The Post-Patent Cliff Tab: Pharma Battered But Still Financially Strong, Says Moody’s

The patent cliff has battered pharma companies’ financial underpinnings over the past three years, both directly and indirectly, but the industry is still comparatively well endowed to face new macro challenges, ranging from health care reform to pricing pressure and relentless competition, according to Moody’s.

The patent cliff has left its mark on pharma’s financials, both directly and indirectly, and a new report by Moody’s tallies the tab, albeit from a 30,000-foot perspective. Changes in the regulatory and economic landscape have weakened the financial position of the pharmaceutical industry over the last three years. Yet, while the pharmaceutical industry – and related sectors – are not as liquid as they once were, the largest companies still can boast a robust cash position and a relatively good handle on their debt levels.

Cash and investments of the 10 largest U.S. pharmaceutical companies – including Pfizer Inc., Johnson & Johnson, Merck & Co. Inc., Eli Lilly & Co., Bristol-Myers Squibb Co., Allergan Inc., Amgen Inc., Gilead Sciences Inc., Celgene Corp. and Biogen Inc. – totaled over $100 billion as of the end of 2012, according to Moody’s Healthcare Quarterly released on July 9.

Among those with the largest cash holdings at the end of 2012 were Pfizer with $35 billion, Merck with $19 billion, Amgen with $18 billion and J&J with $15 billion. Yet, the majority of this cash is kept offshore and likely to stay there, even as economic turmoil and pricing pressures continue to effect markets overseas, said Moody’s Senior VP Michael Levesque in an interview.

It’s hard to say just how much of their cash companies are keeping overseas – as many do not disclose these numbers. One pharma that tends to be more transparent abo is Pfizer, which said in its most recent 10-K that between 10% and 30% of its cash holdings are U.S.-based.

“Cash holdings provide the industry with considerable liquidity. Cash coverage of debt will remain relatively stable going forward, as both cash and debt levels rise for most companies,” wrote Levesque in the report.

Debt: A Rising Tide

Pushing debt levels upward since 2009 from $139 billion to the current level of $156 billion have been big pharma’s efforts to provide shareholders with greater returns, despite the considerable number of patent expirations dragging down earnings.

Big pharma companies have made considerable share repurchases over the last three years and increased dividend spending significantly in an effort to keep shareholders happy as they rebuild their pipelines (Also see "Biopharma M&A In An Era Of Elusive Growth, Capital Triage, and New Competitors" - In Vivo, 19 Jun, 2013.).Some companies have use one-off injections of cash from spinning out a unit or asset to conduct a share repurchase This has been Pfizer’s strategy as it continues to make over its business – first with the sales of its nutrition business to Nestle SA for $11 billion in April 2012 and later with the spin-out of its animal health unit Zoetis (Also see "Pfizer Sells Nutrition Portfolio To Nestle For Nearly $12B" - Pink Sheet, 23 Apr, 2012.) and (Also see "Ahead Of Schedule, Pfizer Prepares To Set Zoetis Free In Stock Swap" - Pink Sheet, 22 May, 2013.).

But not all big pharmas are taking this approach – Moody’s recently downgraded Merck’s credit rating a notch to A1, from Aa3, citing the $15 billion share repurchase program the company announced in May. Merck’s debt is expected to increase steadily, but Moody’s still considers the company’s outlook to remain stable.

Levesque noted that Moody’s typically views share buybacks more favorably than dividend increases because they provide companies with more flexibility. “This is a lever that is easy for a company to control,” he said. He also pointed out that companies only tend to cut dividends in times of severe stress, making that form of capital allocation a bit more rigid.

This increase in debt and the strain on earnings has pushed free cash flow down since 2009 to under $40 billion for the 10 largest pharma companies – free cash flow is measured as the amount of cash on-hand after dividends and other capital expenditures are paid.

“Until newly launched products become blockbusters, cash flow will remain at these lower levels,” Levesque wrote in the report.

Some of the drugs that Moody’s expects to reach blockbuster status include Pfizer/Bristol’s blood thinner Eliquis (apixaban), Pfizer’s rheumatoid arthritis drug Xeljanz (tofacitinib), J&J’s diabetes medication Invokana (canagliflozin), Lilly’s recently filed diabetes drug dulaglutide and Celgene’s multiple myeloma treatment Pomalyst (pomalidomide), among others.

Hospital Sector Financially Buoyed For Health Care Reform

Moody’s also looked at other sectors of the health care industry in its quarterly report. It said the for-profit hospital sector is looking strong – having kept debt levels relatively stable, but increased free cash flow, despite an uptick in dividend payouts, share repurchases and acquisition activity.

Meanwhile, not-for-profit hospitals are looking much better than they did three years ago. “Though total debt outstanding has increased since the recession, there has been a notable improvement in three key liquidity and cash flow metrics, including absolute cash balances, cash-to-debt and debt-to cash flow,” wrote Moody’s SVP Lisa Martin in the report.

Health insurers have a stronger credit profile than post-recession, but have less financial flexibility due to acquisitions and higher debt levels. From the end of 2009 to the end of 2012, total adjusted debt for the 14 rated health insurers increased by $19.3 billion to a total of $61.3 billion. The increase in debt largely was used to fund acquisitions as insurers sought diversification in Medicaid, Medicare and international operations.

Medical device makers have a weaker credit profile than before due to an increase in debt spurred by acquisitions and shareholder initiatives. Yet, top-line growth continues to be weak as hospital admissions have slowed, the regulatory environment has grown more stringent and pricing pressured have increased.