Big Pharma companies have been steadily dropping in the eyes of credit ratings agencies since 2014—and the downward spiral won’t likely end this year.
That’s all thanks to the industry’s unrelenting appetite for mergers and acquisitions, as well as expected U.S. pricing pressure for branded drugs from both payers and the government, analysts at S&P Global Ratings said in a report released Tuesday.
Despite a few positive developments, such as the industry’s improved reputation due to its contributions during the COVID-19 pandemic, S&P still believes it will hand out more company downgrades than upgrades in 2021. Of the 65 pharma companies it rates, 28% currently have negative business outlooks, versus 68% with stable expectations.
M&A is the culprit
M&A has been driving most downgrades among investment-grade pharmas in the past seven years, S&P noted. They include AbbVie’s multi-notch lowering to BBB+ from A- in 2020, which resulted from its Allergan purchase. Bayer also saw its rating fall to BBB from A- in 2018 in the wake of its Monsanto buy.
Acquisitions are often funded partly with debt, which increases credit risks that can outweigh any boost to business strength, S&P said. Of course, that’s not always the case. For example, Bristol Myers Squibb withstood its Celgene megamerger in 2019 without a downgrade; in fact, the company’s A+ rating hasn’t changed since at least 2007.
After a slowdown in 2020, industry watchers expect that biopharma M&A will rebound in 2021, given that large companies have the cash and the need to invest in key therapeutic areas and technologies to drive long-term growth. Companies with looming patent expirations or relatively weak internal pipelines will be particularly active buyers, experts predict.
What’s more, Big Pharma companies are steadily pulling back from long-held policies of only shouldering conservative debt loads, S&P noted. The average and median adjusted debt-to-EBITDA ratios have ticked up from about 0.5x in 2010 to over 2.0x in 2019 for the pharma companies S&P tracks. “We anticipate this trend may influence shareholder expectations and increase the tolerance for higher leverage among pharma company boards,” the analysts wrote in the report.
S&P also included divestitures in its M&A analysis. Over the past few years, many biopharma companies have sold off noncore assets in generics, consumer health, animal health and mature branded drugs.
“Divestitures typically reduce profits (EBITDA), scale and diversity, which weakens business strength and stability,” the analysts said. When the proceedings aren’t used to reduce debt load but are instead diverted to fuel further M&A or distant pipeline products, a company’s rating could suffer, they added.
Pfizer sold off its established medicines unit Upjohn to Mylan for $12 billion to form Viatris, and it’s planning a spinoff of its newly formed consumer health joint venture with GlaxoSmithKline. Hence S&P lowered the New York pharma’s rating to A+ in 2020 from AA- the prior year. S&P expects Pfizer will use the proceeds to acquire clinical-stage assets to support its innovative drug pipeline.
Merck & Co. got a similar downgrade to AA- from AA after it decided to spin off its women’s health franchise, along with some legacy products and biosimilars, into Organon. The S&P analysts expect the New Jersey pharma to pour the proceeds of $8 billion to $9 billion into future M&A. Merck has made several deals in the past few years, as investors have pressured the company to diversify beyond its megablockbuster immuno-oncology drug Keytruda. As a result, the S&P team plans to further lower Merck’s rating by one or two notches at the close of the transaction.
S&P noted some recent positive developments that could ameliorate—but probably entirely offset—the M&A effect on ratings. “Leverage is already at a long-term high for many companies, and several have communicated that deleveraging is a priority,” it said. For example, Takeda, which had its S&P rating demoted to BBB+ from A- in the wake of the Shire buyout, has put paying off debt on its agenda.
Moreover, S&P sees the increasing adoption of heavily backloaded licensing deals versus outright buyouts as less negative for company ratings, but the firm warns that these milestone-based deals could also come with the risk of contingent liabilities.
Constraints on pricing could help
Drugmakers have been facing increasing resistance from U.S. pharmacy benefit managers, the public and the government over price hikes— a trend that S&P expects will persist this year as net prices of branded drugs remain flat.
The consolidation of PBMs, pharmacies and insurance companies in recent years has given PBMs more negotiating power, S&P noted.
In addition, with a shift in public opinion, PBMs “have the public and political support to require prior authorization, use step-therapy, and exclude substitutable products from their formularies,” the analysts said. PBMs have used different tools to target drugs in antivirals, neurology, autoimmune disease and even biosimilars to drive down net prices, they pointed out.
Pricing pressure could play into M&A, too. When companies struggle to achieve growth through price increases, they could turn to M&A, the analysts said.
U.S. drug pricing reform could further weigh on the effort to boost drug prices. Since the introduction of Medicare Part D for U.S. seniors, out-of-pocket and payer spending on drugs have both grown faster than inflation, S&P noted. This has inspired several policy proposals from both legislative and administrative bodies.
Such talks may have been delayed by COVID-19, but as the Democratic Party comes into power amid bipartisan support for controlling drug spending, “we believe it’s more likely some combination of proposals could advance in 2021,” the S&P team predicted.
Nevertheless, S&P said pharmas could survive drug pricing reform relatively unscathed in terms of profits, given the industry’s sustained innovation and “the emergence of an improved appreciation for the pharmaceutical industry’s contributions during the pandemic.”
The S&P team pointed to several other potentially positive influences on ratings, including a benefit from selling COVID vaccines and drugs, an opportunity for long-term cost savings from the shift to digital marketing, the continued resolution of opioid litigation and flattened price erosion in the generic sector.