News Column

Fitch Affirms Cardinal Health at 'BBB+'; Outlook Stable

February 12, 2014

CHICAGO--(BUSINESS WIRE)-- Fitch Ratings has affirmed the ratings of Cardinal Health, Inc. (Cardinal), including the long-term Issuer Default Rating (IDR), at 'BBB+'. The Rating Outlook is Stable.

The ratings apply to approximately $3.9 billion of debt at Dec. 31, 2013. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

-- The oligopolistic nature of the U.S. drug distribution industry and steady pharmaceutical demand contribute to exceptionally stable operating profiles for Cardinal and its peers, excluding recent contract switches. Drug distribution, though low margin, is relatively insulated from pricing and regulatory pressures faced by other areas of healthcare in the U.S.

-- Margins and cash flows continue to benefit from the mostly durable effects of the generic wave, which is set to ramp up again in calendar 2014-2015. Cardinal's joint venture (JV) with CVS Caremark Corp. (CVS) and the anticipated introduction of biosimilar drugs to the U.S. drug channel should further support margins beginning in 2015-2016.

-- Overall industry trends, including brand-to-generic conversions, favorable drug pricing, and base business growth, are offsetting the Fitch-estimated $230 million of lost EBITDA from expired contracts with Express Scripts, Inc. (ESRX) and Walgreen Co. (Walgreens). Fitch projects modestly higher EBITDA in fiscal 2014 and 2015 compared to 2013, despite the loss of about $30 billion in annual sales.

-- Cardinal's material underrepresentation in the specialty drug distribution space relative to its peers could hinder intermediate-term growth and profitability. The acquisition of AssuraMed and Cardinal's plans for growing its Medical business present compelling growth opportunities and could offset this concern somewhat, but could also introduce new forms of operating risk (e.g. product liability) depending on the strategies pursued.

-- Fitch expects Cardinal to generate cash sufficient to fund operations, shareholder payouts, targeted M&A, and debt service. Solid liquidity is supported by relatively large available cash balances, and only $500 million of debt is due before October 2016.

RATING SENSITIVITIES

Maintenance of a 'BBB+' IDR will require debt leverage generally maintained below 1.7x, accompanied by continued robust cash flows and stable or growing margins over the ratings horizon (excluding the impact of the lost Walgreens contract). Liquidity should be adequate to fund targeted M&A that bolsters the firm's intermediate-term growth outlook; but there is currently limited room for additional long-term debt at the 'BBB+' ratings.

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 1.2x-1.3x, combined with responsible M&A activity that contributes to an overall improved intermediate-term growth outlook. A sustained commitment to Cardinal's core distribution business will also be necessary to support the consideration of an upgrade.

A downgrade to 'BBB' could result from a leveraging transaction that causes debt leverage to increase to above 1.7x for materially more than 12-18 months. Debt-funded shareholder-friendly activities could also precipitate a negative rating action. The development of a material competitive gap between Cardinal and its peers, possibly arising from the firm's lagging position in specialty distribution, could also pressure ratings.

MODESTLY GROWING EBITDA DESPITE SIGNIFICANT CONTRACT LOSSES

The Fitch-estimated $200 million-$250 million in EBITDA associated with the lost Walgreen Co. (Walgreens) and Express Scripts, Inc. (ESRX) contracts is being offset by the effects of generic conversions, favorable drug pricing, and the addition of AssuraMed. Another wave of generic conversions is now accelerating and will support margins over the next couple years. Fitch forecasts modestly growing EBITDA and relatively steady credit metrics for Cardinal in fiscal 2014-2015 compared to 2013. Notably, Cardinal's peers are experiencing similar margin support from industry trends without significant volume declines.

Despite the very low-margin nature of the aforementioned contracts and the now decreased customer concentration, the removal of such a large amount of drug volumes is a moderate credit negative. Cardinal will no longer benefit from the operating stability and superior growth prospects generally associated with these drug channel participants. Furthermore, the removal of such a large amount of volumes will lessen Cardinal's ability to leverage the largely fixed cost structure inherent in drug distribution.

Fitch believes Cardinal has adjusted appropriately thus far and will continue to review and optimize its cost structure as it annualizes the Walgreens contract expiration so as to limit the credit impact of these developments.

INTERMEDIATE-TERM GROWTH CONCERNS; OFFSET SOMEWHAT BY MEDICAL STRATEGY

Fitch remains concerned about Cardinal's intermediate-term growth profile, primarily due to the company's significant under-representation in specialty drug distribution. Cardinal's lagging position in this important growth market could become more glaring after the bulk of the generic wave has washed through the channel and biosimilars begin to gain market acceptance in 2016 and beyond. Fitch is not convinced that Cardinal's current strategy will take a significant share of the specialty distribution market over the ratings horizon.

Fitch estimates AmerisourceBergen Corp. (ABC), McKesson Corp. (McKesson), and Cardinal control approximately 55%, 25%, and 5% of the specialty drug distribution (primarily to care providers) market in the U.S., respectively.

Cardinal's 2013 acquisition of AssuraMed does provide a profitable growth platform for the firm; but it does not fully address Fitch's concerns. Especially since losing its contract with Walgreens, Cardinal has focused more of its public comments on its strategy to grow its Medical business. Fitch generally views this shift in strategy as appropriate and expects both internal and external investment to support solid Medical segment growth over time.

On balance, Fitch thinks Cardinal will pursue these opportunities responsibly and that most transactions will be funded with cash on hand. Success in this area could alleviate Fitch's intermediate-term growth concerns over time. Fitch views certain tenets of Cardinal's outlined strategy for growing its Medical segment cautiously though, depending on the pacing thereof. Specifically, Fitch is wary of new types of business risk that could accompany potential acquisition targets (i.e. product liability with manufacturing).

JV WITH CVS TO DRIVE COST SAVINGS; DIFFERENTIATED FROM PEERS

The 10-year joint venture Cardinal announced with CVS Caremark Corp. (CVS) in December 2013 should provide both firms with cost savings, ramping up over the course of calendar 2015 and beyond. Cardinal also disclosed that it had extended its distribution contract with CVS through 2019. Fitch thinks future collaborative agreements between the two firms are possible, though the current relationship is strictly for the procurement of generic drugs, excluding injectables. Notably, CVS' Caremark PBM business is served under a contract with McKesson that was just renewed in April 2013.

The CVS/Cardinal JV will become the largest purchaser of generic drugs in the U.S., and the second-largest in the world. The JV is similar in principle to the other scale-aggregating deals executed over the last 12 months, though it lacks the equity ownership components of the other two. Fitch expects the benefits of increased scale to be recognized more or less in proportion to the purchasing power of each entity over the course of the next few years. The longer-term implications of the various degrees of business integration are at this time difficult to measure and predict.

GOOD LIQUIDITY, CASH FLOWS; MANAGEABLE DEBT MATURITIES

Fitch expects Cardinal's liquidity to remain strong over the ratings horizon, bolstered in the near term by a significant cash inflow from working capital associated with the expired WAG contract. Cash flows will remain robust, with annual free cash flow (FCF) forecasted to exceed $1 billion in the forecast period. Fitch thinks the firm will generate sufficient cash to sufficiently fund operations and internal investment, to fulfill its public commitment to shareholder payouts, and to consummate small-to-medium sized M&A that strengthens intermediate-term growth prospects.

Debt maturities are manageable, with only $500 million of debt coming due before October 2016. Fitch estimates debt maturities as follows: $500 million in fiscal 2015; $770 million in 2017; $560 million in 2018; and $1.78 billion thereafter. Fitch expects debt to be refinanced as it comes due over the ratings horizon.

Fitch has affirmed Cardinal's ratings as follows:

-- Long-term IDR at 'BBB+';

-- Senior unsecured bank facility at 'BBB+';

-- Senior unsecured notes at 'BBB+';

-- Short-term IDR at 'F2';

-- Commercial paper at 'F2'.

Fitch has also assigned a long-term IDR of 'BBB+' to Allegiance Corp., an issuer subsidiary of Cardinal.

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' (Aug. 5, 2013);

--'U.S. Healthcare Stats Quarterly - Third-Quarter 2013' (Jan 2, 2014);

--'2014 Outlook: U.S. Healthcare - Secular Challenges Require a Compelling Value Proposition' (Nov. 25, 2013);

--'Trekking the Path to Biosimilars - The Destination' (Oct. 4, 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:

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

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

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

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726356

2014 Outlook: U.S. Healthcare -- Secular Challenges Require a Compelling Value Proposition

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724141

Trekking the Path to Biosimilars -- The Destination

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

Vital Signs -- Currents in the Drug Channel

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

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

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

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=820355

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE '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. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.



Fitch Ratings

Primary Analyst

Jacob Bostwick, CPA

Associate Director

+1-312-369-3169

Fitch Ratings, Inc.

70 W Madison Street

Chicago, IL 60602

or

Secondary Analyst

Bob Kirby, CFA

Director

+1-312-368-3147

or

Committee Chairperson

John Culver

Senior Director

+1-312-368-3216

or

Media Relations:

Brian Bertsch, +1-212-908-0549 (New York)

brian.bertsch@fitchratings.com


Source: Fitch Ratings


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