Standard & Poor's Ratings Services expects near-term revenue pressure as a result of the contracting cardiac rhythm management (CRM; 53% of sales for the first nine months of 2012) market, and additional negative publicity surrounding St. Jude's (silicone-coated) Riata defibrillation lead. Our base-case scenario incorporates an 8% decline in ICDs and a 5% decline in pacemakers in 2012, offset by gains in the cardiovascular (24%), atrial fibrillation (AF; 16%), and neuromodulation (8%) business segments. At 1% constant currency growth for the first three quarters of 2012, St. Jude is performing slightly above our expectations of a 0.5% revenue decline for the year.
The adjusted EBITDA margin of 32.6% (per our calculation), achieved in the 12 months ended Sept. 29, 2012 has not eroded to the 30% used in our base case, as cost cutting measures have offset volume declines and the attendant negative impact on operating leverage. As a result, debt leverage and funds from operations of 1.5x and 45%, respectively, for the 12 months ended Sept. 30, 2012, are already modestly stronger than our year- end expectations. While financial metrics have benefited from the pay down of all its commercial paper outstanding in the third quarter, we believe commercial paper usage will rise in the short term to fund the share repurchase program, but be largely paid down within a year. Still, we do not expect adjust debt leverage to exceed 2x.
We expect the CRM market to remain sluggish for several years, but St. Jude's overall revenue growth should accelerate in 2013 and beyond (to mid-single digits in 18 months) as new products are approved and commercialized. The company has increased internal R&D and acquired several new technologies over the past few years. Operational efficiencies garnered from restructuring activities, including the relocation of CRM manufacturing from Sweden to tax-advantaged locations, should offset the Jan. 1, 2013 implementation of the 2.3% medical device tax on U.S. product revenues (48% of revenues). We expect the EBITDA margin of about 32% to 33% to remain stable, additionally driven by increasing volumes. We believe that free cash flow exceeding $500 million annually will largely cover small to mid-size acquisitions. Furthermore, the company has demonstrated a commitment to rapid debt repayment following more material acquisitions.
Despite the need for constant innovation, barriers to entry are high in the high-technology medical device industry, supporting the company's strong business risk profile. St. Jude spends 12%-13% of revenues (slightly higher than peers, but it is smaller in scale) on R&D to maintain a competitive product pipeline. St. Jude competes in the CRM, cardiovascular, atrial fibrillation, and neuromodulation spaces against the other two leading market participants, Medtronic Inc. and Boston Scientific Corp. St. Jude gained CRM market share over the past several years by filling out its CRM portfolio and competitor recalls. However, competition, generic industry quality concerns, and U.S. Department of Justice investigations into hospitals' ICD implant practices depressed industry sales. St. Jude is operating under U.S. Food and Drug Administration (FDA) warning letters at its AF neuromodulation division, and is working to resolve FDA concerns.
Our short-term rating on St. Jude is 'A-1'; we believe its liquidity is "strong". On Nov. 29, 2012, the company authorized a $1 billion share repurchase program. Share repurchases have ranged between $600 million and $900 million annually over the past several years, largely funded with a mix of cash and commercial paper. Despite this use of cash, we believe liquidity remains strong, because:
-- We expect liquidity sources (primarily cash and discretionary cash flow) to exceed uses by at least 1.5x over the next 18 to 24 months. We expect liquidity sources to continue exceeding uses, even if EBITDA declines by 30%.
-- We believe St. Jude can absorb a high-impact, low-probability event.
-- We believe St. Jude would not breach its covenants in the event of a 30% revenue decline. In our assessment, St. Jude has well-established bank relationships.
-- As of Sept. 29, 2012, St. Jude had $1 billion of cash and short-term investments (all held outside the U.S.), and no borrowings on its $1.5 billion revolver, which backs up a $1.5 billion commercial paper program; the facility expires in February 2015.
-- At Sept. 29, 2012, there was no commercial paper outstanding. St. Jude has no significant maturities until 2013, when $450 million senior notes mature.
-- Operating cash flow of $1.3 million for the 12 months ended Sept. 29, 2012 fully covered capital expenditures of $258 million.
St. Jude operates in a highly litigious industry, and ongoing patent infringement and product liability litigation remains an ongoing risk. The FDA's Class I recall classification of its Riata leads could raise litigation risk. However, we believe the risk of material adverse outcomes is a medium- to long-term issue, and that maintaining a sizeable cash cushion provides some insulation to such events.
Our rating outlook on St. Jude is stable. We expect CRM sales declines to be short term in nature. In our view, St. Jude has up to $750 million of incremental debt capacity at current ratings. We expect debt leverage to approximate 1.5x and 2x, and funds from operations (FFO) to debt to generally range between 40% and 45% over the next several years. We are unlikely to consider a rating upgrade because of the current uncertainty in the CRM market and CRM product concentration. We could lower our rating if St. Jude makes a large, debt-financed acquisition or further increases debt to repurchase stock that causes debt to EBITDA to exceed 2x and FFO to debt to fall under 40%. In that event, we would reassess St. Jude's financial policy.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Use Of CreditWatch And Outlooks, Sept. 14, 2009
-- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008