Nov 6 - Fitch Ratings has affirmed the Issuer Default Rating (IDR) and other
long-term ratings of Cardinal Health, Inc. (Cardinal) at 'BBB+'. The
Rating Outlook has been revised to Stable from Positive. The ratings apply to
approximately $2.9 billion of outstanding debt at Sept. 30, 2012.
KEY RATING DRIVERS
-- Steady pharmaceutical demand and oligopolistic market position support stable
operating profile, profit margins, and core cash flows;
-- Drug distribution has slim profit margins, but profitability has benefited
from the pharma patent cliff;
-- Cardinal has significantly less exposure to specialty pharmaceutical
distribution than its peers, contributing to intermediate-term growth concerns;
-- Demonstrated commitment to maintaining a solid credit profile, but
uncertainty related to intermediate-term cash generation in light of recently
announced dividend payout increase;
-- Very strong liquidity profile supported by robust cash flows, though expected
to be muted somewhat in 2013 due to one-time items;
-- Potential for indirect pricing pressure pertaining to generic profits within
the drug channel and more direct pressure in connection with upcoming contract
renewals with largest customers.
GUIDELINES FOR FUTURE RATING ACTIONS
Fitch believes Cardinal has significant flexibility at its current ratings to
pursue targeted M&A and to fund expansionary initiatives in stated core areas of
growth. Maintenance of a 'BBB+' IDR will require leverage (debt-to-EBITDA)
generally maintained between 1.2x and 1.7x and annual funds from operations
(FFO) in excess of $800 million.
An upgrade to 'A-' will require the company to demonstrate a commitment to
operating with leverage below 1.2x-1.3x, combined with evidence of an
intermediate-term growth driver. A sustained commitment to Cardinal's core
distribution business, accompanied by strong cash flows and stable or improving
profit margins will also be necessary to support the consideration of an
A downgrade to 'BBB' could result from a large, leveraging acquisition that
caused leverage to increase to above 1.7x for more than 12-18 months, or from
debt-funded shareholder-friendly activities. Material margin pressure greater
and more direct than expected, though unlikely, would also pressure ratings.
STEADY PHARMA DEMAND, OLIGOPOLY PROVIDE EXCEPTIONAL STABILITY
The oligopolistic nature of the U.S. drug distribution industry and steady
pharmaceutical demand contributes to exceptionally stable operating profiles for
Cardinal and its peers. The drug distribution industry has proven rather
resilient in recent years, despite depressed patient and procedure volumes and
elevated measures of unemployment. Longer-term organic top-line growth in
traditional drug distribution is expected to be sustained in the low
single-digits, driven by favorable demographics, population growth, and
increased utilization as a result of the Affordable Care Act in the U.S. over
the ratings horizon.
GENERIC WAVE DRIVING MARGIN EXPANSION, THOUGH LIMITING TOP-LINE GROWTH
Cardinal and its peers are benefitting from the unprecedented wave of branded
drug patent expirations, especially in calendar 2012-2014. Most drug channel
participants, including distributors, earn higher margins on the sale of
lower-cost generic drugs. Generic conversions drove EBITDA margin expansion of
20 basis points (bps) in Cardinal's fiscal 2012. Fitch expects
branded-to-generic conversions to contribute 10-15 bps of additional EBITDA
margin expansion in fiscal 2013 and 2014. Fitch believes much of this margin
expansion is durable as several of the most-prescribed medications in the U.S.
have recently been or soon will be converted to generic. Fitch expects generic
penetration in the U.S. to remain above 80% over the ratings horizon.
INTERMEDIATE-TERM GROWTH CONCERNS DUE TO WEAK POSITION IN SPECIALTY DISTRIBUTION
Cardinal significantly lags its two major competitors in its share of the
higher-margin and faster-growing specialty drug distribution market. Market
participants estimate that Cardinal's two primary competitors, AmerisourceBergen
Corp. and McKesson Corp. (McKesson), together control approximately 80% of the
specialty drug distribution market in the U.S. Fitch estimates that Cardinal
holds less than 5%. Fitch sees Cardinal's significant underrepresentation in the
important growth and profit area of specialty distribution as a key
differentiator between the company and its competitors.
Furthermore, Fitch is not convinced that Cardinal's current strategy for its
specialty distribution business will take significant market share over the
ratings horizon. Cardinal's lack of a meaningful presence in specialty drug
distribution leaves a potential hole in the company's intermediate-term growth
prospects, particularly after the generic wave has washed through the channel in
The company's growth potential in China, though robust, does not sufficiently
offset this concern. There exist many opportunities for growth and expansion for
Cardinal Health China. However, the overall impact from the company's China
operations is expected to remain modest over the ratings horizon compared to
Cardinal as a whole. Fitch believes it is important for Cardinal to focus on its
core competency of healthcare distribution as it seeks to expand its presence in
the rapidly evolving Chinese healthcare industry.
POTENTIAL FOR BOTH INDIRECT AND DIRECT PRICING PRESSURE
Fitch acknowledges the evolving landscape of the global healthcare markets.
Legislated healthcare reform and government budget cuts in the U.S. have
recently accelerated the push to moderate growth in healthcare spending.
Additionally, ongoing consolidation among Cardinal's downstream customers
contributes to some margin compression within the drug channel. Fitch believes
distributors, while not immune, are well-insulated from these forces. However,
especially in light of a growing pool of generic profits within the drug
channel, distributors' generic profit margins could become a target for
government and third-party payors' to moderate drug spend.
Cardinal's contracts with Walgreen Co. (Walgreens) and CVS Caremark Corp. (CVS)
are both set to expire in the summer of 2013. Cardinal will likely be squeezed
on pricing somewhat, but Fitch expects both the Walgreens and CVS contracts to
be renewed. Contracts of this size are very sticky due to material investments
in working capital and IT infrastructure.
SOLID CREDIT PROFILE, BUT STRENGTH OF INTERMEDIATE-TERM CASH FLOWS UNCERTAINTY
Fitch believes Cardinal is committed to maintaining strong credit metrics in
line with Fitch's expectations for a 'BBB+' rating. The company has demonstrated
this commitment by maintaining solid credit metrics while consummating nearly
$2.5 billion in acquisitions in multiple areas of growth over the past two
fiscal years. The company has also spent approximately $1.2 billion in the form
of dividends and share repurchases over the same timeframe. Fitch expects
acquisition activity to be considerably more modest in coming years, though the
amount of cash returned to shareholders will likely continue to grow, as
evidenced by Cardinal's recently announced dividend increase.
Fitch believes Cardinal's stated plan to increase dividends in line with
earnings is consistent with the current 'BBB+' ratings. Near-term cash flows are
forecasted to cover increases in near-term shareholder payouts. However, Fitch
is less certain that intermediate-term growth will drive sufficient cash
generation to support any further increased focus on shareholder returns.
Fitch expects free cash flow (FCF), not including one-time tax payouts and an
unfavorable working capital swing due to the loss of the Express Scripts, Inc.
contract, to approximate $800 million in each of fiscal 2013 and 2014. Fitch
does not expect the loss of the Express Scripts contract or the suspension of
Cardinal's license to distribute controlled substances out of one of its
distribution centers, other than the aforementioned working capital swing, to
materially impact cash flows.
STRONG LIQUIDITY PROFILE
Cardinal maintains a strong liquidity profile, consisting of $2.44 billion in
cash and equivalents at Sept. 30, 2012 and a $1.5 billion revolver due May 2016.
The revolver supports a $1.5 billion commercial paper program. The company also
has an undrawn $950 million accounts receivable facility due November 2012.
Debt maturities are well-laddered and manageable for the firm. Debt maturities
are as follows: $300 million in fiscal 2013, $500 million in 2015, $768 million
in 2017, and $1.03 billion thereafter. Other than the $300 million due in 2013,
which Cardinal pre-funded with notes issued in May 2012, debt will likely be
refinanced with incrementally larger amounts consistent with EBITDA growth.
Fitch has affirmed Cardinal's ratings as follows:
-- Long-term IDR at 'BBB+';
-- Short-term IDR at 'F2';
-- Senior unsecured bank facility rating at 'BBB+';
-- Senior unsecured notes ratings at 'BBB+';
-- Commercial paper rating at 'F2'.
The Rating Outlook has been revised to Stable from Positive.
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);
--' Short-Term Ratings Criteria for Non-Financial Corporates' (Aug. 9, 2012);
--' Navigating the Drug Channel - The ABCs (and Ds) of Drug Pricing' (July 25,
--' Navigating the Drug Channel - Drug Distributors: A Deeper Dive' (March 13,
Applicable Criteria and Related Research:
Corporate Rating Methodology
Short-Term Ratings Criteria for Non-Financial Corporates
Navigating the Drug Channel -- The ABCs (and Ds) of Drug Pricing
Navigating the Drug Channel -- Drug Distributors: A Deeper Dive