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
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
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
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
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
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.
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:
--Short-term IDR 'F1';
Covidien International Finance S.A. (CIFSA)
--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