CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings of Allergan plc (Allergan; NYSE: AGN) and subsidiaries at 'BBB-'. The Rating Outlook is Stable.
A full list of rating actions, which apply to approximately $32.8 billion of debt outstanding at Sept. 30, 2016, follows at the end of this release.
KEY RATING DRIVERS
Scaled and Growing
Allergan is among the largest pharmaceutical companies in the world, with a diversified, durable, and growing product portfolio and a strong product pipeline. Fitch expects Allergan to generate mid- to high-single-digit organic sales growth, strengthened through strategic acquisitions, over the ratings horizon. However, expectations for EBITDA and FCF growth have moderated somewhat during 2016.
Strong Liquidity, Robust FCF
Liquidity is strong, given large cash balances remaining from the sale of its generics business to Teva Pharmaceutical Industries Ltd. (NYSE: TEVA; 'BBB'/Stable), and about 100 million Teva shares, which may be monetized mid-2017. Fitch expects Allergan to generate robust pre-dividend FCF of $4 billion or more in 2017 on. Strong FCF supports management's commitment to repay all debt maturing in 2017-2018 and continued public commentary suggesting that M&A will be funded with internal liquidity. Furthermore, Allergan's Irish domicile provides an efficient tax structure and allows the firm to use its cash without material repatriation penalties.
Differentiated R&D Strategy
Allergan is pioneering a somewhat new R&D strategy termed "Open Science" by the firm. While Fitch agrees that the strategy should have lower development risk than that of most traditional pharma firms, we recognize that large cash outflows related to in-licensing and milestone payments ($542 million YTD 2016) will offset lower organic/adjusted R&D expenses, which lead to somewhat inflated EBITDA margins and understated leverage figures.
Notably, this dynamic is likely to moderate in the longer term, as Fitch expects acquired R&D to become a smaller proportion of total R&D activities as the firm grows. Fitch's treatment of these expenses is discussed further below.
Shareholder Payouts Reduce Divestiture Benefits
Large-scale share repurchase activity and the initiation of a dividend commits a sizeable portion of liquidity and FCF to shareholders, therefore reducing the benefits of the generics divestiture for bondholders. However, at current levels, shareholder payouts should not threaten the repayment of debt maturing in 2017-2018, funded with remaining liquidity and FCF, to the advantage of bondholders.
Active Acquirer, Now More Targeted
Fitch expects Allergan will remain an active acquirer, using steady FCF and large cash balances for targeted growth-oriented assets. Deals are expected to be generally smaller and funded with internally-generated liquidity, supporting a more stable debt leverage profile than during the past five years. However, management has stated that large leveraging M&A is not out of the question.
A short period of several transformational acquisitions and divestitures poses the risk of operational inefficiencies and/or financial dis-synergies. Fitch's assessment of Allergan's management team is strong; though a continued active M&A strategy adds to the risk of a transactional or operational misstep.
Allergan's 'BBB-' ratings consider run-rate gross debt/EBITDA in the range of 3x-3.5x. Possible temporary increases are permitted if expected to be followed by a period of de-leveraging. Annual post-dividend, post-milestone FCF of at least $1 billion-$2 billion should provide ample ongoing liquidity for continuing bolt-on acquisitions of established businesses and in-process R&D assets.
Several facets of Allergan's credit profile could support higher ratings than the current 'BBB-', including its growth outlook, profitability, and durable product portfolio. Positive ratings momentum is slowed to the degree internal liquidity is directed toward share repurchases and committed dividend payouts. Nevertheless, a capital deployment strategy that provides a period of time without large, leveraging M&A that allows gross debt/EBITDA trending to 3x or below on a reported basis will be required before an upgrade to 'BBB' is considered. In the meantime, Fitch expects Allergan to operate with solid financial flexibility at current ratings.
A downgrade could be considered if the firm were to pursue a significantly large debt-funded acquisition (particularly before repaying 2017 bond maturities and in light of directing large amounts of divestiture proceeds toward shareholders) that would cause gross debt/EBITDA to be sustained above 3.5x for a period of greater than 18-24 months. Given the well-diversified nature of Allergan's product portfolio, a downgrade scenario involving operational difficulties is unlikely.
Fitch makes the following key assumptions in its ratings case forecast for Allergan:
--Organic sales growth in the mid-single digits in 2016, accelerating to high single digits in 2018-2019; total revenues exceeding $16 billion in 2018.
--Heightened SG&A associated with recently-launched products and growing R&D costs offset gross margin improvements, resulting in steady EBITDA margins around 50%.
--All debt maturities repaid (not refinanced) in 2017-2018, leading to debt balances of $30.1 billion and $26.4 billion and gross debt/EBITDA of 4.0x and 3.3x at YE2017 and 2018, respectively.
--M&A funded only with internal liquidity in 2016-2017.
STRONG FINANCIAL FLEXIBILITY
Fitch does not expect further debt repayment in 2016 and expects annual FCF in excess of debt maturities in 2017-2018. Estimated debt maturities, pro forma for recent debt repayment, include: $2.7 billion in 2017; $3.75 billion in 2018; $1.95 billion in 2019; $4.65 billion in 2020; and $19.7 billion thereafter.
Unlike many of its U.S. pharma peers, Allergan is able to use substantially all of its cash flows free from the relatively high U.S. taxes associated with repatriation of earnings generated outside the U.S. Notably, this advantage relative to U.S. domiciled peers could wane depending on possible reformation of the U.S. tax code.
FOCUS ON BRANDED "GROWTH PHARMA"
Allergan has emerged from several transformative acquisitions and, now, divestitures, as a wholly branded pharmaceutical company, with a meaningful presence in eye care (Rx and consumer), medical aesthetics & dermatology, central nervous system, gastroenterology, women's health, urology, and anti-infective therapeutic categories. The firm has placed itself in a self-described category of "growth pharma," aspiring to double-digit annual sales growth.
There are relatively few synergy opportunities for firms operating both branded and generic pharma businesses in North America. Branded products require significant investment in R&D and S&M, while pure generic drugs require less R&D and almost no S&M. With a limited presence outside the U.S. in its branded pharma business, Allergan's divestiture of its generics business - albeit a meaningful EBITDA and FCF contributor - was strategically sound. Furthermore, the global generic drug industry is in the midst of large-scale consolidation, and Allergan management decided that the firm would not be a consolidator in generics and needed to divest the business in order for it to be optimally successful.
STRONG GROWTH FROM DIVERSIFIED, DURABLE PRODUCT PORTFOLIO
Allergan's product portfolio is diversified, durable, and growing. Growth is further strengthened by a relatively promising R&D pipeline and a few key recent new product launches.
Allergan's top-selling product (Botox) is expected to account for less than 20% of total sales, and the top 5 products (Botox, Restasis, Fillers, Namenda/Namzaric, Lumigan/Ganfort) will generate less than 45% of total sales. Botox on its own generates sales from both cosmetic and various therapeutic indications (~45%/~55% split), further supporting diversification.
Namenda and Restasis are contending with new forms of competition - generic Namenda IR was launched in July 2015 and Shire launched a competing dry-eye treatment in August - but most of the rest of Allergan's top-selling products are not expected to face direct competition during the ratings horizon.
Allergan stemmed losses from Namenda IR's patent expiration through patient switching to an extended-release formulation, Namenda XR. Recently launched Namzaric is a therapy that combines Namenda XR and generic Aricept for the treatment of Alzheimer's. Such combination is common already in practice, so Fitch shares Allergan's expectation that Namzaric could grow to replace a sizeable portion of today's Namenda XR sales over the ratings horizon. We forecast sales of Namenda/Namzaric to remain fairly steady, but with some net erosion in the 2016-2018 timeframe.
Shire's Xiidra is expected to gain market share slowly given Restasis' long-standing position as the only therapy for the treatment of dry eye specifically. Most growth will likely come from overall market growth. However, longer-term sales erosion could occur depending on outcomes and emerging prescribing patterns, but probably not materially before 2018. Even still, the overall market for dry eye is growing as the disease is diagnosed with increasing frequency in the U.S. Markets outside the U.S. are largely underpenetrated.
Recent product launches should provide solid growth for Allergan for the foreseeable future. Key products recently launched include Linzess, Viberzi, and Vraylar. We forecast sales of $823 million, $1.19 billion, and $1.57 billion for these products in 2016, 2017, and 2018, respectively.
"OPEN SCIENCE" R&D MODEL
Allergan has demonstrated that its R&D strategy will rely primarily on the acquisition of programs and products from other sources over the discovery activities of traditional pharma. Spending for such transactions YTD in 2016 is nearly $2 billion. Continuing business organic R&D (before acquisitions) is expected to approximate $1.5 billion for the year.
This strategy is somewhat unique in the industry, such that the firm has coined the term "Open Science" to describe its model. Management asserts that this strategy is a more efficient and transparent use of shareholder investment, since traditional discovery activities will inherently include failures and since success rates and amounts invested in failed therapies are almost never disclosed. In theory, we tend to agree with Allergan's claims, but the model is too new and the trends too nascent to form any conclusions concrete enough to help or hurt the credit profile.
While large established pharma firms usually spend a relatively steady percentage of revenues for R&D activities, Allergan's R&D-related cash outlays will probably be more sporadic. Furthermore, upfront spending to acquire R&D assets represent only a portion of spending, as nearly all the deals the firm has consummated thus far include a sizeable portion of total consideration in the form of milestone payments and/or sales-based royalties. This strategy helps de-risk these investments, and may help smooth costs, but will require internal liquidity and ongoing strong cash generation.
U.S. GAAP requires that upfront acquisition costs and development milestones paid for R&D programs/products be expensed as R&D. Sales-based milestones are expensed as a portion of cost of sales. Approval-based milestones are capitalized and amortized as expenses over time, recognized as investing or financing cash flows when paid. This treatment can result in sporadic EBITDA and FFO figures and convoluted R&D productivity measures.
Because the acquisition of in-process R&D assets is expected to comprise a material portion of Allergan's R&D strategy, Fitch has decided to treat all such transactions as acquisitions of businesses, removing related one-time expenses from COGS and R&D. Upfront acquisition costs are instead recognized in investing cash flows (as acquisitions) and milestone payments are recognized as non-recurring operating cash flows. In this way, we account for the discretionary nature and the otherwise lumpy effects of upfront acquisition costs, removing them from EBITDA and FFO and classifying them as acquisitions to be funded with FCF. Milestone payments, too, are removed from EBITDA and FFO. However, these payments are not discretionary, and classifying them as non-recurring operating cash flows appropriately reduces FCF available for debt service, acquisitions, and share repurchases. Importantly, going-forward R&D costs related to acquisitions are not removed from reported R&D expenses, resulting in projected EBITDA and FFO that correctly takes into account the increasing R&D spend that follows after the acquisition of an in-process R&D asset.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
--Issuer-Default Rating (IDR) at 'BBB-'.
Warner Chilcott Limited
--IDR at 'BBB-'.
Actavis Funding SCS
--Senior unsecured notes at 'BBB-'.
Allergan Finance LLC (fka Actavis, Inc.)
--IDR at 'BBB-';
--Senior unsecured notes at 'BBB-'.
Forest Laboratories, Inc.
--IDR at 'BBB-';
--Senior unsecured notes at 'BBB-'.
--IDR at 'BBB-';
--Senior unsecured notes at 'BBB-'.
The Rating Outlook for all IDRs is Stable.
Date of Relevant Rating Committee: Dec. 7, 2016
Summary of Financial Statement Adjustments
Financial statement adjustments that depart materially from those contained in the published financial statements are outlined in the section titled "Fitch-Specific Treatment" above. Other adjustments are customary for U.S. Corporates, including the removal of stock-based compensation and other non-cash and non-recurring expenses from Fitch's EBITDA calculation.
Additional information is available at www.fitchratings.com
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
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