Standard & Poor's base-case scenario
-- We expect Lilly to face revenue declines of around 7%, 2% lower than we previously expected, in 2012, with only a modest, low-single-digit recovery in 2013. After the October 2011 expiration of patent protection for $5 billion anti-psychotic Zyprexa, sales of this top-selling product declined rapidly. By the quarter ended June 30 2012, more than 95% of the U.S. market was taken by generics. Also, anti-depressant Cymbalta will lose patent protection in 2014, leading to a further low double-digit revenue decline. These estimates give no credit to the products in phase III testing.
-- Despite this revenue contraction, we expect Lilly to maintain or slightly increase R&D spending over the next two years; EBITDA margins therefore should decline to about 28% during that time, a level that still exceeds the majority of industrial issuers. EBITDA at the trough should still be in excess of $5 billion.
-- These still-strong margins, limited internal capital needs, and a dividend that we expect to be relatively stable should lead to discretionary cash flow remaining just over $2 billion for the next two years, providing substantial capacity to pursue moderate-sized acquisitions while maintaining debt to EBITDA well under 1.5x, the limit for a minimal financial risk profile.
The strong business risk profile reflects the longer-term promise of products currently in development, despite recent disappointments. Lilly has strong positions in the neuroscience, endocrinology, oncology, cardiovascular, and animal health markets. We expect it to continue benefitting from product- and therapeutic-class diversity. In 2013, we believe Lilly will have at least seven drugs with sales in excess of $1 billion each, with five generating mid-single-digit growth. The largest selling at that time will be Cymbalta, which has prospered in a market dominated by a variety of not-dissimilar generic drugs.
Lilly has 12 products in phase III development, with an emphasis on cancer and other chronic diseases, suggesting an ample, but still uncertain, ability to expand the portfolio and revenues.
We expect Lilly to maintain a conservative financial policy regarding share repurchases, dividends, and acquisitions. We believe it will continue generating good levels of profitability, strong discretionary cash flow, high cash balances, and very low leverage, supporting the minimal financial risk profile. Financial metrics are now strong for even a minimal financial risk profile. As of Dec. 31, 2011, Lilly had no net debt. Even assuming $1 billion to $2 billion of acquisitions, we expect cash reserves to exceed debt.
We view Lilly's liquidity as exceptional; our short-term rating is 'A-1+'. Sources of cash are expected to exceed mandatory uses of cash over the next two to three years. Relevant aspects of Lilly's liquidity are:
-- We expect liquidity sources to exceed uses by at least 2x over the next two to three years.
-- We expect liquidity sources to continue exceeding uses, even if EBITDA declines by 50%.
-- With its ample cash balance and access to the commercial paper market, we believe Lilly could absorb, without refinancing, high-impact, low-probability events.
-- The credit facility does not include financial maintenance covenants.
-- Lilly has well-established, solid relationships with banks and a generally high standing in the credit markets.
Sources of liquidity as of June 30, 2012, included cash and readily available investments of about $9.7 billion. The $1.24 billion credit facility is largely undrawn: It is the backup to a commercial paper program that can be as large as $8 billion, but seldom exceeds $2 billion. The largest single use of cash flow is the dividend, which is in excess of $2 billion. For the 12 months ended June 30, 2012, Lilly generated $3.2 billion of discretionary cash flows.
Our rating outlook on Lilly is stable. We expect conservative financial policies and continued strong growth of protected products will preserve the company's existing minimal financial profile. However, the first of two major patent expirations took place in 2011, with the loss of patent protection for sales leader Zyprexa. The inevitable--but, in our view--modest revenue declines will strongly limit the chance for an upgrade. Still, over time, the successful commercialization of several new products could bolster our view of Lilly's business risk profile, contributing to an upgrade, although this is not a near-term prospect. A major shift in financial policies, such as significant debt-financed acquisitions to bolster the portfolio and/or pipeline, could lead us to lower our rating if leverage remains above the 1.5x upper limit for minimal financial risk. Given Lilly's essentially unleveraged posture, we estimate that cash uses would need to exceed $14 billion to breach this upper limit.
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