Ed Silverman06.01.10
For years, the pharmaceutical industry could crow about a pristine credit rating. Drugmaker after drugmaker issued debt and, thanks to strong cash flows, huge revenue and healthy product pipelines, the interest rates paid were as competitive as could be. But like so much else that now characterizes this beleaguered industry, those heady days are gone.
Today, the world's biggest drug makers collectively face worsening credit ratings and the prospects for an improvement just don't seem to be on the horizon. Over the past few years, a perfect storm has emerged. Much of this will sound familiar - the confluence of major patent expirations and thinning pipelines, as we know, prompted big mergers. Yet these debt-financed deals and ongoing share buybacks used to prop up stock prices have combined to weaken credit.
Consider some numbers. The aggregate industry debt reached $270 billion at the end of last year, compared with $124 billion at the end of 2006 - that's an eye-opening increase of 117%, according to Moody's Investor Service. Meanwhile, the industry's cash position grew by 25%, to $234 billion. That might seem like a healthy sum but, in fact, the industry turned from a net cash position to a net debt position of $36 billion in just three years.
As one might expect, the drug makers with the largest changes in debt include Pfizer, Roche and Merck, due to the respective acquisitions of Wyeth, Genentech and Schering-Plough. But others have also increased debt levels, typically for acquisitions and share repurchases. The list includes Novartis, Johnson & Johnson, AstraZeneca and GlaxoSmithKline.
So it's not surprising that Moody's now views the median rating for the large global drug makers as A2, down two notches from Aa3 in 2006. Why does this matter? In short, the industry faces what the rating agency calls "less (of a) cushion" to fund more M&A without risking further damage to credit ratings. Yet drug makers are in a conundrum; to grow, they will have to continue to deal for other players, if not consider a large merger, for the foreseeable future.
"One of our predictions is that there will, in fact, be more M&A," Michael Levesque, a Moody's senior vice president who follows the pharmaceutical industry, told us. "It's a clear trend. Whether we'll see more of the huge mega-mergers remains to be seen. It's still possible. Right now, it would have to be slower than last year [when Merck bought Schering-Plough, Pfizer acquired Wyeth and Roche scooped up the remainder of Genentech], but deals won't be taken off the table."
Such views are increasingly shared by executives at many pharmaceutical and biotech companies, too. A recent survey of more than 380 industry executives by Marks & Clerk, a firm of patent attorneys in the UK, found that 68% believe substantial acquisition activity will occur within the next two years and 19% anticipate "major activity" within the next year. Why? A sobering 82% predict big drugmakers - almost certainly, a group of companies that includes some of their own employers - won't be able to innovate sufficiently from within or via in-licensing to replenish dwindling pipelines.
The most recent example cropped up in mid-May, when Astellas Pharma, Japan's second-biggest drugmaker, agreed to pay $4 billion to scoop up OSI Pharmaceuticals. The motivation was fairly simple: beyond wanting to expand its oncology business by winning OSI's Tarceva medication, Astellas needed to compensate for patent expirations on two of its flagship products - Flomax treatment for urinary incontinence and Prograf, an organ transplant drug.
Knowing this deal was likely to occur - Astellas had to sweeten its bid, but showed no intention of walking away at any time since its initial bid - Moody's recently placed the drugmaker under review for a possible credit downgrade to Aa3 from Aa2, the third-highest of 10 investment grades. Even though Astellas doesn't have any long-term borrowing, the rating service figured the drugmaker's cash position may deteriorate in order to buy OSI stock and then issue external debt to fund operations. You can be sure Astelllas executives knew this was likely to occur, but they were undeterred. "Companies can be willing to sacrifice ratings to pursue their strategies," says Moody's Mr. Levesque. "We know where companies have come out on that decision. And we expect that to continue."
Of course, cash is king. As he points out, one of Moody's key metrics for examining balance sheets for drugmakers is cash coverage of debt, which measures the adjusted cash relative to adjusted debt. A ratio of 100%, for instance, would indicate zero net debt. But among drug makers, this ratio has been declining steadily during the past three years from 95.4% at the end of 2006 to 58.4% at the end of last year.
And what exactly is happening to all that cash? After all, so many drugmakers are throwing so many employees overboard and closing numerous facilities. In May, for instance, Pfizer announced that the latest installment of the Incredible Shrinking Drugmaker would involve eliminating 6,000 manufacturing jobs as eight more plants located in various countries would eventually be shuttered. But it's not that simple to say such cutbacks are translated quickly into savings that can be deposited in the bank. In some cases, cash is being used not just for acquisitions, but also to buy back gobs of stock.
Last November, Merck's board approved a $3 billion share buyback. There was no timeframe set for the purchases, but the announcement came in the same month that its acquisition of Schering-Plough was completed. More recently, Bristol-Myers Squibb announced its own $3 billion share buyback. Although the drugmaker had about $9.8 billion in cash and marketable securities on hand at the time, the plan still involves a sizeable portion of assets. Within days, Gilead Sciences announced a $5 billion stock repurchase program of its own, which won a vote of confidence from Standard & Poor's healthcare analyst Steve Silver, who wrote in an investor brief that the biotech is "well positioned" to execute on its strategy and "still acquire new growth assets to diversify revenues."
There are different ways to view this sort of move. Top executives always want to bolster their share price - there are myriad selfish reasons for doing so, of course - and pharmaceutical stocks, in particular, have taken a beating in recent years. Those drugmakers that are blessed with large amounts of cash on hand are simply reasoning that buying back its stock on a dip is a good way to use those funds.
Then again, why not keep more money on hand if acquisitions are more likely? There is more than one devil's advocate at play here, because there is always the possibility that the pipeline being purchased - be it a sizeable company or a collection of compounds - will fail to deliver on the initial promise. And since the bidding is driving up prices GSK chief executive Andrew Witty recently disclosed that his team turned its nose at a handful of possibilities because the price tags were too high - finding another use for the cash and, presumably, pleasing investors at the same time is a comforting alternative.
"When there's really no other investment to make and the company isn't taking on debt to execute the share repurchase, we view that as neutral," says Mr. Levesque. "We usually prefer deploying cash to purchase an asset that would generate cash flow, but these assets do come with risks. They are pipelines, after all."
The upshot is that running the risk of a poor credit rating just won't matter. After all, the biggest players have impressive offshore cash positions and tax schemes to maximize those holdings, so the need to blunt higher borrowing costs can wait. And as Mr. Levesque reminds us, the pharma sector still remains rather healthy compared with others. So who needs good credit?
Ed Silverman is a prize-winning journalist who has covered the pharmaceutical industry for The Star-Ledger of New Jersey, one of the nation's largest daily newspapers, for more than 12 years. Prior to joining The Star-Ledger, Ed spent six years at New York Newsday and previously worked at Investor's Business Daily. Ed blogs about the drug industry at Pharmalot. He can be reached at ed.silverman@comcast.net.
Today, the world's biggest drug makers collectively face worsening credit ratings and the prospects for an improvement just don't seem to be on the horizon. Over the past few years, a perfect storm has emerged. Much of this will sound familiar - the confluence of major patent expirations and thinning pipelines, as we know, prompted big mergers. Yet these debt-financed deals and ongoing share buybacks used to prop up stock prices have combined to weaken credit.
Consider some numbers. The aggregate industry debt reached $270 billion at the end of last year, compared with $124 billion at the end of 2006 - that's an eye-opening increase of 117%, according to Moody's Investor Service. Meanwhile, the industry's cash position grew by 25%, to $234 billion. That might seem like a healthy sum but, in fact, the industry turned from a net cash position to a net debt position of $36 billion in just three years.
As one might expect, the drug makers with the largest changes in debt include Pfizer, Roche and Merck, due to the respective acquisitions of Wyeth, Genentech and Schering-Plough. But others have also increased debt levels, typically for acquisitions and share repurchases. The list includes Novartis, Johnson & Johnson, AstraZeneca and GlaxoSmithKline.
So it's not surprising that Moody's now views the median rating for the large global drug makers as A2, down two notches from Aa3 in 2006. Why does this matter? In short, the industry faces what the rating agency calls "less (of a) cushion" to fund more M&A without risking further damage to credit ratings. Yet drug makers are in a conundrum; to grow, they will have to continue to deal for other players, if not consider a large merger, for the foreseeable future.
"One of our predictions is that there will, in fact, be more M&A," Michael Levesque, a Moody's senior vice president who follows the pharmaceutical industry, told us. "It's a clear trend. Whether we'll see more of the huge mega-mergers remains to be seen. It's still possible. Right now, it would have to be slower than last year [when Merck bought Schering-Plough, Pfizer acquired Wyeth and Roche scooped up the remainder of Genentech], but deals won't be taken off the table."
Such views are increasingly shared by executives at many pharmaceutical and biotech companies, too. A recent survey of more than 380 industry executives by Marks & Clerk, a firm of patent attorneys in the UK, found that 68% believe substantial acquisition activity will occur within the next two years and 19% anticipate "major activity" within the next year. Why? A sobering 82% predict big drugmakers - almost certainly, a group of companies that includes some of their own employers - won't be able to innovate sufficiently from within or via in-licensing to replenish dwindling pipelines.
The most recent example cropped up in mid-May, when Astellas Pharma, Japan's second-biggest drugmaker, agreed to pay $4 billion to scoop up OSI Pharmaceuticals. The motivation was fairly simple: beyond wanting to expand its oncology business by winning OSI's Tarceva medication, Astellas needed to compensate for patent expirations on two of its flagship products - Flomax treatment for urinary incontinence and Prograf, an organ transplant drug.
Knowing this deal was likely to occur - Astellas had to sweeten its bid, but showed no intention of walking away at any time since its initial bid - Moody's recently placed the drugmaker under review for a possible credit downgrade to Aa3 from Aa2, the third-highest of 10 investment grades. Even though Astellas doesn't have any long-term borrowing, the rating service figured the drugmaker's cash position may deteriorate in order to buy OSI stock and then issue external debt to fund operations. You can be sure Astelllas executives knew this was likely to occur, but they were undeterred. "Companies can be willing to sacrifice ratings to pursue their strategies," says Moody's Mr. Levesque. "We know where companies have come out on that decision. And we expect that to continue."
Of course, cash is king. As he points out, one of Moody's key metrics for examining balance sheets for drugmakers is cash coverage of debt, which measures the adjusted cash relative to adjusted debt. A ratio of 100%, for instance, would indicate zero net debt. But among drug makers, this ratio has been declining steadily during the past three years from 95.4% at the end of 2006 to 58.4% at the end of last year.
And what exactly is happening to all that cash? After all, so many drugmakers are throwing so many employees overboard and closing numerous facilities. In May, for instance, Pfizer announced that the latest installment of the Incredible Shrinking Drugmaker would involve eliminating 6,000 manufacturing jobs as eight more plants located in various countries would eventually be shuttered. But it's not that simple to say such cutbacks are translated quickly into savings that can be deposited in the bank. In some cases, cash is being used not just for acquisitions, but also to buy back gobs of stock.
Last November, Merck's board approved a $3 billion share buyback. There was no timeframe set for the purchases, but the announcement came in the same month that its acquisition of Schering-Plough was completed. More recently, Bristol-Myers Squibb announced its own $3 billion share buyback. Although the drugmaker had about $9.8 billion in cash and marketable securities on hand at the time, the plan still involves a sizeable portion of assets. Within days, Gilead Sciences announced a $5 billion stock repurchase program of its own, which won a vote of confidence from Standard & Poor's healthcare analyst Steve Silver, who wrote in an investor brief that the biotech is "well positioned" to execute on its strategy and "still acquire new growth assets to diversify revenues."
There are different ways to view this sort of move. Top executives always want to bolster their share price - there are myriad selfish reasons for doing so, of course - and pharmaceutical stocks, in particular, have taken a beating in recent years. Those drugmakers that are blessed with large amounts of cash on hand are simply reasoning that buying back its stock on a dip is a good way to use those funds.
Then again, why not keep more money on hand if acquisitions are more likely? There is more than one devil's advocate at play here, because there is always the possibility that the pipeline being purchased - be it a sizeable company or a collection of compounds - will fail to deliver on the initial promise. And since the bidding is driving up prices GSK chief executive Andrew Witty recently disclosed that his team turned its nose at a handful of possibilities because the price tags were too high - finding another use for the cash and, presumably, pleasing investors at the same time is a comforting alternative.
"When there's really no other investment to make and the company isn't taking on debt to execute the share repurchase, we view that as neutral," says Mr. Levesque. "We usually prefer deploying cash to purchase an asset that would generate cash flow, but these assets do come with risks. They are pipelines, after all."
The upshot is that running the risk of a poor credit rating just won't matter. After all, the biggest players have impressive offshore cash positions and tax schemes to maximize those holdings, so the need to blunt higher borrowing costs can wait. And as Mr. Levesque reminds us, the pharma sector still remains rather healthy compared with others. So who needs good credit?
Ed Silverman is a prize-winning journalist who has covered the pharmaceutical industry for The Star-Ledger of New Jersey, one of the nation's largest daily newspapers, for more than 12 years. Prior to joining The Star-Ledger, Ed spent six years at New York Newsday and previously worked at Investor's Business Daily. Ed blogs about the drug industry at Pharmalot. He can be reached at ed.silverman@comcast.net.