At Dec. 31, 2014, Merck had roughly $21.7 billion in debt outstanding, although the company issued an additional $8 billion in debt in February 2015. After the issuance the company had roughly $30.5 billion in debt outstanding, with $2.7 billion maturing in 2015, $2.4 billion in 2016, $0.3 billion in 2017 and $3 billion in 2018. Fitch expects near- to mid-term maturities will be satisfied primarily through refinancing in the public debt markets.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include the following:

--Improving operations including new product development that support long-term positive revenue growth and margin stability/increases;

--An operational profile that would consistently generate significantly positive FCF;

--Cash deployment strategy that maintains gross debt leverage below 1.7x, including managing through operational stress such as patent expiries.

Negative: Future developments that may, individually or collectively, lead to negative rating action include the following:

--Material and lasting deterioration in operations and FCF, possibly driven by patent expiries not being offset by new product development;

--Leveraging acquisitions without the prospect of timely debt/leverage reduction;

--Persistent leverage above 2.2x.

RATING ACTIONS

Fitch has downgraded Merck's ratings as follows:

--Long-term IDR to 'A' from 'A+';

--Senior unsecured debt rating to 'A' from 'A+';

--Bank loan rating to 'A' from 'A+'.

Fitch has also affirmed Merck's short-term ratings as follows:

--Short-term IDR at 'F1';

--Commercial paper rating at 'F1'.

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

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

Applicable Criteria and Related Research:

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

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

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=982844

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Contacts

Fitch Ratings
Primary Analyst
Bob Kirby, CFA
Director
+1 312-368-3147
Fitch Ratings, Inc., 70 West Madison Street, Chicago, IL 60602
or
Secondary Analyst
Gregory Dickerson
Director
+1 212-908-0220
or
Committee Chairperson
Megan Neuburger
Managing Director
+1 212-908-0515
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Bob Kirby, CFA
Director
+1 312-368-3147
Fitch Ratings, Inc., 70 West Madison Street, Chicago, IL 60602
or
Secondary Analyst
Gregory Dickerson
Director
+1 212-908-0220
or
Committee Chairperson
Megan Neuburger
Managing Director
+1 212-908-0515
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com