Regulatory changes and strategic M&A are among six key risk categories in the healthcare and pharmaceutical sector, according to a special report by Fitch Ratings.
Authors of the report cited mega-deals like Bristol-Myers Squibb Co.'s acquisition of Celgene Corp. and proposals like Medicare for All as potential negatives for credit profiles.
Regulatory risk, in particular, was highlighted as a "perennial concern" for the healthcare industry, especially with persisting debates around drug pricing. Other risks, identified as "event risks" not built into a company's existing ratings profile include contingent liabilities, special payments to shareholders, financial sponsor M&A and monetization of assets.
The report evaluated 19 companies across the industry, including medical device makers, healthcare distributors, pharmaceuticals and laboratories.
In both strategic and financial sponsor M&A, Fitch suggested that the vulnerability companies face is generally low to moderate; however, the report singled out Mylan NV as a high-risk company for strategic M&A.
Mylan is undergoing a strategic review, which may increase chances of "a transformational type transaction," Fitch said.
Fitch noted that companies with healthy drug development pipelines and good organic growth prospects are less likely to pursue defensive M&A; in addition, companies with acquisitions "posting lackluster returns" may also be leery of pursuing further deals.
Despite the fact that many of the report's evaluated companies, including Bristol-Myers, do not have the capacity for another large acquisition without risking investment-grade ratings, Fitch said, M&A should still be a source of growth for the industry.
"Building scale through M&A is an important part of a strategy to combat pricing pressure increasingly felt across the healthcare industry," Fitch said.
The report also pointed out that the pharmaceutical industry "does not lend itself to a robust investment case for a financial buyer," citing the inherent product development risk and unpredictability of pharma as potential unappealing factors for financial sponsors.
Within the healthcare industry as a whole, Fitch said political and regulatory developments are also contributing to the unlikelihood of a financial buyer.
Fitch's report warned that the political environment in 2019 is "more volatile," particularly pointing to the continued emphasis on lowering healthcare costs in the U.S.
Fitch identified 11 companies as high-risk in this area, including all eight of the evaluated pharma companies: Allergan PLC, Amgen Inc., Bristol-Myers, Eli Lilly and Co., Johnson & Johnson, Merck & Co. Inc., Mylan and Pfizer Inc. Healthcare distributors AmerisourceBergen Corp., Cardinal Health Inc. and McKesson Corp. were also listed as high-risk in this category.
According to Fitch, the high-risk companies have the most direct exposure to "threats to pricing power and, by extension, profitability and cash flow."
The remaining companies, including lab equipment and tools maker Thermo Fisher Scientific Inc. and medical device developer Boston Scientific Corp., were rated at moderate risk.
Another headline-dominating issue that poses risk to the healthcare industry, according to the report, is the opioid crisis. In particular, Fitch said healthcare distributors AmerisourceBergen, Cardinal Health and McKesson are especially vulnerable to such liabilities.
Fitch said the risks were evaluated based on legal costs and operational challenges.
"In the case of the opioid crisis, there is no perfect [historical] parallel," the report said.
Other examples of contingent liabilities, Fitch said, are product liability issues and financial and accounting fraud.
Mylan, in addition to being related to the opioid crisis, was also listed as high-risk due to alleged price-fixing accusations, the report noted.
"Litigation is becoming an increasing cost of doing business," Fitch said of the generic drugmaker.
Due to the overall higher scrutiny on the healthcare industry, all companies included in the report are said to have at least moderate risk.
Special payments to shareholders
Meanwhile, companies with activist shareholder engagement or concentrated ownership, such as Allergan, face higher risk of giving special payments to shareholders that may influence credit profile.
Otherwise, Fitch said it expects companies to "favor internal investment and M&A over shareholder payouts."
The report added that the majority of the included companies "already distribute a significant proportion of cash from operations to shareholders," though others rated at low risk may also lack the ability to finance shareholder payouts.
Monetization of assets
Fitch took note of the trend among companies "actively pruning portfolios," and said most companies are unlikely to complete spinoffs or divestitures that would affect their credit profiles.
In addition, Fitch said companies with "more diverse" offerings and geographic presences are not facing shareholder pressure to initiate any sales, though Allergan may be an exception.
Pfizer was the only company rated at high-risk, due to a yearslong discussion of divesting its generic pharmaceuticals and consumer health divisions, Fitch said.
While activist shareholder engagement was not counted as a risk, Fitch acknowledged that shareholder activism "goes hand in hand with event risk, since many transactions introducing event risk to the credit profile are motivated by an issuer's desire to increase returns for shareholders."
Allergan is subject to substantial shareholder activism, but Fitch said a trend toward increasing shareholder engagement "should better align with creditors' interests."
In particular, Fitch pointed to ESG, or environmental, social and governance, investing as a major "long-term value creation [theme]."
ESG initiatives, in addition to board diversity and compensation strategies aligned with such objectives, will more "adequately capture a company's vulnerability to activist engagement," Fitch concluded.