Fitch: Bayer Remains on Rating Watch Negative
The RWN continues to reflect Bayer's planned acquisition of US-based agrochemical company Monsanto (A-/RWN) for USD66bn (of which we expect up to USD47bn will be funded by debt), which could result in a downgrade of minimum two notches.
Excluding the acquisition, Bayer's credit profile is compatible with a Long-Term 'A' IDR with a Stable Outlook on a standalone basis as the group has been deleveraging since its Merck consumer health acquisition, driven by strong free cash flow (FCF) generation, in combination with asset disposals and the use of hybrid debt to manage its financial risk profile. The ratings continue to reflect Bayer's strong market positions in different, uncorrelated sectors, spanning pharmaceutical, consumer and animal health, crop science as well as a majority stake in specialist plastics manufacturer Covestro.
KEY RATING DRIVERS
Business Risk Profile Strengthening
The ratings remain underpinned by Bayer's strong market positions in the healthcare, animal health, and crop science markets. We believe the repositioning of Bayer's business model towards the life science sector will offer sound organic growth opportunities, which Fitch has incorporated into its rating case projections. All of these sectors share a strong focus on R&D and benefit from long-term positive economic and demographic trends.
Bayer also holds a 64% stake in specialist plastics manufacturer Covestro, following a partial IPO in October 2015. While Bayer still controls Covestro's Board of Directors and its financial policy, we view this stake as non-core and expect a gradual divestment over time, subject to value creation for Bayer's shareholders.
Although Covestro has performed satisfactorily post IPO as a result of prior significant restructuring, we would see the exit from this business as positive for Bayer's business risk profile. This is because it will reduce cyclicality, remove a structurally lower-margin business and free up capital to be invested in the remaining business that offers higher returns.
Improving Profitability, Pharma-Driven
We expect Bayer's profitability to improve over a four-year rating horizon, with EBITDA margin gradually trending towards 24% (from 21% in 2015). This will be driven by the encouraging performance of new treatments in the pharma segment, which attract structurally higher margins.
Bayer's profitability is also supported by the realisation of cost synergies in the consumer health division and the currently satisfactory performance of Covestro. Bayer has, however, under-delivered on the revenue synergies expected from the Merck consumer health integration, due to under-investment in brands and R&D under previous ownership.
Satisfactory FFO Generation, Deleveraging
Fitch expects Bayer to return to funds from operations (FFO) adjusted net leverage of below 2.0x during the course of this year (around 1.7x by year-end), following a temporary breach peaking at 2.7x in 2014 as a result of the Merck consumer health acquisition.
The deleveraging path is supported by the sale of the Covestro minority stake and the placement of hybrid debt, in addition to strong FCF margin of more than 5% achieved in 2015. We project fixed charge cover to trend towards 14x by 2018, which is strong for the rating category considering Bayer's exposure to both healthcare and chemicals, from 8.9x in 2015.
Monsanto Acquisition Drives RWN
The USD66bn acquisition of Monsanto could lead to an increase of Bayer's debt of up to USD47bn (USD19bn will be funded by equity). In line with our May 2016 rating action, we continue to expect Bayer's 'A' rating to be downgraded by at least two notches on completion, but to remain in the 'BBB' category.
Bayer's final rating will be determined by the proportions of senior and subordinated/hybrid debt (which will depend on market conditions and investor appetite) and by the specific features of the hybrid debt (which will determine how much equity credit it receives). Depending on the level of the IDR, we would expect Bayer's subordinated debt to attract a crossover (BBB-) rating at best.
We view the impact of the Monsanto transaction on Bayer's business profile as mixed. The acquisition is part of Bayer's shift towards the more cyclical agri-business from being a healthcare-orientated company with a below-average business risk profile but this will be balanced by better scale and diversification. In addition, Bayer faces execution risks in delivering an ambitious integration plan while attempting to maintain its focus on capital allocation, as the healthcare business also offers growth and investment opportunities and is subject to strong competition.
'A' Rating Category Targeted
Bayer has communicated its intention to return to the 'A' rating category over the medium term. We believe it has a variety of strategic options to achieve this, including divestments. However, we view a successful integration of Monsanto and the delivery of the expected medium-term EUR1.5bn cost synergies as key to supporting FCF generation and a return to a higher rating, especially if the dividend policy remains unchanged.
Hybrids Provide Financial Flexibility
Fitch views hybrid debt now as a permanent feature of Bayer's capital structure to optimise investor reach as well as funding mix and costs. Fitch rates the hybrid notes two notches below Bayer's IDR given their long-dated maturity (more than 60 years), contractual subordination to senior debt and senior ranking only to common equity, reflecting their consequently lower recovery prospects in a bankruptcy or liquidation scenario relative to senior obligations.
The hybrid issues qualify for 50% equity credit as they meet Fitch's criteria with regard to deep subordination, remaining effective maturity of at least five years (including coupon step up of less than 1% and replacement language) and deferrable interest coupon payments at the option of the issuer. All these features offer sufficient financial flexibility to protect the capital structure in our view.
KEY ASSUMPTIONS
Fitch's expectations are based on the agency's internally produced, conservative rating case forecasts. They do not represent the forecasts of rated issuers individually or in aggregate. Key Fitch forecast assumptions include:
-Satisfactory organic growth profile with turnover growing at CAGR 2.6% over the four-year rating horizon.
-EBITDA margin improving towards 24% in 2019 (from 22% in 2016) driven by the good performance of the recently launched pharma products. Profit margins are also supported by ongoing restructuring in the consumer health division, in addition to a resilient near-full year performance from Covestro.
-Break-up fee of USD2bn (EUR1.8bn) in 2017 should the proposed Monsanto acquisition not go ahead.
-An annual bolt-on acquisition budget of EUR800m in addition to capex assumed at around 5% of sales.
-No further reduction of Covestro ownership, which remains a strategic option and management's intended strategy. Any disposal of shares applied to debt reduction or an acquisition accretive to profits could provide upside to the rating case projections (current value of Bayer's stake in Covestro estimated at EUR6.5bn)
-A degree of FX volatility (part. EM - Russia, Brazil, China - and USD exposure) resulting in continued FX translation risk.
RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- FFO adjusted net leverage above 2x on a continuing basis, for example, as a result of a severe drop in EBITDA due to an adverse economic environment or driven by large debt-financed acquisitions or shareholder returns
- FFO fixed charge cover below 6x
Upon completion of the Monsanto transaction, we will likely downgrade Bayer's ratings by at least two notches. The final ratings will depend on pro-forma leverage on completion and on the visibility and credibility of a sustainable de-leveraging path using cash flow and potential divestment proceeds.
Positive: A positive rating action is currently not envisaged. If the transaction does not proceed, Fitch expects to affirm the rating at the current 'A' level. However future developments that could lead to positive rating actions include:
- Further improvement in FFO adjusted net leverage to 1.0x or below on a continuing basis
- FFO fixed charge cover above 8x
- A larger proportion of sales stemming from the defensive healthcare segment.
LIQUIDITY
Fitch views Bayer's liquidity as strong. Bayer has access to funding sources spanning bonds, bank debt, commercial paper and EUR6.2bn of revolving credit facilities, of which EUR3.5bn are available at Bayer and EUR2.7bn at Covestro level. Both facilities were undrawn at end-2015. Bayer's cash position amounted to EUR1.9bn at end-2015 and the agency assumes a minimum FCF generation of EUR2.5bn p. a. over the four-year rating horizon (discounting any break-up fee associated with the Monsanto acquisition). Fitch assumes EUR200m as non-readily available cash in its liquidity calculation to allow for intra-year working capital swings.
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