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Fitch: U.S. Pharmaceutical Manufacturers and Services 2007 Outlook: Political Winds Changing

Posted on: Wednesday, 6 December 2006, 12:00 CST

The U.S. pharmaceutical manufacturing and distribution channel generally fared well in 2006, in Fitch's view. The brand name pharmaceutical companies, generic drug manufacturers, drug distributors, and pharmacy benefit managers (PBMs) have been able to sustain, and in some cases, improve their credit profiles in the midst of aggressive political and consumer health care cost containment efforts. Two key issues that Fitch closely monitored during 2006 were the effects of the initiation of Medicare Part D under the Medicare Prescription Drug Improvement and Modernization Act of 2003 and the start of a new wave of brand-name pharmaceutical patent expirations in the U.S.

Medicare Part D has so far increased drug utilization without significantly affecting pricing. Meanwhile, rapid generic substitution rates after the expiration of U.S. drug patents during the year have detrimentally affected only one large pharmaceutical company while other firms remained relatively consistent. On the other hand, increased sales of generic drugs supported the credit profiles of drug distributors and PBMs due to higher gross margins despite softer top-line growth from the increased mix of lower priced generic drug sales. The combination of the new prescription drug program and rapid generic uptake contributed to a slowing of overall growth of drug sales in the U.S. to the middle single-digit range so far this year.

2007 Outlook

The focus in 2007 will remain on containing prescription drug spending. Despite sustained pressure from managed care organizations and government programs to moderate health care spending through rapid generic drug substitution, Fitch anticipates a similar level of sales growth from 2006 to continue into 2007. Revenue growth is supported by the launch and uptake of new brand-name drug products in 2007 and growing demand for pharmaceuticals commercialized over the past few years. The growth in the development and utilization of specialty pharmaceuticals will help drive revenue growth.

Margins across the pharmaceutical distribution channel are anticipated to hold relatively steady aided by operating cost efficiencies for brand-name drug manufacturers, and increased generic drug utilization for generic drug manufacturers, distributors and PBMs. Additionally, continued efforts to rationalize capital spending will support free cash flow generation. Free cash flow will be directed to business development opportunities and share repurchase activities.

Fitch foresees a generally stable outlook for the drug manufacturing and distribution channel during 2007. The Rating Outlooks for the vast majority of credits are currently Stable, while there are three Negative Outlooks and Watches and one Positive Watch.

Fitch-rated pharmaceutical manufacturers and service entities had outstanding debt of approximately $62 billion at the end of the third quarter of 2006. Scheduled debt maturities in 2007 for companies in the pharmaceutical, drug distribution and PBM industries total $8.3 billion. Incremental debt in 2007 will come from Abbott Laboratories' acquisition of Kos Pharmaceuticals and J&J's acquisitions of Pfizer's consumer health business and Conor Medsystems, Inc.

Key Factors in 2007

Key drivers determining drug pricing and volume trends are the second year of Medicare Part D programs, brand-name drug patent expirations paired with rapid generic substitution rates, and possible increased political pressure from the change of political control of Congress. In addition, merger and acquisition activity and cost-containment initiatives continue to be potential sources of margin expansion.

Medicare Part D:

Fitch expects to see increased volumes from increased access to drugs during the second year of Medicare Part D. The drug manufacturers' ability to push through pricing increases may be dampened as the government becomes a larger purchaser of pharmaceuticals in light of the change of control of Congress. Currently, the Federal government is not allowed to negotiate pricing for pharmaceuticals purchased through the Medicare program as the duty is handled by insurers and managed care organizations on behalf of patients. Proposed changes to the drug program include the ability of the government to utilize its purchasing power and directly negotiate drug pricing, and the closure of the funding gap in drug coverage between $2,250 and $5,100 per year. Fitch believes that there is sufficient political motivation to successfully initiate change to the Medicare Part D program in 2007. However, Fitch expects that potential margin pressure from any change to the drug program will not occur until after 2007.

Branded Pharmaceutical Patent Expirations:

The wave of patent expirations that began this year will continue to a lesser degree in 2007. Brand-name drugs representing approximately $7 billion of revenues in the U.S. will potentially lose patent exclusivity next year. The most notable originator pharmaceuticals that may lose patent protection are Norvasc and Zyrtec (both from Pfizer; U.S. sales of $610 million and $330 million in 2005, respectively), Coreg and Imitrex (both from GlaxoSmithKline; U.S. sales of $1.03 billion and $920 million in 2005, respectively), Ambien-IR (Sanofi-Aventis; U.S. sales of approximately $1.5 billion in 2005), and Risperdal (J&J U.S. sales of $1.95 billion in 2005).

Pharmaceutical companies in the U.S. that will be most challenged by patent expirations during 2007 are Bristol Myers Squibb, Merck and Pfizer. Merck and Pfizer have reacted to the anticipated patent losses with aggressive cost reduction programs that will continue throughout 2007 in order to shore up margins. The successful launch of a generic version of Plavix despite pending litigation has significantly decreased U.S. revenues of Plavix for Bristol Myers Squibb and Sanofi Aventis and has created uncertainty as to the total amount of generic drug inventory in the distribution channel. The issue warrants close monitoring in the near term taking into consideration the start of the trial pertaining to patent validity on Jan. 22, 2007. Remaining large pharmaceutical manufacturers strengthened their product portfolios with newer offerings over the past few years and are less exposed to intellectual property losses in the near term. During the year, Fitch expects to see the continuation of aggressive legal tactics by generic drug companies seeking to invalidate composition-of-matter patents of brand-name pharmaceutical many years prior to actual expiration.

Patents expirations should not greatly affect volumes for drug distributors and PBMs, but revenues will be dampened from sales of lower priced generics. However, Fitch believes that margins in the drug distribution and PBM sectors will hold up fairly well, driven by increased overall utilization of the more-profitable generic drugs.

Shift in Control of Congress:

In addition to possible changes to Medicare Part D, parallel importation may also reappear in the limelight as a new Congress contemplates another option to reduce drug spending. Currently, the Federal government does not allow the importation of pharmaceuticals from other countries, citing safety concerns. But five states have launched programs over the past few years that buy drugs from Canada, Britain and others. Although the cross-border trade has dropped to around $600 million from a peak of approximately $1 billion, sufficient consumer sentiment may prompt the new Congress to enact legislation at the Federal level to open up drug re-importation.

The new Congress could also support Rep. Waxman's Access to Life-Saving Medicine Act (or subsequent bills), which establishes a framework for the approval of generic biological drugs. Previous efforts to build the structure for a generic biological drug industry were hampered by lack of technological methods to fully characterize the highly variable large molecular structures. The Waxman bill amends the Public Health Service Act to allow the Secretary of the Health and Human Services Department to decide on an individual basis the studies necessary to determine comparability of follow-on biological products. Fitch expects that significant progress will be made with the new legislation, first introduced to Congress in September 2006, and that it may possibly be approved in some form in 2007.

Mergers and Consolidation:

Recent acquisition activity in the pharmaceutical industry has been devoted to enhancing research and development pipelines for mid-sized to large companies, and broadening the technology base and distribution network for generic drug firms. Additionally, a true business model change occurred in the PBM space with the announcement of the CVS/Caremark merger in November 2006.

Fitch expects that mergers and acquisitions will continue in a similar vein in 2007 as in 2006. Brand-name pharmaceutical firms will focus on increasing the breadth of current product and R&D portfolios by completing corporate and technology transactions, while generic drug companies will direct investment toward increasing reach, adding foreign manufacturing capacity, and broadening current product offerings. Fitch expects further consolidation of the generic drug industry, but not with the larger brand-name drug manufacturers. Also, the proposed CVS/Caremark merger has raised the prospects for further consolidation between retail drugstores and PBMs. Fitch does not anticipate large acquisitions with the drug distributors.

Sector Outlooks

U.S. Pharmaceutical Industry:

The U.S. pharmaceutical industry will contend with sustained pressure on margins from containment of branded prescription drug pricing and funding of R&D programs. Development of specialty drugs, especially oncology products, will continue to be a focus for treating unmet medical needs, with the sales of these products potentially providing stronger margins. Companies will continue to extract efficiencies across entire operating cost structures including the previously considered sacrosanct R&D programs. Fitch does not expect significant margin erosion during 2007 for brand-name pharmaceutical companies, with the exception of Bristol-Myers Squibb.

Generic drug manufacturers, as do their brand-name counterparts, benefit from positive industry dynamics, including an aging population and increased patient access due to Medicare Part D. Moreover, generic firms will continue to be advantaged during 2007 by the increasing demand for generic pharmaceuticals supported by consumer, political and managed care motivation to control health care costs. However, pricing for commodity-type generics will continue to be pressured by low-cost providers, prompting companies to offer more exclusive (e.g. difficult to manufacture) generic products.

Cash flows will continue to be sufficient to cover capital needs in 2007 for both generic and brand-name drug companies, with excess cash flow devoted to the continuation of dividends, satisfying share repurchase programs, and acquisition and licensing strategies. Additional, cash outflows for a few pharmaceutical companies will be dedicated to resolving product liability concerns with particular emphasis on Merck's Vioxx litigation.

PBMs and Drug Distributors:

Generally, Fitch expects reasonably strong demand for PBMs and drug distributors will be driven by demographics, Medicare Part D, and potential introductions of novel therapeutics, especially specialty pharmaceuticals. Fitch expects margins in both sectors to be supported mainly by the increased utilization of generic drugs. Moreover, distributors should continue to benefit from 'fee-for-service' agreements, and PBMs should benefit from an increase in specialty business. However, continued political and consumer efforts to moderate their drug spending growth do pose a moderate risk to margins.

The recent announcement of the merger of CVS and Caremark does present some further risk of merger activity in the PBM industry. However, there is uncertainty regarding potential channel conflicts that may offset the benefits of increased purchasing power and a broader offering of services from the combined company.

Two notable attempts to address the increase in drug spending are Wal-Mart's program offering a select group of generic drugs for $4.00 per prescription, eventually nationwide, and the potential elimination of reimbursement of branded drugs from third-party payers based on Average Wholesale Price (AWP).

Fitch believes there will not be a mass movement of patients to Wal-Mart, mitigating a widespread pricing battle. However, PBMs and distributors could lose some business and margin. While distributors and PBMs and distributors have not been materially affected by the program so far, the possibility of a more competitive pricing environment bears monitoring.

Fitch recognizes that a change in reimbursement methodology away from AWP poses a risk to margins. However, the PBM industry adds value by moderating the growth of a client's drug spending. If the industry can soundly demonstrate that value, clients may be less sensitive to where the industry makes money in the process. As long as fees, discounts and rebates in the aggregate add up to a satisfactory level of margin, the industry should be able to maintain its level of profitability. Drug distributors should not be greatly affected by this issue given that most pharmacies do not use AWP when purchasing inventory. Also, distributors have already changed their business models to be more reliant on fees from branded manufacturers rather than on branded-drug pricing.

Following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. pharmaceutical manufacturing and services sectors.

Pharmaceuticals:

--Abbott Laboratories ('AA-'; Rating Watch Negative);

--Allergan, Inc. ('A-'; Outlook Stable);

--Bristol-Myers Squibb Co. ('A+'; Rating Watch Negative);

--Eli Lilly & Co. ('AA'; Outlook Stable);

--Johnson & Johnson ('AAA'; Outlook Stable);

--Merck & Co. ('AA'; Outlook Negative);

--Pfizer, Inc. ('AAA'; Outlook Stable);

--Schering-Plough Corp. ('A-'; Outlook Stable);

--Watson Pharmaceuticals, Inc. ('BBB-'; Outlook Stable);

--Wyeth ('A-'; Outlook Stable).

PBMs:

--Caremark Rx ('BBB'; Rating Watch Positive);

--Express Scripts, Inc. ('BBB'; Outlook Stable);

--Medco Health Solutions, Inc. ('BBB+'; Outlook Stable).

Drug Distributors:

--AmeriSource-Bergen Co. ('BBB'; Outlook Stable);

--Cardinal Health, Inc. ('BBB+'; Outlook Stable);

--McKesson Corp. ('BBB+'; Outlook Stable).

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Source: Business Wire

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