TEXT-S&P affirms McKesson Corp ratings, outlook is Stable
Oct 26 - Overview -- U.S.-based medical products and pharmaceutical distributor McKesson Corp. announced a definitive agreement to acquire distributor PSS World Medical Inc. (PSS) for $2.1 billion including the assumption of PSS' debt. -- While financing plans have yet to be announced, we do not expect McKesson to breach or operate above our previously published threshold for a "modest" financial risk profile of 2x debt to EBITDA for an extended period of time. -- We do not believe the acquisition will alter our view of the company's liquidity as "exceptional." -- We are affirming all ratings on McKesson, including our 'A-' corporate credit and 'A-1' short-term ratings. -- The rating outlook remains stable, reflecting our expectation that initial post-transaction debt to EBITDA will not exceed 2x, and that McKesson will operate over the medium and long term with debt leverage closer to its historical level of about 1.5x. Rating Action On Oct. 26, 2012, Standard & Poor's Ratings Services affirmed all ratings on McKesson including our 'A-' corporate credit and 'A-1' short-term ratings. The rating outlook remains stable. We believe that the PSS acquisition is a logical extension of McKesson's existing medical products distribution business and that some synergies should be achievable given the superior negotiating leverage of the combined entity and the potential to eliminate operating redundancies. However, we believe the acquisition will likely eliminate the company's capacity for additional large debt-financed acquisitions at the current rating level until credit metrics improve to historical levels. Rationale The ratings reflect Standard & Poor's Ratings Services' assessment of McKesson's business risk profile as "satisfactory" given the company's leading position in a very stable industry and its financial risk profile as "modest" given its strong credit metrics and exceptional liquidity. The ratings also reflect our expectation for low single digit revenue growth in fiscal 2013 (excluding the PSS acquisition), in line with our expectations for the pharmaceutical distribution industry. Year-to-date, revenues are in fact up 1% in fiscal 2013. We believe revenues will be hurt by the conversion of branded drugs to generic, but expect this to help operating margins. We project a 10-basis-point annual improvement in margin beginning in fiscal 2013, and operating margins are up roughly 15 basis points year-to-date. McKesson has industry-leading margins, largely because of its higher-margin technology solutions business. The company's "satisfactory" business risk profile (as we define the term) reflects its important position as one of the three largest drug distributors, diversified customer and supplier mixes, high barriers to entry in its industry, favorable demographics, and an increase in the usage of more profitable generic drugs. It also reflects McKesson's narrow margins and competition from AmerisourceBergen Corp. (ABC) and Cardinal Health Inc. The three companies are about 90% of the entire drug wholesaling sector, which, in turn, distributes the vast majority of drugs dispensed in the U.S. McKesson's operating profits are more diverse than ABC and Cardinal Health, but it is not significant enough to warrant an improvement in our assessment of business risk over the other large distributors. McKesson's Technology Solutions business accounted for 14% of adjusted operating profits for fiscal 2012. We believe that, while this business provides diversity, it is also somewhat more exposed to a weak U.S. economy. However, its performance was very stable during the past three fiscal years, likely related to the recurring nature of maintenance and service revenues. As is typical for the industry, distribution margins are very thin. We believe that McKesson should maintain or improve margins, drawing on the cost efficiencies associated with its massive scale and the increasing proportion of generic drugs in its delivery mix. McKesson generally has a well-diversified customer base: Its two largest customers accounted for 16% (CVS Caremark Corp.) and 10% (Rite Aid Corp. of fiscal 2012 revenues, respectively; its 10 largest customers were 52%. This diversity reduces the risk of large contract losses. McKesson's financial risk profile is "modest" (according to our criteria), partly defined as adjusted debt to EBITDA of 1.5x-2.0x and funds from operations to adjusted debt of 45%-60%. As of June 30, 2012, total adjusted debt to EBITDA was 1.4x, and is expected to peak at no more than 2x with the PSS acquisition. Funds from operations to total lease-adjusted debt are 51%; we believe this metric could decline to the mid-30% area, but should rapidly improve. The credit metrics no longer provide flexibility for significant variations in operating margins, acquisitions, and share repurchases at the current rating level. Liquidity Our short-term credit rating on McKesson is 'A-1'. We view its liquidity as exceptional, with sources of cash likely to exceed mandatory uses over the next 12 to 24 months. Relevant aspects of McKesson's liquidity are: -- Sources of liquidity will exceed uses by 2x. -- Sources of liquidity as of Sept. 30, 2012 included cash on hand of $2.8 billion. -- We expect operating cash flow to remain robust at more than $2 billion in fiscal 2013; the company generated nearly $3 billion of operating cash flow in fiscal 2012. -- We expect McKesson to maintain significant availability under its undrawn $1.3 billion revolving credit facility maturing in September 2016. -- The company also has an undrawn $1.35 billion receivable securitization facility due in May 2013. -- We expect operating performance to remain well above covenant levels and we expect ongoing access to capital markets to accommodate maturing debt. -- We expect uses of cash to include capital expenditures of about $400 million. -- We also expect McKesson to maintain its liquidity while making share repurchases and acquisitions. -- The balance sheet remains very liquid; cash, inventory, and accounts receivable are a substantial percentage of assets. Outlook Our rating outlook on McKesson is stable. The acquisition of PSS will like eliminate flexibility for additional debt-financed acquisitions, which we would view as a change in financial policy and could lead to a lower rating. However, we expect McKesson to actively manage its debt to EBITDA to roughly 1.5x, consistent with historical levels; the company's strong cash flow for debt repayment and growing EBITDA should be the catalysts. We view a ratings upgrade as unlikely in the foreseeable future, given the company's narrow focus and temporarily stretched financial risk profile. Related Criteria And Research -- Methodology: Short-Term/Long-Term Ratings Linkage Criteria For Corporate And Sovereign Issuers, May 15, 2012 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Ratings Affirmed McKesson Corp. Corporate Credit Rating A-/Stable/A-1 Senior Unsecured A- Commercial Paper A-1 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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