Over the next year, we expect a relatively balanced mix of upgrades and downgrades in the global pharmaceuticals industry. This contrasts with the preponderance of negative rating actions over the last few years (2019-2021). Rising leverage led to downgrades among investment-grade branded pharma companies (Big Pharma) over the last eight years (2014-2021), with 25 downgrades and four upgrades among investment-grade companies during that period (see Table 1). There has also been a notable rise in defaults in the sector over the last few years (2017-2021; see "Mortality In Health Care: What Factors Lead To Default For Pharmaceutical Companies," Feb 14, 2022).

Table 1

Table 2

Various Trends Point To Greater Ratings Stability

Table 3 summarizes several of the drivers that increased debt leverage, which led to the disproportionate number of downgrades in recent years. Several trends suggest more moderate M&A activity and greater rating stability going forward.

Table 3

The Pace Of M&A Activity Will Slow

The biggest driver of the higher leverage and downgrades among big pharma was an increase in spending on debt-financed acquisitions (see "Lessons Learned: What Leads To Rating Changes For Investment-Grade Pharmaceutical Companies," Jan. 22, 2019). Acquisitions are generally negative for the acquirer's creditworthiness because they're usually financed--at least in part--with debt. The increase in leverage (especially on relatively conservatively leveraged investment-grade companies) nearly always outweighs the incremental benefits such deals provide to business strength. The impact on creditworthiness is especially pronounced when the acquisition occurs at high multiples or includes clinical-stage drug assets that aren't expected to generate profits for several years.

We expect a more moderate level of spending on acquisitions for these reasons:

Following the elevated M&A and rise in leverage in recent years, many Big Pharma companies are prioritizing deleveraging.  The average leverage among Big Pharma companies hit a 10-year high in 2019 but has been improving since then. Indeed, this year we revised our outlooks on Bristol Myers, Gilead, and Eli Lilly to stable from negative due to their improving credit metrics. We also recently revised our financial risk profile on GSK to reflect lower leverage and prospects for further improvements to leverage from the planned spin-off of its consumer health division (Haleon). Moreover, given that leverage is still near peak levels, we see potential for further deleveraging at some companies. This deleveraging increases the cushion (and capacity for debt-financed M&A and further investments in R&D) at current ratings and improves the potential for upgrades. An upgrade would be contingent on leverage falling to a level consistent with a higher rating, and the company would also need to demonstrate a commitment to generally maintaining leverage at that lower level.

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Table 4

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As an alternative to outright acquisitions, Big Pharma companies are increasingly pursuing partnerships, joint ventures, and milestone-based agreements with biotech start-ups.  We view this as a positive credit consideration, as it requires a lower upfront investment and shares the development and regulatory risks with the biotech target. It also allows Big Pharma companies to diversify their M&A investments more broadly. We believe these deals have been increasing partly because Big Pharma companies' balance sheets are already burdened with substantial debt leverage. Big Pharma companies are also seeking to preserve the biotech target's uniquely nimble, creative, and entrepreneurial culture that fosters innovation. Moreover, with the weak valuations and weak IPO market for biotech firms, we believe these companies will likely find partnerships more attractive than an outright sale (at a low valuation).

That said, these partnerships usually involve revenue sharing or contingent liabilities, often structured as milestone payments or royalties. We generally burden debt (but not EBITDA) with an (often risk-adjusted) estimate of future milestone payments within our forecast horizon. Conversely, we generally burden EBITDA (but not debt) with outgoing royalty payments that are spread over time and fluctuate in tandem with revenues. So far, these amounts are increasing but have not generally been material enough to meaningfully affect any Big Pharma ratings.

We believe the current rise in interest rates makes debt-financed acquisitions less attractive.  Although rising interest rates increase the cost of outstanding debt, interest expenses tend to be a relatively small cost for investment-grade companies. Rising interest rates could increase pressure on highly leveraged companies that generate limited free cash flow. However, we account for this in our ratings by focusing more on leverage than on interest-coverage ratios (which were strong when interest rates were exceptionally low in recent years).

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The increase in accessibility of overseas cash, which followed changes in repatriation taxes for U.S.-based companies in 2018, contributed to the surge in M&A spending.  Although M&A did not surge immediately after the tax reform, we believe the increase in M&A in subsequent years was partially attributable to the increased accessibility of sizeable amounts of cash held overseas. Indeed, it often takes some time for companies to find a value-creating acquisition, especially when there is substantial competition for acquisitions that increase valuations.

We also believe the growing resistance in the U.S. to pharma companies raising drug prices drove companies to pursue M&A as an alternative way to support revenue growth.  In the U.S., historically many pharma companies implemented mid- to high-single-digit percent price increases annually. However, the American public has become less tolerant of such increases, and some highly publicized aggressive price hikes have only accelerated the resistance. This has led to heightened lawmaker scrutiny and the discussion of drug price reform legislation. This pressure was further compounded by more aggressive negotiations by pharmacy benefit managers (PBMs), which have been increasingly using the threat of formulary exclusions to negotiate lower drug prices. As a result, we expect net prices to be relatively flat to slightly down in 2022 and 2023 (nominally positive given the elevated inflation rate), as in the last few years.

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While the less-favorable price trends persist, we believe Big Pharma companies have adapted by increasing their focus on innovation-driven growth, partnerships, and combination products. In some instances, they have divested slower-growing non-core businesses (such as animal health, consumer health, generic, or branded-generic businesses), at least in part to support higher revenue growth. We also believe expectations for revenue growth are tied to average growth in the industry, which is now lower given the flat to modestly declining pricing.

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We believe there was a unique window of opportunity in recent years to establish a presence in the high-growth areas of oncology and immunology on the heels of advances in medical science.  Over the last few years, many big pharma companies have sought M&A to establish or strengthen their presence in those two therapeutic areas. While those markets are large and still growing, at this point, we see those areas as having become more crowded, with many approved products and a slew of clinical-stage products under development leveraging the improved understanding of how regulating the immune system can combat these diseases.

Market valuations, the IPO market, and funding for (typically pre-revenue) biotech start-ups have significantly contracted over the last year.  Moreover, these start-ups often rely on access to continued funding, as they typically generate no profits and burn through cash. Although lower valuations could increase acquirers' appetites for acquisitions, it also provides Big Pharma acquirors a significantly better return on investment--whether pursuing a partnership or outright M&A. Moreover, the biotech companies' weaker valuations make partnership agreements more attractive than an outright sale.

Moreover, the Federal Trade Commission (FTC) has expressed concerns with mergers in the industry and launched a working group in 2021 to study whether mergers are harming competition. We believe this could make large M&A deals more difficult to complete.

Given these trends and developments, we expect the pace of debt-financed M&A to continue at a more moderate pace than in recent years.

Ratings Now Largely Reflect Headwinds Related To Opioids And Pricing

The realization of material opioid-related liabilities contributed to several downgrades (see Table 4), and those costs are now mostly quantified and reflected in our ratings.  At this point, we believe the liability is mostly quantified and there is limited risk of this issue leading to further downgrades.

Table 5

Product liability relating to opioids has been financially material for several industry participants in recent years. However, we believe that is relatively uncommon for drugs approved by the U.S. Food and Drug Administration (FDA), as federal pre-emption usually precludes liability from adverse effects of drugs, provided companies diligently follow fair marketing and safety disclosure regulations.

Although the erosion in pricing power of branded pharma companies exacerbated pressure on ratings in recent years, at this point, we have largely incorporated this into our ratings.  We now generally assume prices will remain relatively flat going forward, with growth coming from new drug approvals and higher volumes, offset by a loss of exclusivity, such as from biosimilar competition.

Generic drug companies faced an extended period of faster-than-usual pace of price erosion, which contributed to several downgrades (see Table 6).  Price erosion has since slowed to more typical rates. Moreover, we see growing opportunities in the blossoming market for biosimilars and complex-generic drugs, which we expect will support rating stability for the generic companies. (See appendix for more details on the outlook for generic drug companies.)

Table 6

We see lower risk of meaningful drug price reform in the U.S. in the near term.  We believe the pharmaceutical industry's reputation had reached a low point prior to the pandemic, which emboldened some U.S. lawmakers to propose potentially disruptive drug price reforms. Our base case has consistently assumed any drug price reform would not be disruptive. Nevertheless, at this point we see reduced risk of meaningful near-term drug price reform in the U.S. given the controversial nature of that, and in the other more pressing legislative and political priorities.

We expect that U.S. lawmakers will resume examining drug prices eventually. However, the industry's reputation has improved given its prominent role during the pandemic and as the industry has shifted away from aggressive and controversial pricing tactics. We believe these factors reduce the risk of disruptive changes to drug prices. We still expect drug price reform could occur at some point over the next five years, and that if it does, it would likely only moderately reduce profit margins (not more than a few hundred basis points, which is moderate relative to average industry margins of 30%-40%). We see potential for federal and state budgets pressures potentially acting as a catalyst.

Outlook And CreditWatch Distributions

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Appendix: Unique Dynamics For Companies Focused on Generic Drugs, Branded Generics, and Speculative Grade Pharma

Specific factors affecting smaller and more highly leveraged pharmaceutical companies

The pharmaceutical industry includes both 1) Big Pharma, firms with good product diversity and relatively conservative leverage typically with investment-grade ratings, and 2) smaller, more concentrated, and often aggressively leveraged companies with speculative-grade ratings. We see some distinctions in how industry trends are likely to affect the two groups:

• Smaller and more aggressively leveraged companies have less capacity for significant debt-financed acquisitions, but our speculative-grade ratings on these companies are often less sensitive to acquisitions, as leverage is already elevated. Moreover, for companies owned by private equity sponsors, we generally factor in an expectation for persistently high leverage.
• We see PBMs focusing more intensely on large blockbuster products--often owned by Big Pharma--that are meaningful enough to move the economic needle, whereas smaller specialty drugs can sometimes fly below the radar. Also, so-called orphan drugs, which have a relatively small patient base, can often achieve very attractive pricing with less pushback from PBMs. That said, smaller companies tend to be more focused on life cycle management (such as offering moderate improvements like more convenient dosing) and price increases to drive growth, rather than investing heavily in R&D to drive innovation.

Our expectation is for normalized pricing trends in the generics subsector

Although pricing trends were severely negative in the U.S. generics subsector in 2017-2018, with double-digit percent annual declines, those pressures eased in 2019-2021, returning to more typical single-digit percent annual erosion. We expect this to persist going forward. Underlying this expectation is our view that the unusual pricing pressure in 2017-2018 was primarily the result of a wave of consolidation among the buying consortia and an initiative by the FDA to clear the backlog of generic products seeking approval. We believe such consolidation has since stabilized with a relatively consolidated group of buyers. The FDA has also progressed through much of its approval backlog.

That said, we expect generic drug prices to remain under pressure in the U.S. due in part to the market's high fragmentation, increased purchasing power of customers following consolidation of buying groups over the past few years, ongoing efforts from the private and public sectors to contain health care costs by promoting competition, and our view that competitors in India have grown in scale and quality. We assume these factors will contribute to annual price and gross profit margin erosion on many existing products in the U.S. in the mid-single-digit percent area, which is an improvement from accelerated price erosion in recent years. Furthermore, we see branded drug manufacturers more aggressively cutting prices to maintain market share after their products lose patent protection, thereby lowering the return on investment for generic launches across the industry.

The ability to acquire and/or develop new products will play an important role to offset the gross profit erosion we expect in existing generic drugs. We believe companies with strong new drug pipelines that primarily consist of complex-generic drugs and biosimilars are in a stronger position to preserve gross profits over the long term. We expect these products will benefit from higher barriers to entry, less competition, and thereby stronger gross profit potential compared to simple molecule generic drugs in more crowded markets.

We expect some generic companies, including major players Teva Pharmaceuticals Industries Ltd. and Viatris Inc., to prioritize deleveraging given their weakened credit measures. As a result, we do not assume any meaningful business development over the next couple of years from either company, unless they are redeploying proceeds from asset sales, a situation Viatris could find itself in. With discretionary cash flow generation from these companies being deployed primarily toward debt reduction, we expect debt leverage to gradually decline, but for their respective competitive positions to potentially weaken due to the limited capacity to reinvest in its new product pipeline through business development or R&D.

Unique market dynamics for branded generic products

More than a dozen rated companies have material exposure to the branded generic drugs market, including leading branded and generic companies such as Sanofi, Novartis AG, Teva, Viatris, and Abbott Laboratories.

Branded generics are drugs for which the patent has expired but are marketed under a brand name. Typically, it's the brand used by the original patented product, though in some markets, there are brands other than that of the originator product. The brand implies higher quality, safety, and efficacy than an unbranded generic. These products are priced at a premium over unbranded generics--substantial in percentage terms but still low enough to appeal to the middle-class patient paying out-of-pocket.

Demand for branded generics is meaningful in emerging markets including China, India, Russia, Brazil, and other geographies where there is patient concern about the quality of unbranded generics. The market characteristics vary across countries, but these markets generally offer doctors and patients a product choice. Patients often pay for these drugs out-of-pocket. In some markets such as small countries, there might be no valid alternative to a branded generic, at least for some period. Companies invest in marketing (typically to doctors) of their branded generic products to support demand, similar to products on-patent.

Branded generic businesses are not exposed to the sharp drop in revenue that occurs with on-patent drugs, nor the intense price-based competition of unbranded generic drugs in the U.S., where regulatory assurance of high quality makes them interchangeable and commodity-like. This market is supported by a steady stream of new products and a rapidly expanding middle class in emerging markets, increasing demand.

We believe revenues for branded generic products often erode over time (typically gradually) as patients (paying out-of-pocket) or health care systems seek and transition to lower-cost options. We believe there could also be more acute pressure in specific geographies driven by changes to government reimbursement. China implemented a volume-based procurement (VBP) policy in 2019 that included several rounds of drug sourcing bidding aimed at increasing products sourced from China and reducing pharmaceutical spending. As a result, branded generic products from foreign manufacturers were subject to significant competition in the country's hospital channel. We believe foreign products with strong brand recognition in the region are able to somewhat mitigate the loss in sales within the hospital channel by increasing volume in the fast-growing retail channel, in which patients can choose to pay a premium for the brand-name drug. Sales volume in the retail channel is aided by a growing middle class in China that can pay cash for branded drugs, which should limit revenue declines here. These regulatory risks can also be partially mitigated by product and geographic diversification.

Related Criteria

• Key Credit Factors For The Pharmaceutical Industry, April 8, 2014

Related Research

• Mortality In Health Care: What Factors Lead To Default For Pharmaceutical Companies, Feb. 14, 2022
• How Business Strength Varies Across Speculative-Grade Branded Pharma Companies, Jan. 24, 2022
• How Business Strength Varies Across The Top Pharma Companies, Aug. 27, 2020
• Lessons Learned: What Leads To Rating Changes For Investment-Grade Pharmaceutical Companies, Jan. 22, 2019