TEXT - Fitch revises Eli Lilly & Co rating outlook
Oct 22 - Fitch Ratings has affirmed Eli Lilly & Co. Inc.'s (Eli Lilly) ratings, including the Issuer Default Rating (IDR) at 'A'. The Rating Outlook is revised to Negative from Stable. A full list of ratings is shown below. The ratings apply to approximately $4.9 billion of debt at June 30, 2012. The ratings reflect the following key credit considerations: Patent cliff steepest in the industry: Eli Lilly faces the industry's most severe patent expiration period over the next three years, with approximately 35% of sales for the latest 12-months ending June 30, 2012 subject to patent expiration. Most recently, the company lost market exclusivity for the its top-selling pharmaceutical, Zyprexa, in October 2011. Fitch is highly concerned about the company's ability to counter the negative effects on earnings and cash flows from a patent cliff that lasts until the loss of market protection for Cymbalta in December 2013. Fitch anticipates the loss of market protection for Cymbalta and Humalog will result in sales decreasing at a compound rate of nearly 8% in 2012-2014, including potential commercialization of the growing late-stage R&D pipeline. Potential upside to Fitch's estimation is a delay in generic competition to Humalog. Eli Lilly faces another period of key patent expiry in 2017, involving Alimta, Strattera, and Cialis, while it is still recovering from the first wave of patent losses. Significant margin compression expected in 2014: Fitch sees the greatest challenge for Eli Lilly occurring in 2014, when the company faces the impact of potential losses of Cymbalta and Humalog in 2013. The company has sufficient margin flexibility under the current rating in 2012 and 2013; but deterioration in financial flexibility because of margin erosion in 2014 could pressure the credit profile to a degree that financial metrics are no longer consistent with the 'A' IDR. Eli Lilly has stated that it expects to maintain gross margins in the middle 70% range and limit research spending to 25% of total sales through 2014. Utilizing expense control near company targets, Fitch anticipates EBITDA margin to fall below 20% in 2014. Fitch believes that it will be difficult for the company to reduce research costs to its target ceiling and achieve Fitch's expectation in 2014 considering the R&D program is fundamental to recovery from the patent cliff. Profitability in this range is indicative of a lower rating category; however, a strong recovery from the patent cliff would make margin pressure temporary. Shareholder-friendly capital deployment increases: Along with a potential deterioration in financial flexibility, an increased focus on shareholder returns as a use of cash could pressure ratings through 2014. The recent resumption of share repurchases after a long pause in activity and the potential for incremental dividends show a shift in focus that may strain Eli Lilly's ability to address $1 billion of debt maturing in March 2014. If Eli Lilly pays down the maturing debt, Fitch anticipates leverage around 1.4x on a gross basis and 1.9x on an adjusted basis at the end of 2014, levels still indicative of the current rating. However, if long-term debt were refinanced, negative rating action would be warranted as gross debt leverage would rise to 1.7x at the end of 2014, which is more reflective of an 'A-' IDR. Following $1.5 billion of debt reduction in 2012, total debt and adjusted debt leverage for the LTM ending June 30, 2012 were 0.8x and 1.1x, respectively. R&D successes to aid sales recovery beyond 2014: Eli Lilly's strategy to restore growth coming out of its patent expiration period emphasizes its research program. Fitch recognizes the company's success in achieving its goal of increasing the size of the late-stage pipeline to 10 or more projects by the end of 2011. At the end of the second quarter of 2012 (2Q'12), Lilly had 12 projects undergoing Phase III clinical investigation or registered to drug agencies. In addition, Fitch favorably views Lilly's industry-leading research investment (as a percent of sales) that represented 21.8% of sales for the LTM ending June 30, 2012. However, the broadened late-stage portfolio, even if commercialized, will not meaningfully benefit the company until the current patent expiry wave eases in 2015. Free cash flow declining: Free cash flow (FCF: operating cash flow less capital spending and dividends) has decreased to $3.2 billion for the LTM at the end of 2Q'12 from a peak of $4.4 billion for the same period in 2011, due to the expiration of the U.S. patent for Zyprexa. Fitch sees sequential annual FCF deterioration through 2014 driven by sales declines outpacing operating expense control. FCF generation is expected to remain indicative of the current rating, with FCF margin greater than 10% until the potential patent lapses of Cymbalta and Humalog in 2013. Cash and short-term investments of $5.3 billion, long-term investments of $4.5 billion, and $1.24 billion of unused lines of credit at the end of the second quarter provide additional liquidity. What could trigger a rating action: Fitch believes Lilly can withstand the negative effects to earnings and cash flows from generic drug competition through 2013. However, potential key drug patent lapses in 2013, notably Cymbalta, will severely compromise profitability and cash flow in 2014. The company's ability to mitigate the impact of key drug patent expiration relies on a combination of successful commercialization of the late-stage R&D pipeline, continued debt reduction, and significant proactive cost control. Further pressure on the rating would arise if the company chooses to refinance the maturing debt in 2014, whereby total debt leverage would be 1.7x, a level no longer reflective of the current rating. Paying the maturing debt in 2014 would keep gross debt leverage commensurate with the current rating category at 1.4x. Fitch needs more clarity regarding cost containment and debt paydown during 2014, but currently bases the 2014 forecast for leverage on a 15% revenue decline and margin compression of 10% from 2013, leading to EBITDA margin below 20%. Positive rating action is not anticipated through the ratings horizon due to the severity of the company's drug patent expiration period. Fitch affirms the following ratings on Eli Lilly: --Long-term IDR at 'A'; --Senior unsecured debt rating at 'A'; --Bank loan rating at 'A'; --Short-term IDR at 'F1'; --Commercial paper rating at'F1'.