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Fitch Revises Cardinal Health's Outlook to Negative Following $6B Deal
April 18, 2017 / 11:32 AM / 3 months ago

Fitch Revises Cardinal Health's Outlook to Negative Following $6B Deal

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(The following statement was released by the rating agency) NEW YORK/BUENOS AIRES, April 18 (Fitch) Fitch Ratings has revised Cardinal Health, Inc.'s (Cardinal, NYSE: CAH) Rating Outlook to Negative from Stable following the announcement that it had agreed to acquire certain assets from Medtronic (Not Rated) for approximately $6 billion. KEY RATING DRIVERS The Negative Outlook reflects Fitch's expectation that Cardinal's leverage will remain elevated for the rating category for an extended period of time pro forma for the acquisition of certain assets from Medtronic's Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency businesses for approximately $6 billion. The assets were originally acquired by Medtronic as part of the Covidien acquisition in 2015. ACCELERATING GROWTH IN THE MEDICAL SEGMENT The transaction follows other smaller acquisitions in recent years to grow the medical segment (10% of FY2016 revenues) and will build on the Cordis acquisition of cardiovascular and endovascular medical devices and supplies in 2015 for $1.9 billion. Cardinal has been focused on growing its medical business and increasing its penetration of "preferred products" which often carry Cardinal's logo and may be produced by Cardinal itself. Successful implementation of vertically integrated transactions could result in growing penetration of preferred / generic-like product driving margin expansion and cash flows, expose the company to increased business risk from product liability and potential channel conflicts with other suppliers. Fitch expected that Cardinal would continue to invest in the medical segment, though not to this degree. At approximately $6 billion, the transaction exceeds the $4 billion spent cumulatively since 2012 on related assets including Cordis and AssuraMed. LEVERAGE SUSTAINING ABOVE SENSITIVITES Fitch projects leverage will increase towards 2.4x (gross debt/operating EBITDA after associates) and decline towards 1.9x by FY2020 as compared to Fitch's previous expectations of low- to mid-1x range through FY2020. The revision in Outlook to Negative, rather than a downgrade to 'BBB' reflect that leverage will approach the high end of the range by the second full year of contributions and CAH has some flexibility with capital deployment priorities given Fitch's assumption of $500 million per year of incremental acquisitions, $300 million per year of share repurchases, and a 5% growth rate in the common dividend. The issuer could choose not to invest to this degree though it would likely manifest as a larger cash balance given the lack of debt maturing for CAH to repay beyond what is already maturing. KEY ASSUMPTIONS Fitch's ratings case forecast incorporates the following assumptions: --Revenue growth of 7.5% in 2017 and 4%-6% in 2018-2020. Solid top-line growth in fiscal 2017 is due in large part to M&A (Harvard, Metro, Cordis) and new customers (OptumRx). The 2018 growth rate assumes a 4% run rate in the existing business plus three quarters' worth of contributions from the transaction. --EBITDA margin declines in excess of 10bps in fiscal 2017 and 2018 in existing business lines offset by higher margins in the acquired businesses. Moderate margin pressures in fiscal 2017 - 2018 are from lower branded-drug price inflation, heightened competitive pressures particularly among independent pharmacy customers, and the addition of the OptumRx business (which likely carries lower margins than the overall business). Upside is associated with the pacing of growth in Cardinal's Medical segment strategy and/or the abatement of currently prevailing drug pricing dynamics. --FFO approximating $2.3 billion in 2017 and $2.4 billion in 2018. Cash generation is expected to be slightly less favorably affected by working capital in 2017- 2018, but growing EBITDA will drive growing FFO over the ratings horizon, growing toward $3 billion through 2020. FCF is expected to approximate $1.2 billion-$1.6 billion per year after capital expenditures of 0.4% of revenues, $500 million of acquisitions in excess of the transaction, common dividends growing by 5% per year, and approximately $300 million of share repurchases. --Gross debt/EBITDA of approximately 2.4x in FY2018 reflecting partial-year contributions, declining to 2x and 1.9x in FY2019 and FY2020, respectively. RATING SENSITIVITIES A downgrade to 'BBB' could result from an additional leveraging transaction that causes debt leverage to be sustained above 2x for more than 12-18 months. Debt-funded shareholder-friendly activities or material operational issues, particularly related to Cardinal's Medical segment strategy, could also precipitate a negative rating action. Evidence or anticipation of material margin pressure (either buy-side or sell-side) greater and more direct than currently expected could also pressure ratings. Negative rating actions are not expected to result just from recent shifts in the industry's competitive and pricing dynamics - namely lower branded inflation and key contract renewals. A revision of the Outlook to Stable and maintenance of a 'BBB+' Issuer Default Rating will require gross debt/EBITDA generally between 1.4x and 2x, accompanied by continued robust cash flows and stable or growing margins over the ratings horizon. Fitch has widened the leverage range from 1.4x-1.8x to 1.4x-2x to better reflect the issuer's improving scale, diversification and current business profile as being largely commensurate with its peers. An upgrade to 'A-' is not anticipated in the intermediate term. Upward ratings migration could result from a demonstration of and commitment to operating with debt leverage below 1.4x, combined with responsible M&A activity that supports a sustained commitment to Cardinal's core drug distribution business. LIQUIDITY Cardinal has adequate liquidity with cash balances of $1.9 billion ($552 million held offshore) at Dec. 31, 2016 and near full availability under its $1.75 billion revolving credit facility (RCF) due 2019, plus an undrawn $700 million accounts receivable securitization program. The RCF also backs the $1.75 billion commercial paper program. Cardinal also had $201 million of available-for-sale marketable securities at Dec. 31, 2016 of which Fitch considers approximately $64 million to be available as a source of liquidity after discounting for the types of holdings. Fitch expects Cardinal will supplement this position and fund the transaction by issuing senior unsecured notes before the closing. Fitch expects this plan will be backstopped by a bridge facility. Fitch projects cash flows will remain robust, with annual FFO forecasted to approach $3 billion in the forecast period ($2.4 billion in fiscal 2017). Cash generation is sufficient to fund the firm's dividend and capex requirements. Debt maturities are manageable and well-laddered with approximately $500 million of debt maturing per year through FY2022. The ratings generally assume Cardinal will refinance debt maturities with like amounts though it will likely repay debt maturities over the next few years to reduce leverage. FULL LIST OF RATING ACTIONS Fitch has affirmed the ratings as follows: Cardinal Health, Inc. --Long-Term IDR at 'BBB+'; --Short-Term IDR at 'F2'; --Senior unsecured bank facility at 'BBB+'; --Senior unsecured notes at 'BBB+'; --Commercial Paper at 'F2'. Allegience Corp. --Senior unsecured notes at 'BBB+'. The Rating Outlook has been revised to Negative from Stable. Contact: Primary Analyst Britton Costa, CFA Senior Director +1-212-908-0524 Secondary Analyst Bob Kirby, CFA Director +1-312-368-3147 Committee Chairperson John Kempf, CFA Senior Director +1-646-582-4710 Date of Relevant Rating Committee: April 17, 2017 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: Aside from financial adjustments customary to U.S. Corporates (removal of non-cash expenses, such as stock-based compensation expenses, from EBITDA calculation), Fitch notes that EBITDA has been adjusted to add back reported LIFO expense figures when material. Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Additional information is available on www.fitchratings.com Applicable Criteria Criteria for Rating Non-Financial Corporates (pub. 10 Mar 2017) here Parent and Subsidiary Rating Linkage (pub. 31 Aug 2016) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here#solicitation Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE. 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Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. The manner of Fitch’s factual investigation and the scope of the third-party verification it obtains will vary depending on the nature of the rated security and its issuer, the requirements and practices in the jurisdiction in which the rated security is offered and sold and/or the issuer is located, the availability and nature of relevant public information, access to the management of the issuer and its advisers, the availability of pre-existing third-party verifications such as audit reports, agreed-upon procedures letters, appraisals, actuarial reports, engineering reports, legal opinions and other reports provided by third parties, the availability of independent and competent third- party verification sources with respect to the particular security or in the particular jurisdiction of the issuer, and a variety of other factors. Users of Fitch’s ratings and reports should understand that neither an enhanced factual investigation nor any third-party verification can ensure that all of the information Fitch relies on in connection with a rating or a report will be accurate and complete. Ultimately, the issuer and its advisers are responsible for the accuracy of the information they provide to Fitch and to the market in offering documents and other reports. In issuing its ratings and its reports, Fitch must rely on the work of experts, including independent auditors with respect to financial statements and attorneys with respect to legal and tax matters. Further, ratings and forecasts of financial and other information are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts. As a result, despite any verification of current facts, ratings and forecasts can be affected by future events or conditions that were not anticipated at the time a rating or forecast was issued or affirmed. The information in this report is provided “as is” without any representation or warranty of any kind, and Fitch does not represent or warrant that the report or any of its contents will meet any of the requirements of a recipient of the report. A Fitch rating is an opinion as to the creditworthiness of a security. This opinion and reports made by Fitch are based on established criteria and methodologies that Fitch is continuously evaluating and updating. Therefore, ratings and reports are the collective work product of Fitch and no individual, or group of individuals, is solely responsible for a rating or a report. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. 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