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Pharma's record-high offshore cash may go to buybacks, deals in tax holiday

Federal tax reform could end what has become a record-high level of cash hoarding among big healthcare companies, giving rise to potential buybacks and acquisitions, according to a May 25 S&P Global Ratings report.

The health sector is second only to the tech industry when it comes to holding cash and storing it overseas, the report found. Twenty-five nonfinancial corporates in the U.S. together held more than half of a record $1.9 trillion in cash and short- and long-term liquid investments at the end of 2016, with $1.1 trillion of this cash currently offshore, according to S&P Global data.

However, this trend may be due for a change with tax reform looming. A key component of the long-discussed overhaul by the Trump administration includes a tax holiday, or the chance for companies to bring back offshore cash at a significant discount.

Seven healthcare companies — Johnson & Johnson, Amgen Inc., Gilead Sciences Inc., Merck & Co. Inc., Pfizer Inc., Abbott Laboratories and Eli Lilly & Co. — are among the top cash holders with a combined $207.9 billion in cash and marketable investments. The rating agency calculated that Johnson & Johnson holds 99% of its cash overseas, followed by Amgen at 90% and Gilead at 84%.

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At the same time, outstanding debt has also increased, reaching $5.8 trillion last year as many companies choose debt at a low interest rate over bringing cash back onshore.

Several U.S. pharmaceutical companies could be flush with cash following a reform, begging the question of where they might spend first. While repatriated cash could be positive for credit in the long run, it could hurt companies' standings in the short term, Arthur Wong, one of the analysts who worked on the ratings agency's report, said in an interview.

"Over the next year or two immediately after tax reform, it's a credit negative, and we might see some downgrades because of it," Wong said.

Slight M&A bump on horizon

That's because companies will have a number of priorities to balance in the wake of reform — from shareholder returns to pipeline prospects and acquisition appetite — that will channel cash in certain directions.

"When that cash comes onshore, you're going to see some element of shareholder activism, especially for the companies that may have growth pressures," Wong said. One of those may be Gilead, which faced calls for an acquisition well before tax reform was put on the table.

"I'd hate to see them run out there to do an acquisition just to do an acquisition, so I think that's the danger," Wong said, adding that repatriated cash could "force their hand a bit."

In the company's first-quarter earnings call, CEO John Milligan seemed to brush aside implications of policy changes.

"There may be tax reform, there may be repatriation, but you can't count on it and you can't wait for it either," he said. "So we're going to just focus on what's right for Gilead, try to ignore the noise globally in terms of tax reform and deal with the best thing for the company and for the shareholders in the long term."

It is unlikely that repatriated cash will trigger an acquisition frenzy across the biopharma industry. While an influx of assets might encourage companies that were on the fence about certain targets, it is unlikely to be the sole impetus for a big deal, Wong said, pointing to Pfizer as one drugmaker that may be encouraged to add to its string of buys.

Pfizer is "keenly aware" that tax reform could open up new avenues of capital deployment, CEO Ian Read said in the drugmaker's first-quarter earnings call, though he suggested a lack of clarity on the reform's details was holding the company back in the meantime.

Buybacks a likely bet

Share buybacks and dividends are more likely, according to the report, with companies potentially ramping up share repurchases ahead of tax reform in order to prepare for the cash influx.

While each can have their benefits, Wong said the repurchases in particular could be concerning from a credit standpoint. Dividends, with their one-time nature, could be better in this context, but "it's still cash going out the door," Wong said.

Companies such as Amgen, which has a less clear path for cash, could be in an interesting place after repatriation. Wong noted that among businesses included in the report, the California-based biotech company has one of the bigger gaps between net and gross leverage due to its cash holdings. The company could make a drastic change to its leverage numbers with cash coming back on shore, he said.

Amgen will have $36 billion offshore by 2017-end, CFO David Meline said during a May 17 presentation at the Bank of America Merrill Lynch 2017 Healthcare Conference, where he emphasized the company's enthusiasm for tax reform.

Meline said Amgen is looking to fund discovery research and potential acquisition, but admitted that a buy would not be limited by cash repatriation.

"Even without tax reform, we don't believe that the company is constrained to pursue acquisitions of basically any stage or any size," Meline said.

"So if we have tax reform, if we have cash returns, we may look at both our equity and our debt balances and address those to continue to optimize, and that could involve certainly some level of returns to shareholders as part of that."

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.