U.S.

Aging Creates A Long-Term Challenge For Global Big Pharma Ratings

Primary Credit Analyst: David K Lugg, New York (1) 212-438-7845; david.lugg@standardandpoors.com Secondary Contacts: David P Peknay, New York (1) 212-438-7852; david.peknay@standardandpoors.com Olaf Toelke, Frankfurt (49) 69-33-999-125; olaf.toelke@standardandpoors.com Michael G Berrian, Boston (1) 617-530-8307; michael.berrian@standardandpoors.com

Table Of Contents
High Industry Margins Are Now Feeling The Pinch Overseas Where Does The U.S Stand On Reigning In Medical Cost Inflation? The Affordable Care Act's Mixed Impact The Sector Is Weathering The Wave of Patent Expirations--But Short-Term Challenges Persist The Outlook For Potential New Blockbusters Ultimately, Profit Margins Will Likely Erode

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U.S. Aging Creates A Long-Term Challenge For Global Big Pharma Ratings
Despite eroding overseas profit margins due to government payor pricing pressures outside the U.S., large American pharmaceutical companies with global reach have generally been successful in offsetting shrinking overseas margins by implementing price increases at home. These pricing increases have averaged in the medium- to upper-single-digit percent range annually over the past few years. Domestic pricing flexibility has been an important factor in offsetting revenue losses from patent expirations and supporting the stable outlook for highly rated U.S. Big Pharma companies. The U.S. market is also critical for large global European pharmaceutical companies' profitability, as their substantial American sales and profits are helping to offset pricing pressure elsewhere, contributing to their healthy credit standing. But Standard & Poor's Ratings Services is concerned that Big Pharma's American pricing flexibility may diminish increasingly over the next few years because of the rapidly mounting costs of Medicare and Social Security with the aging of the U.S. population, and public and private sector health care payors looking to control their burgeoning medical expenses. While there will be a material increase of sales of medicines in the U.S. as the population ages and The Affordable Care Act (ACA) expands insurance coverage to a broader percentage of the population, we expect that falling prices will more than offset this rise in volume. In our view, this could well cause significant erosion in drug makers' currently high operating margins and lead to rating downgrades if these companies cannot boost margins in other ways. Growing competition from low-cost generic manufacturers, which are becoming stronger with consolidation in the subsector, will also likely hamper the big pharmaceutical companies' ability to offset the potential revenue and margin deterioration. (Watch the related CreditMatters TV segment, titled "How The Aging U.S. Population Could Affect Big Pharma," dated June 26, 2013.) Overview Investment-grade global pharmaceutical companies have been resilient in facing recent challenges, such as margin erosion outside the U.S. and major patent expirations, and generally have been able to preserve their high credit ratings. The potential for pressures on pricing flexibility in the U.S., with health care payors focusing on controlling costs at a time when the population is aging, could derail drug makers' ability to contend with these difficulties. Standard & Poor's expects the efforts to control health care costs to lead to downgrades of Big Pharma companies toward the end of the decade if the drug makers cannot find other sources to boost margins.

High Industry Margins Are Now Feeling The Pinch Overseas

The average 2012 EBITDA margin for the top 11 global pharmaceutical companies was 35% (see table), which is markedly higher than for most other major industries as a result of the protection afforded by patents and, to a lesser extent, the value of brands. It is also substantially higher than that of the branded consumer staples sector--another

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U.S. Aging Creates A Long-Term Challenge For Global Big Pharma Ratings

industry that enjoys high margins and benefits from powerful brands (but not patents) (see chart 1). Current Big Pharma Ratings And Historical Adjusted EBITDA Margins*
EBIDA margin (%) Issuer Johnson & Johnson Pfizer Inc. Abbott Laboratories Merck & Co. Inc. Eli Lilly & Co. Bristol-Myers Squibb Co. Roche Holding AG GlaxoSmithKline PLC Novartis AG Sanofi AstraZeneca plc Avg annual adjusted EBITDA margin Rating AAA AA A+ AA AAA+ AA A+ AAAA AA2012 32.4 46.6 30.5 37.6 29.9 34.8 41.5 29.8 28.5 31.1 37.6 34.6 2011 31.4 44.0 31.0 38.5 32.4 37.6 38.2 33.8 31.8 32.5 43.0 35.8 2010 33.1 40.8 31.7 33.1 36.3 37.3 34.0 22.3 34.0 34.9 40.7 34.4 2009 33.0 45.8 31.4 28.4 36.7 35.3 35.6 33.1 27.5 39.0 40.7 35.1 2008 31.1 47.3 29.0 34.8 33.5 30.5 36.4 34.8 27.4 36.9 37.5 34.5

*See "2008 Corporate Criteria: Ratios And Adjustments," published April 15, 2008.

Chart 1

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U.S. Aging Creates A Long-Term Challenge For Global Big Pharma Ratings

Downside pressure on margins in business outside the U.S. is largely a function of government efforts to slow the growth in spending on health care, including pharmaceutical products. This is often part of a fiscal consolidation process that seeks to reduce government deficits and debt burdens, which rose sharply in 2007-2008 and subsequent years, particularly in Europe, as a result of economic pressures and financial sector aid. With public pensions and health care typically accounting for about 40% of government spending and single-payor systems giving governments substantial influence over drug pricing, governments often make pharmaceuticals an important part of expenditure restraint programs. As a result, pharmaceutical company pricing flexibility continues to be more restricted outside the U.S.

Where Does The U.S Stand On Reigning In Medical Cost Inflation?

Health care budget and cost controls are less advanced in the U.S. than in some other large developed countries, in part because of historical long-term difficulties in gaining political consensus for meaningful cost reforms. The U.S., in contrast with most other developed countries, does not use a single-payor system, diffusing pricing decisions across a number of payors. In Europe, on the other hand, pharmaceutical companies usually negotiate prices directly with national government entities, which have had greater historical pricing leverage with industry players. While outlays/costs per patient in the U.S. are currently markedly higher than in most other developed countries and continue to grow, clinical outcomes are often weaker. This suggests room for improved efficiency in health care dollar spending, including opportunities to cut costs. We believe that because of burgeoning aging-related health costs, controlling per capita health care expenditures will likely become unavoidable for the federal government and other payors, and thus precipitate a radical reform of spending processes to avoid financial calamity in the health care system.

The Affordable Care Act's Mixed Impact

The ACA is easily the most significant medical legislation since Medicare. It attempts to replace a fee-for-service paradigm with a value-based approach to acquiring medical products and services, while expanding coverage to a larger portion of the population. We expect this expansion to be a modest positive for pharmaceutical companies because Medicare Part D covers the age group that consumes the most medicines. The coverage expansion will mainly affect patients in the 20-59 age group, who take about one-third the amount of medications that those 60 years and older use, according to the National Center for Health Statistics. The impact of the emphasis on value is more difficult to assess. Reimbursement to providers will be based on medical outcomes rather than on the procedures performed, with a financial incentive to lower the cost of effective care. While this suggests that doctors will write prescriptions with more care, under-prescribing can cause poor outcomes. We expect pricing pressure to increase nonetheless, as increasing data sharing between insurers and providers could provide the evidence to narrow the range of medications reimbursed, with discounts from manufacturers becoming the "price of admission" for many drugs.

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The Sector Is Weathering The Wave of Patent Expirations--But Short-Term Challenges Persist
While we believe U.S. aging will pose a bigger problem for the industry toward the end of this decade, global pharmaceutical companies have thus far been able to weather the industry's immediate hurdles without a significant impact on credit quality. Big pharma firms got through the wave of patent expirations in 2011-2012, when $40 billion worth of drugs lost patent protection, with their credit quality largely intact. The lack of any downgrades related to patent expirations during this patent cliff demonstrated these companies' credit resilience. Large drug makers with investment-grade ratings (of 'BBB-' or higher) have low leverage, high margins, and large cash resources. Moreover, the companies benefit from their products' largely nondiscretionary nature, many industry players' successful acquisition strategies, and conservative financial policies that provide buffers to absorb deterioration in credit metrics. However, the road ahead is hardly free of obstacles, even over the near term. Companies are struggling to replace sales from blockbuster drugs that have gone off patent as pricing restrictions in important pharmaceutical markets continue to grow. Generic drug manufacturers' aggressive challenges to U.S. patents, along with a less predictable regulatory environment, are other concerns. And while emerging markets' rapid economic growth is creating vast new sales prospects for global drug companies, these are lower-margin opportunities.

The Outlook For Potential New Blockbusters

The U.S. Food and Drug Administration (FDA) has approved a growing number of new molecular entities (NME)-active ingredients that have never before been marketed--in the past five years, which is good news for the industry. While NMEs provide a foundation for future growth, sales from such products over the next few years will not fully replace the steep sales losses from patent expirations. And although many companies' new products have blockbuster potential, it will likely take years to begin to recapture some of the revenues lost on patents that have expired.

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U.S. Aging Creates A Long-Term Challenge For Global Big Pharma Ratings

Chart 2

Ultimately, Profit Margins Will Likely Erode

Despite Big Pharma's general success in withstanding the wave of recent patent expirations with its high margins and ratings intact, the subsector's outlook is increasingly pointing to darkening skies as the end of the decade approaches. We expect payors to look to cut pharmaceutical and other medical costs to offset the surge in expenses associated with a rapidly aging population. We believe that profit margins and ratings will face increasing pressure as pricing flexibility in the U.S. shrinks. While the industry appears to have some significant blockbuster drugs in the pipeline, they may well be insufficient to offset the eroding margins from pricing pressure and patent expirations.

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