TEXT-Fitch maintains Covidien IDR at 'A', ratings still on negative watch
Dec 6 - The ratings of Covidien International Finance S.A. (CIFSA), including the 'A' Issuer Default Rating, remain on Rating Watch Negative. A full list of ratings follows at the end of this release. The ratings apply to approximately $5.0 billion of debt outstanding as of Sept. 28, 2012. Covidien's ratings reflect the following considerations: SPIN-OUT OF PHARMACEUTICALS SEGMENT In Q4'11, Covidien announced plans to execute a tax-free spin of its pharmaceuticals segment. The ratings remain on Negative Watch due to uncertainties about the specifics of the transaction. Management has indicated that they expect to file an SEC registration form for the new company, to be called Mallinckrodt Pharmaceuticals (Mallinckrodt), in Q1'13 and expect the transaction to be complete in June 2013. The impact of the transaction on Covidien's credit profile over the longer-term will depend on the items discussed below. BALANCE SHEET MANAGEMENT EXPECTATIONS Fitch believes balance sheet and cash flow management will remain essentially consistent post the spin-off of Mallinckrodt, and so expects a downgrade of Covidien's ratings to be limited to one-notch. Covidien's 'A' IDR is based on the expectation that gross debt leverage remains at 1.5x or below with temporary spikes tolerable for funding for large acquisitions. Post the spin of Mallinckrodt, Fitch projects that pro forma leverage could be close to 1.7x if debt remains constant or 1.5x if debt is reduced by $500 million. Management has indicated that they will maintain a long-term target leverage ratio of 1.5x. However, Fitch questions the company's commitment to debt reduction post the spin and thinks leverage could exceed 1.5x through 2014. After the spin-off is completed, Covidien's medical devices segment will contribute about 80% of total sales. Fitch believes that the more favorable organic growth profile of the devices business could potentially support more conservative management of the balance sheet, including lower debt leverage and cash returns to shareholders. However, management has recently become more aggressive in its capital deployment policy, increasing the target for cash returns to shareholders to a minimum of 50% of pre-dividend free cash flow (FCF) versus a previous policy of 25% - 40%. Furthermore, Fitch expects Covidien to continue to grow the medical devices business through acquisitions that could add debt to the capital structure. BUSINESS OUTLOOK POST-SPIN The loss of the pharmaceuticals segment has mixed implications for Covidien's bondholders. It has lower growth prospects than the company's medical devices segment and includes some commoditized product lines, which are a drag on profitability. However, the pharmaceuticals business is also stable and cash generative. Overall, Fitch thinks the more favorable growth profile of the medical devices segment will offset the negative implications of the spin on the business profile. Organic sales growth in the medical devices business is facing volume and pricing headwinds in the developed markets for healthcare products and services, as well as negative foreign exchange effects in the first half of Coviden's fiscal 2013. Excluding the impact of foreign exchange, Fitch expects mid-single digit organic growth for the devices business in fiscal 2013. Growth in EBITDA should slightly outpace the top-line as margin expansion will continue to be aided by mix shift to the faster growth, higher margin devices segment. While medical procedure volumes are somewhat cyclical with the economy, favorable demographic shifts worldwide, rapid uptake of medical technologies in emerging markets, and the anticipated increase in covered lives through U.S. healthcare reform will support higher medical spending and procedure volumes. Pricing will continue to be under pressure due to fiscal pressures in the U.S. and Eurozone. The end users of Covidien's devices, including hospitals, physicians and surgery centers, will attempt to pass pressure on government healthcare reimbursement rates through to suppliers. Commoditized products will face the strongest pricing headwinds, so solid uptake of new product launches will be. Fitch sees Covidien's growth prospects as slightly better than those of medical device industry overall. This is due to its highly diversified product portfolio, focus on developing products in relatively high growth areas such as minimally invasive surgery and the low-cost consumable nature of some of its major product lines. EFFECT ON COVIDIEN'S LIABILITIES Fitch expects that some of Covidien's liabilities other than debt could be reduced post spin. These include some environmental clean-up and pension liabilities that are associated with the pharmaceuticals segment. These items are relatively small however, and the reduction will not be transformational to Covidien's balance sheet. Fitch currently assumes that Covidien will retain liability for the legacy tax liabilities dating to prior to the company's split from Tyco International in 2007, which are more sizable than the environment and pension liabilities. Fitch believes that there has been good progress in addressing the liabilities resulting from the 2007 Tyco Int'l spin-off. All substantial legal liabilities from have been resolved. As noted above, Covidien does continue to have significant financial exposure to settlement of tax issues from prior to the spin-off, the ongoing settlement of which will continue to impact FCF generation, probably for several years to come. However, Fitch believes that Covidien has sufficient financial flexibility to meet the tax settlement obligations without negatively affecting its credit profile. Covidien's Sept. 28, 2012 balance sheet reflects a total of $1.7 billion in non-current liabilities for future tax payments, of which $1.35 billion relates to tax obligations from prior to the 2007 separation. Covidien is responsible for 42% of the tax payments related to periods prior to the separation, and Tyco International and TE Connectivity are responsible for the other 58%. Covidien also has a $585 million non-current liability for its portion of the other companies' tax settlement payments, yielding a total liability of about $1.7 billion for the pre-separation tax settlement payments. The liability is offset by a $614 million receivable from the other companies, reflecting their portion of Covidien's anticipated settlement payments. The three companies are jointly and severally liable for the tax obligations under the tax sharing agreement. Fitch believes that the other two companies also have the financial resources necessary to meet the tax settlement obligations. MORE AGGRESSIVE CAPITAL DEPLOYMENT POLICY Covidien generated about $1.9 billion of FCF before dividends (cash from operations less capital expenditures) during fiscal 2012. During the year the company increased its stated pre-dividend FCF shareholder pay-out target to a minimum of 50% from a previous 25% - 40%. In years without significant acquisition activity, the company expects to exceed the 50% target. Despite spending nearly $1.2 billion on seven separate acquisitions in fiscal 2012, Covidien exceeded the payout target, returning 71% of pre-dividend FCF through dividends and share repurchases during the year. Although the increase in the targeted payout percentage is a shift to a more aggressive financial policy, it so far remains consistent with the 'A' credit profile. Recently more aggressive capital deployment has contributed to higher debt leverage however. The company increased debt by $800 million during fiscal 2012, resulting in year-end debt to EBITDA of 1.5x versus 1.3x at the end of fiscal 2011. SOLID LIQUIDITY PROFILE Covidien's solid liquidity is a key support of its credit profile. Fitch projects ongoing pre-dividend FCF generation for Covidien of around $1.9 billion annually. Cash generation could be slightly lumpy due to the uncertain timing of cash payments for the settlement of legacy Tyco tax liabilities. Otherwise liquidity at Sept. 28, 2012 was supported by the company's $1.5 billion CP program (backed by a $1.5 billion credit revolver, $210 million outstanding) and $1.9 billion of cash on hand. Debt maturities are manageable; near-term maturities could be paid down with cash on the balance sheet. There is a $500 million senior notes issue maturing June 2013 and a cumulative $1 billion of notes maturities in 2015. Fitch believes that Covidien has some degree of financial incentive to maintain a solid 'A' category rating in order to maintain its access to the tier-I CP market. The company does access the CP market on an ongoing basis, although the amount of CP outstanding in the capital structure is usually nominal. Furthermore, the company's large cash balances and its ability to access international cash without adverse tax implications lessen its reliance on CP as a short-term funding source. RATING TRIGGERS The resolution of the Rating Watch Negative will follow increased clarity on the specifics of the spin-out transaction. The business profile of remaining Covidien is consistent with the 'A' IDR since the stronger growth profile and higher margins of the medical devices segment offset the negative implications of the loss of business diversification provided by the pharmaceuticals segment. However, a one-notch downgrade to 'A-' could result if Fitch believes Covidien intends to manage its balance sheet more aggressively post the spin, with gross debt leverage maintained above 1.5x. A positive rating action is relatively unlikely, but could result from a commitment to maintenance of gross debt leverage at 1.3x or below. DEBT ISSUE RATINGS Fitch rates Covidien follows: Covidien plc --IDR'A'; --Short-term IDR 'F1'; Covidien International Finance S.A. (CIFSA) --IDR 'A'; --Short-term IDR 'F1'. --Commercial paper program 'F1'; --Credit facility 'A'; --Senior unsecured notes 'A'. The ratings are on Rating Watch Negative CIFSA, which is the obligor of Covidien's debt, is a wholly owned subsidiary of Covidien plc. CIFSA directly or indirectly owns all of the operating subsidiaries of Covidien, issues debt, and performs treasury operations for Covidien, otherwise it conducts no independent business operations of its own. CIFSA's senior notes are fully and unconditionally guaranteed by both Covidien Ltd. and Covidien plc. Covidien plc replaced Covidien Ltd. as the ultimate parent company in May 2009. Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings. Applicable Criteria and Related Research: 'Corporate Rating Methodology' (Aug. 8, 2012). Applicable Criteria and Related Research: Corporate Rating Methodology
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