S&P Downgrades Perrigo (PRGO) to 'BBB-'; Sees Weakness in High-Margin Business

Standard & Poor's Ratings Services lowered all of its ratings on Perrigo Co. plc (NYSE: PRGO), including the corporate credit rating to 'BBB-' from 'BBB'. The outlook is stable. Reported debt outstanding as of Dec. 31, 2015 was about $6 billion.

"The downgrade reflects our expectation for weakness in Perrigo's high-margin generic pharmaceutical business, largely resulting from intensifying competition and lower pricing, and a further expected decline in the recently acquired European branded consumer business," said Standard & Poor's credit analyst Gerald Phelan. "As a result, we now forecast adjusted debt-to-EBITDA in the mid-3x area over the next two years, which is significantly weaker than our previous forecast of debt-to-EBITDA between 2.5x-3.0x. Moreover, we view the departure of Perrigo's long-time CEO as a negative, as it comes after the second negative earnings announcement over the last few months. In our view, the acquisition misstep in Europe and negative earnings developments have, at least temporarily, diminished investors' trust in the company's management, especially after its stockholders' vote in favor of Perrigo's management in the face of Mylan's hostile takeover attempt last year. As a result, we believe Perrigo will continue to prioritize shareholder-friendly actions, including share buybacks, over strengthening the balance sheet, in order to buoy its share price."

Standard & Poor's rating on Perrigo reflects its strong and established position in the generic store brand consumer health care over-the-counter (OTC) and infant nutritional markets. Growth potential for the core consumer health care OTC business is supported by favorable long-term demographic trends, particularly an aging population seeking lower-cost health care products, and ongoing prescription Rx to OTC switches. We consider Perrigo's number one ranking in approved OTC New Drug Applications and Abbreviated New Drug Applications, and its good track record operating in a highly regulated environment, as evidence of its industry expertise. Although we assume Perrigo's generic Rx business will face some pressure this year, we still believe it has a satisfactory position as a small niche player, particularly in the extended topicals and specialty generics segment. Moreover, we believe the Tysabri Multiple Sclerosis (MS) drug treatment, to which Perrigo owns royalty rights, is highly effective, although it presents unique, low-probability risks to Perrigo, including with respect to the treatment's safety and reimbursement rates. We assume Perrigo will maintain this investment, although we believe a future monetization is possible over the longer term.

The rating also incorporates the substantial bargaining power of many of Perrigo's large retail and wholesale drug distribution customers, and the significantly greater scale and financial resources of many branded consumer health care and pharmaceutical competitors. We view the European branded health care business less favorably given its small market share, relatively low margins, and continued profit erosion. In our opinion, any material synergistic benefits from this recent acquisition, which included instant access to millions of European consumers and the ability to launch new products in these markets, are unlikely over the next few years.

The stable outlook reflects our forecast that Perrigo's pro forma EBITDA will decline about 10% in 2016, leading to a sustained debt-to-EBITDA ratio in the mid-3x area over the next two years.

We could lower the ratings if we were to reassess the strength of Perrigo's business risk profile downwards, which could occur if competition in the generic pharmaceutical segment intensifies, if there are meaningful shortfalls in the European branded health care business, if there is an unexpected weakening in the U.S. consumer health care business, or if financial policy becomes more aggressive (share repurchases or acquisitions materially beyond our current expectations). We could lower the ratings if we project that debt-to-EBITDA will weaken to above 4x on a sustained basis, which we believe could occur if Perrigo adds about $700 million of debt or EBITDA falls 15%-20% compared to our revised projection.

While unlikely over the next two years, we could raise the ratings if Perrigo's financial policy becomes more conservative, such that we believe debt-to-EBITDA will improve to around mid-2x on a sustained basis. We estimate this could occur if-EBITDA strengthens by about 30% over the next two years, or debt is reduced by about $1.8 billion.

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