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Pharma Outlook: Eighth Straight Year Of Credit Deterioration In 2021

S&P Global Ratings' outlook for the pharmaceutical industry is negative for 2021, with downgrades expected to again exceed upgrades, especially among Big Pharma companies--the trend for the last seven years.

Still, we expect certain positive developments to temper the severity. We continue to hold a relatively favorable view of the industry given its many strengths. These include strong barriers to competition, excellent profitability (average margins of 30%-40%, after accounting for the high costs of research and development, R&D), relative insensitivity to the business cycle, and the essential life-extending and life-improving nature of pharma products. They support the relatively high ratings in this sector.

Four primary factors drive our expectation for a continued trajectory of credit and rating deterioration in 2021.

Merger and acquisition (M&A) activity:   We expect a continued appetite for cash- and debt-financed M&A, given the attractive opportunities for growth in therapeutic areas such as oncology and immunology on the heels of medical science advances. Another element is divestitures in which proceeds are not used for deleveraging.

Intensified pricing pressures:   In contrast to the longer-term historical trends of annual price increases on branded (patented) drugs in the U.S., we expect net pricing trends to be flat in 2021 (as in the last few years). This stems from intensified pressures from pharmacy benefit managers (PBMs) and industry participants eager to improve their reputations following public scrutiny on drug price increases in recent years.

Renewed potential for advances in drug price reform:   There could be legislation in the U.S. under the new Biden administration and Democrat-controlled Congress, especially given federal and state budgetary pressures during the COVID-19 pandemic.

The mix of negative versus positive outlooks and CreditWatch placements:   This points to many more companies at risk of a downgrade than those poised for a potential upgrade.

Big Pharma ratings have persistently deteriorated from 2014-2020, with about 20 downgrades and three upgrades among investment-grade firms. Despite some pockets of operating weakness, including intense pricing erosion in the generic pharmaceutical product market and the realization of material liabilities relating to opioid and other litigation, the majority of downgrades among investment-grade companies stemmed from debt- or cash-financed M&A activity.

Table 1


M&A Is Poised To Continue Eroding Creditworthiness

Acquisitions are often negative for creditworthiness, because they are typically financed at least in part with debt. Increased leverage (especially on conservatively leveraged investment-grade companies) nearly always outweighs the incremental benefits such deals provide to business strength. For more details on historical rating actions in the sector, see "Lessons Learned: What Leads to Rating Changes for Investment-Grade Pharmaceutical Companies", published Jan. 22, 2019, and "Big Pharma’s Renewed Appetite For M&A Will Put Pressure On Ratings", published Feb. 1, 2019.

We believe M&A is likely to persist in 2021 for several reasons. First, many industry participants are eager to invest in the very attractive, rapidly expanding, and highly profitable therapeutic areas of oncology and autoimmune diseases on the heels of meaningful advancements in medical knowledge and pharmaceutical technologies. Moreover, most Big Pharma companies view M&A as an essential element of their long-term drug development strategy alongside internal R&D efforts (which average about 20% of revenues). In addition, some companies have potential patent expirations or gaps in their development pipelines of new drugs that could lead to periods of stagnant or declining revenues over the medium term. We expect those companies to be particularly eager to address this by acquiring drugs with high growth potential.

We also believe small biotech companies that succeed with new drugs often need the economies of scale and other resources of Big Pharma companies--including an international presence, regulatory experience, marketing teams, and improved negotiating power with payers--to fully capture their value. Finally, low interest rates and easy access to debt capital markets fuel the appetite for higher leverage. Indeed, over the past few years financial policies among many Big Pharma companies have moderately eroded from the very conservative leverage they once maintained. We anticipate this trend may influence shareholder expectations and increase the tolerance for higher leverage among pharma company boards.

Divestures May Also Weigh On Ratings

Aside from acquisitions, many companies are divesting noncore business segments, including generics, consumer health, and animal health businesses, as well as batches of smaller more mature products. We expect this trend to continue.

Divestitures typically reduce profits (EBITDA), scale, and diversity, which weakens business strength and stability. How these transactions affect ratings depends on whether the proceeds are used to meaningfully reduce leverage, reinvested in other products that are or are not immediately generating profits, or distributed to shareholders. Divestitures can also increase the dividend rate on the remaining company, reducing financial flexibility.

Several recent divestiture announcements in the pharma industry have not involved meaningful deleveraging and therefore weakened creditworthiness. Two notable divestitures include:

  • Pfizer Inc.'s divestiture of its Upjohn Co. segment (about $8 billion of 2020 revenues) to Mylan N.V., which were combined to form a new company, Viatris Inc. We expect Pfizer to redeploy the $12 billion proceeds to acquire clinical-stage, pre-revenue assets to support the development pipeline and help sustain revenue growth over the longer term. We believe this moderately weakened Pfizer's business strength. Compounded by the planned divestiture of its 32% interest in a consumer health joint venture (JV) with GlaxoSmithKline PLC, that led us to lower the rating on Pfizer one notch to 'A+'. (See "Pfizer Inc. Downgraded To 'A+' Following Divestiture Of Upjohn; Outlook Stable", published Nov. 16, 2020.)
  • Merck & Co. Inc. announced plans to spin off many smaller drugs representing about $6 billion-$6.5 billion of its revenue as a separate company, Organon. We expect Merck to use an estimated $8 billion-$9 billion of proceeds for future M&A. We believe this moderately weakens Merck's business strength, and our 'AA-' rating is on CreditWatch with negative implications. We expect to lower the rating one or two notches at the close of the transaction, depending on our assessment of its leverage tolerance. (See our recent full analysis on Merck, published Jan. 5, 2021.)

See "Outlook 2020: Pharmaceuticals Negative On M&A, Opioid Litigation" published Feb. 18, 2020, for a list of meaningful divestitures in the industry in recent years.

We believe some motivations for these divestitures include an effort to increase focus on core business segment(s), improve profit margins and growth profiles by shedding less-profitable or lower-growth segments, and to provide funding for assets in more desirable therapeutic areas.

Chart 1


Chart 2


PBMs And Public Opinion Constrain The Ability To Increase Prices

The industry also faces an inability to raise prices on branded (patented) drugs. This contrasts with the historical practice of many industry participants raising prices in the single-digit percentage area annually in the U.S. Although this constraint has been in place the last few years, we expect it to persist this year and net branded pharma prices to be relatively flat, possibly nominally negative.

This constraint stems from PBMs exerting greater pricing pressure on the industry and from branded pharma companies themselves. They are eager to improve their images after being demonized in recent years as too focused on profits and ignoring the implications of their pricing strategies on patients and society.

PBMs are criticized for creating distorted incentives that may encourage growth in (gross) list prices and rebates, and impede price transparency (via nondisclosure agreements). With higher drug spending, we expect PBMs to continue their vigorous efforts to reduce net prices, to demonstrate their value to payers, sponsors, and patients, and defend their business models.

In addition, with the increased vertical integration between several PBMs, pharmacies, and insurance companies in recent years (such as CVS Health Corp./Aetna Inc. and Cigna Insurance Group Inc./Express Scripts Inc., both in 2018), we believe PBMs have more negotiating leverage with pharma companies.

Moreover, we believe PBMs have the public and political support to require prior authorization, use step-therapy, and exclude substitutable products from their formularies. In contrast, U.S. public opinion had historically viewed these tools negatively, considering these practices an attempt to restrict patient access to the "latest and greatest" drugs.

Indeed, PBMs and other payers are leveraging substitute products in many verticals, including drugs for HIV, neurology, autoimmune diseases, and even biosimilars to negotiate lower net prices. PBMs also refuse to pay a significant premium for products with modest clinical superiority or nominal product improvements (such as changes to improve dosing convenience).

Moreover, we believe this constraint is another factor contributing to the M&A increase. Companies unable to achieve growth through price increases need to spend more on M&A for that same growth so important to equity investors and equity valuations. In fact, with M&A effectively a substitute for internal R&D expense, that need to spend more on M&A could be viewed as a form of margin pressure.

Renewed Potential For U.S. Drug Pricing Reform

Since the 2006 introduction of Medicare Part D, which covers prescription drug benefits for U.S. seniors, growth in both out-of-pocket and payer spending on drugs significantly exceeds inflation. It reflects an aging population, new pharmaceutical products, and substantial increases in list prices. This along with the absence of centralized price negotiations by Medicare and pockets of aggressive pricing by some companies has meant more and more U.S. citizens are struggling to afford critical life-sustaining medicines.

A wide variety of proposals for drug price reform among legislators and administrations in recent years have mostly stalled, particularly in 2020, with attention redirected to the COVID-19 pandemic and presidential election. For more details on some of those proposals and how they could disproportionately affect certain ratings, see "Which Pharma Company Ratings Could Be At Risk If U.S. Drug Pricing Reforms Become Law", published Oct. 31, 2018.

As the Democratic Party controls both the executive and legislative branches, and amid bipartisan support for reducing prescription drug spending in the U.S., we believe it's more likely some combination of proposals could advance in 2021 and be a moderate drag on profit margins. We also believe federal and state budgetary pressures following the pandemic and related economic stimulus packages could escalate this.

That said, given the longer-term benefits of sustaining innovation and investment, and the emergence of an improved appreciation for the pharmaceutical industry's contributions during the pandemic, we expect drug price reform will only moderately reduce industry profitability (not more than a few hundred basis points, which is moderate relative to average industry margins of 30%-40%). This leaves the industry healthy enough to attract capital and fund innovation. Still, we expect some companies may be affected more than others.

Outlook And CreditWatch Distribution Firmly Leans To Rating Deterioration

Most (about 68%) of the 65 companies we rate in the pharma industry have stable outlooks, though 28% have negative outlooks or ratings on CreditWatch negative, and 5% have positive outlooks or ratings on CreditWatch positive. More negative outlooks/CreditWatch placements than positive ones reflects information we already have today, including companies with leverage that is weak for our current ratings. The ratio of negative to positive outlooks and CreditWatch placements is consistent with, and reinforces, our top-down view that downgrades will likely outnumber upgrades in 2021.

Chart 3


Chart 4


Positive Developments Are Likely to Temper The Ratio Of Downgrades To Upgrades

Although we expect downgrades to exceed upgrades in 2021, we expect the ratio to be less severely negative than in recent years, given several positive developments. These include:

  • The severe price erosion in the generic drug subindustry has largely subsided, as the trend's fundamental drivers have since normalized.
  • We believe opioid litigation will be mostly resolved by the proposed global settlement and have already incorporated the associated liabilities of that settlement in our ratings.
  • We believe the industry's reputation is improved and societal contributions are more appreciated in the wake of the pandemic. This reinforces our confidence that legislative efforts to reform drug pricing will be only moderately negative.
  • Leverage is at a long-term high for many companies, and several have communicated that deleveraging is a priority. As such, absent further spending on acquisitions, we could see some credit improvement, though in some cases that potential for deleveraging is limited by the commitment to substantial recurring dividends. (See Chart 5 for capital allocation among pharma companies.)
  • We expect companies with elevated leverage to limit share buybacks to amounts needed to offset dilution from stock-based compensation, as several did in 2020. (See Chart 5 for capital allocation among pharma companies.)
  • Big Pharma is increasingly utilizing partnerships, royalties, and milestone-based agreements in place of outright acquisitions to mitigate the development and regulatory risks. We view these as less negative for creditworthiness than outright M&A. We expect companies to increasingly use these risk-sharing agreements to address the rising tension between weaker balance sheets and the continued appetite for exposure to attractive investment opportunities. That said, these arrangements sometimes result in contingent consideration type liabilities. We typically incorporate those contingent liabilities in our measure of debt, particularly where those are due within the medium term or the achievement of such milestones doesn't necessarily translate into additional profit.
  • Continued industry growth will be supported by generally healthy pipelines of new and recently launched products, exceeding the headwinds from products facing patent expirations.
  • Several pharma companies have indicated an opportunity for long-term cost savings from the accelerated shift to digital marketing as a partial replacement for traditional in-person sales force-based marketing. This could improve margins.
  • We expect several companies to benefit at least temporarily from vaccines and drugs addressing COVID-19, including but not limited to Pfizer, Gilead Sciences Inc., Eli Lilly & Co., and Regeneron Pharmaceuticals Inc. Also, we expect that companies experienced an even modestly negative impact from COVID-19 in 2020--such as those with aesthetic products, anesthesia products used in elective surgeries, certain newly launched products, and vaccines administered at well visits--will see a reversal and improved demand in 2021.


Industry dynamics specific to smaller and more highly leveraged pharmaceutical companies

The pharmaceutical industry includes both Big Pharma, firms with good product diversity and relatively conservative leverage typically with investment-grade ratings, and smaller, more concentrated, and often aggressively leveraged companies with speculative-grade ratings. We see some distinctions in how industry trends are likely to affect the two groups:

  • Smaller and more aggressively leveraged companies have less capacity for significant debt-financed acquisitions but our speculative-grade ratings on these companies are often less sensitive to acquisitions as leverage is already elevated. Moreover, we generally factor in an expectation for persistently high leverage, for companies owned by private equity sponsors.
  • We see PBMs focusing most intensely on large blockbuster products often owned by Big Pharma that are meaningful enough to move the economic needle, whereas smaller specialty drugs can sometimes fly below the radar. Also, so-called "orphan drugs", which have a relatively small patient base, can often achieve very attractive pricing, with less pushback from PBMs. That said, smaller companies tend to be more focused on life cycle management (e.g., offering improvements such as more convenient dosing) and price increases to drive growth, rather than investing heavily in R&D for more innovative solutions. PBMs and legislative efforts have been focused on pushing back against these tactics.
Expectation for normalized pricing trends in generics subsector

Although pricing trends were severely negative in the U.S. generics subsector in 2017-2018, with double-digit percentage annual declines, those pressures eased in 2019 and 2020 to more typical single-digit annual erosion. We expect this to persist in 2021. Underlying this expectation is our view that the unusual pricing pressure in 2017-2018 was primarily the result of a wave of consolidation among the buying consortia and an initiative by the U.S. Food and Drug Administration (FDA) to clear the backlog of generic products seeking approval. We believe such consolidation has since stabilized with a relatively consolidated group of buyers. The FDA has also progressed through much of its approval backlog.

Moreover, generic players have been pursuing consolidation, with some exiting the industry and others rationalizing their portfolios of products that are no longer profitable. This has even led to some pockets of drug shortages. In addition, we expect the FDA to shift its focus to helping clarify and smooth the approval pathway of complex generics and biosimilars, which could benefit the larger generic manufacturers we rate.

We expect some generic companies, including major players Teva Pharmaceuticals Industries Ltd. and Viatris, to prioritize deleveraging, given weakened credit measures and increased wariness about the potential for adverse pricing risks in the U.S. or other markets. We are also watching developments relating to allegations and investigations of price fixing among generic companies, which include many we rate.

Unique market dynamics for branded generic products

More than a dozen rated companies have material exposure to the branded generic drugs market, including leading branded and generic companies such as Sanofi, Novartis AG, Teva, Viatris, and Abbott Laboratories. Moreover, Pfizer's recent spin-off of its Upjohn segment and Merck's spin-off of its Organon business include large branded generic businesses.

Branded generics are drugs for which the patent has expired but are marketed under a brand name. Typically, it's the brand used by the original patented product, though in some markets there are brands other than that of the originator product. The brand implies higher quality, safety, and efficacy than an unbranded generic. These products are priced at a premium over unbranded generics--substantial in percentage terms, but still low enough to appeal to the middle-class patient paying out-of-pocket.

Demand for branded generics is meaningful in emerging markets including China, India, Russia, Brazil, and other geographies where there is patient concern about the quality of unbranded generics. The market characteristics vary across countries, but these markets generally offer doctors and patients a product choice. Patients often pay for these drugs out-of-pocket. In some markets, there may be no valid alternatives to the branded generic (e.g., a small country), at least for some period. Companies invest in marketing (typically to doctors) of their branded generic products to support demand, similar to products on-patent.

Branded generic businesses are not exposed to the sharp drop in revenue that occurs with on-patent drugs, nor the intense price-based competition of unbranded generic drugs in the U.S., where regulatory assurance of high quality makes them interchangeable and commodity-like. This market is supported by a steady stream of new products and a rapidly expanding middle class in emerging markets, increasing demand.

We believe revenues for branded generic products often erode over time (typically gradual) as patients (paying out-of-pocket) or health care systems seek and transition to lower-cost options. We believe there could also be more acute pressure in specific geographies driven by changes to government reimbursement. Recently in China, a tender process referred to as volume-based procurement was initiated for certain off-patent drugs covered by the government to lower pharmaceutical spending. This could also happen if regulatory changes increase confidence in the quality of conventional (unbranded) generics. These risks can be partially mitigated by product and geographic diversification.

Dividend rate and capital allocation of Big Pharma in 2019

Chart 5


This report does not constitute a rating action.

Primary Credit Analyst:David A Kaplan, CFA, New York + 1 (212) 438 5649;
Secondary Contacts:Arthur C Wong, Toronto + 1 (416) 507 2561;
Tulip Lim, New York + 1 (212) 438 4061;
Marketa Horkova, London + 44 20 7176 3743;
Nicolas Baudouin, Paris + 33 14 420 6672;
Matthew D Todd, CFA, New York + 1 (212) 438 2309;
Adam Dibe, Toronto + 1 (416) 507 3235;
Ji Liu, CFA, New York + 1 (212) 438 1217;
Patrick Bell, New York (1) 212-438-2082;

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