Bayer Downgraded By Two Notches To #BBB# On Monsanto Acquisition Outlook Stable

Stocks and Financial Services Press Releases Monday June 4, 2018 17:35
LONDON--4 Jun--S&P Global Ratings

LONDON (S&P Global Ratings) June 4, 2018--S&P Global Ratings said today that it lowered to 'BBB' from 'A-' its long-term issuer credit ratings on Germany-based life sciences group Bayer AG and its related entities. We removed the long-term ratings from CreditWatch with negative implications, where we placed them on May 20, 2016. The outlook is stable. We affirmed the 'A-2' short-term issuer credit rating.

At the same time, we lowered the issue rating on the senior unsecured debt issued by Bayer and related entities to 'BBB' from 'A-', in line with the issuer credit rating on Bayer AG. We also lowered the issue rating on the subordinated hybrid debt to 'BB+' from BBB'.

The downgrade reflects our view that Bayer's credit metrics will be weaker over the next two years due to the large increase in debt levels (over $30 billion) after the closing of the $63 billion acquisition of Monsanto. Bayer expects to receive all necessary regulatory approvals and close the transaction very soon.

We believe that Bayer's stronger business position in agriculture products, notably in the profitable seeds segment, does not fully offset the increased debt in its capital structure. That said, the group should be able to generate strong free cash flow (forecast at EUR3.0 billion-EUR3.5 billion annually in the next two years). This will be thanks to the stable earnings from its large pharma activities (estimated at around 50% of group EBITDA) and gradually from its newly combined agriculture products business.

Agriculture products is an EUR85 billion industry expanding yearly by about 2%-3%. Within this sector, we estimate that Bayer will become No. 1 in seeds (notably in high-value seeds and traits) and No. 2 in crop protection globally. The combined Bayer CropScience division (after disposals) and Monsanto should generate revenues of about EUR20 billion annually. It will have leading market positions in three key cultivation regions (North America, Latin America, and Europe) with a large and well-invested manufacturing and distribution footprint. Its product range will cover large agricultural commodities, notably soybean and corn, which are wide users of genetically modified (GM) seeds and traits. Its large research and development resources of around EUR2.4 billion annually (around 12% of revenues) should enable it to support product innovation and thus pricing premium in seeds and crop protection. This is important because the large resources and proprietary technological capability enable product differentiation against competitors. It also allows Bayer to benefit from changing consumer and regulatory requirements while catering to the rising need for improving farm productivity and crop protection. We also understand that the strategy is to offer seeds and traits, crop protection, and digital farming solutions to farmers to enable them to protect harvests and potentially increase agricultural yields. Finally, the group will benefit from well-known global brands such as Roundup and no large supplier or customer concentration.

Business weaknesses spring from Bayer's greater exposure to agriculture products, which is likely to induce more volatility in group earnings as demand from farmers vary year to year, affected by agricultural prices and weather conditions. The business is likely to be more working-capital intensive and capital expenditure (capex) intensive and bears higher fixed costs due to high regulatory and product development costs (also a barrier to potential new entrants). Herbicide and seeds are subject to pricing pressure notably from generic seeds producers and, given the higher cost of seeds, farmers with limited disposable income could be tempted to trade down to cheaper alternatives. We also see integration risks due notably to Monsanto's large scale of operations, distinct corporate identity, and technology infrastructure. Finally, potential risks could arise from unfavorable regulatory rulings, notably on GM products due to opposition from public opinion.

We view positively that Bayer will continue to benefit from the positive growth prospects in its pharma business, which should generate about EUR16.5 billion-EUR17.5 billion annually and focuses on selected expanding therapeutic areas such as oncology and cardiology. We believe the portfolio is supported by the presence of blockbusters products (Xarelto, Eylea, Mirena); no large patent cliff in the next three to five years; and a pipeline of new products, which should support profitable growth.

We also factor in the relatively stable earnings generation from smaller divisions such as consumer health and animal health, which together should generate about EUR7 billion of revenues annually. In consumer health, Bayer is a top six player globally in a fragmented industry with strong brands and solid market positions in Europe and Asia (an expanding region). There are, however, business headwinds due to high price pressures in the U.S. from online retail and distribution concentration.

In our base case for 2018-2019, we assume:
  • Global crop protection and seeds industry expanding by 2%-3%.
  • Revenues of about EUR44 billion-EUR45 billion. For 2018 we assume strong (+25%) revenue increase compared to 2017, due mainly to the addition of Monsanto despite negative foreign exchange (FX) effects. For 2019 we assume moderate revenue growth of about 2%-3% with relatively neutral FX effects. We see pharma revenues (supported by the growth in blockbuster drugs Xarelto and Eylea) rebounding to about 4% in 2019 from a slight decline in 2018. For agriculture products, we assume 2%-3% revenue growth in 2019 thanks mostly to seeds (volume growth from higher acreage but slight growth from higher prices) offsetting flat growth (volume growth but negative pricing) in crop protection due to price pressures from low cost producers. In consumer health, we see slight revenue decline in 2018-2019 with a product delisting in China in 2018 and continued pricing pressures in the U.S.
  • Adjusted EBITDA margin of 23%-24%, driven mostly by our assumption of stable profitability in pharma. We also take into account sizable integration and restructuring costs over the next two years and by negative FX effects and purchase price allocation. For agriculture products we see profitability gradually rebounding from 2018 due to the positive growth prospects for the high-margin seeds business compared with flat growth in lower-margin crop protection. For consumer health we see profitability continuing to be under pressure over the next two years.
  • Free operating cash flow (FOCF) of about EUR3.0 billion-EUR3.5 billion with negative working capital swings annually and capex of about 7.5% of revenues.
  • Adjusted net debt of about EUR38 billion. This figure includes EUR33 billion of net debt and net pension deficit of about EUR5.8 billion, offset by EUR2.2 billion of hybrids treated as equity. We estimate restricted cash of about EUR850 million for the combined group.
Based on these assumptions, we arrive at the following credit measures:
  • Adjusted debt to EBITDA of about 3.7x-3.9x (annualized in 2018) and 3.4x-3.6x in 2019.
  • Funds from operations (FFO) to debt of 20%-25%.
  • FOCF to debt of 8%-10%.

The stable outlook on Bayer reflects our view that the group's operating performance should firstly remain supported by the growing and profitable pharma business, which--together with the smaller consumer health division--should provide stable cash flows over the next two years. We see gradual improvement in earnings from agriculture products driven mostly by growth in the high-margin seeds segment. That said, in our view, higher interest expenses, sizable cash integration, restructuring cash costs, and likely larger working capital swings due to the larger share of business from agriculture are likely limit free cash flow growth over the next two years.

Under our base-case scenario, we see Bayer being able to generate annual free cash flow of EUR3.0 billion-EUR3.5 billion annually. We believe that for the rating category, Bayer should be able to deleverage gradually to about 3.5x two years after transaction closing.

We could raise the long-term rating if Bayer is able to deleverage faster than expected over the next 12-24 months.

This could arise from Bayer fully integrating Monsanto faster than expected without business disruption or large additional cash costs, or from a stronger-than-expected sustained rebound in earnings from agriculture products, for example due to stronger lasting demand from farmers.

We would view favorably stronger-than-expected growth in pharma and would need to see evidence of a supportive financial policy going forward, notably regarding large debt-financed acquisitions.
We could also consider an upgrade if Bayer reaches adjusted debt leverage of about 3x on a sustained basis, and FFO to debt about 30%.

We would consider lowering the ratings if we saw that adjusted debt leverage had not decreased below 4.0x by the end of 2019, indicating that deleveraging was taking significantly longer than expected and would be difficult to remedy in the next 12-24 months.

We believe this could occur if we see mounting integration problems with Monsanto, such as higher-than-expected cash integration costs and business disruptions.

We would also view negatively a lasting deterioration in the operating performance in both pharma and agriculture products. In pharma, this could arise from higher pricing pressures or an inability to replenish the drugs pipeline. In agriculture, this could arise from a declining market share and profitability in key product segments against competitors. This could occur due to accelerated trading down by farmers pressured by lower disposable income and a failure to successfully market new products, which would support profitable growth in seeds and crop protection.

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