October 4, 2017 / 3:03 PM / 2 months ago

Fitch Maintains Bayer on Rating Watch Negative

(The following statement was released by the rating agency) LONDON, October 04 (Fitch) Fitch Ratings is maintaining German healthcare and life-science conglomerate Bayer AG's (Bayer) Long- and Short-Term Issuer Default Ratings (IDRs) of 'A'/'F1' on Rating Watch Negative (RWN). The senior unsecured notes and subordinated debt - rated at 'A' and 'BBB+' respectively - also remain on RWN. The RWN reflects Bayer's planned acquisition of US-based agrochemical company Monsanto Company (A-/RWN) for USD66 billion, including an assumed USD19 billion equity contribution, which could result in a maximum, instead of our previously anticipated minimum, downgrade of two notches. The potential two-notch downgrade reflects the focus by Bayer on internal cash generation while the transaction faces regulatory delays, its accelerated sale of non-core assets, as well as disciplined capital allocation leading to a temporarily deleveraged and liquid balance sheet ahead of the completion of the acquisition, now expected in 1H18. The ratings also reflect Bayer's strong market positions in different, uncorrelated sectors, spanning pharmaceutical, consumer and animal health, and crop science offering long-term structural growth. KEY RATING DRIVERS Planned Monsanto Acquisition triggers RWN: Fitch expects Bayer's funds from operations (FFO)-adjusted net leverage to peak at around 4.0x post acquisition expected in 1H18, before falling to 3.0x in the following three years on deleveraging. Hence we expect to downgrade the combined entity by a maximum two notches post acquisition to a still solid investment grade credit rating. Previously we had guided for a minimum two-notch downgrade but as time lapsed since the original announcement of the acquisition, cash flow generation, the non-core disposals by Bayer and an assumed unchanged equity contribution of USD19 billion to fund the transaction, result in effectively front-loading some of our anticipated deleveraging and restrict a potential downgrade now to two notches. We expect the FFO fixed charge to bottom out at around 6x, also consistent with a comfortable investment grade profile. Covestro Disposal also Key: Bayer's final rating will depend on the final equity, senior and subordinated debt funding mix and liquidity from further disposal of the company's share in its listed material science business associate Covestro (reduced to below 25% in September 2017 from 33%), which our rating case assumes will be deconsolidated in 2017 and fully sold down in 2018. Bayer Stand-Alone, Deleveraging and Liquid Balance Sheet: We view Bayer's balance sheet without the Monsanto acquisition as liquid and lowly leveraged relative to the company's 'A' rating. We calculate that as Bayer prepares for the completion of Monsanto acquisition, the various capital preservation measures it has undertaken will lead FFO adjusted net leverage to temporarily fall under 1.0x. Our rating is not premised on the maintenance of this conservative capital structure. Should the Monsanto acquisition not go ahead we would likely affirm the 'A' rating, assuming that Bayer will actively manage its balance sheet towards exhausting this ample rating headroom. Strong Business Risk Profile: Bayer's ratings remain underpinned by the company'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. Strategic Rationale behind Monsanto Buy: The combination of Bayer and Monsanto would create a leading player in the crop science industry, where Monsanto's strength in seeds compliments Bayer's strength in crop protection. The transaction would address greater competitive pressure in the rapidly consolidating agricultural supply industry, a process that is being driven by low crop prices and structurally lower income generation in the farm sector. Execution Risk: We view the impact of the Monsanto transaction on Bayer's business profile as positive in the long-term. 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 greater 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. Regulatory Scrutiny delays Completion: Fitch expects the regulatory and competition authority review, spanning a wide range of geographies to last until 1Q18. Regulatory scrutiny centres around sufficient competitive choice for farmers in seeds and pesticides, the pace of innovation in a consolidating industry, as well as food safety in the context of genetically modified crops. A' Rating Category Targeted: Bayer has communicated its intention to be in the 'A' rating category over the medium term. We believe it has various strategic options to achieve this, including divestments. However, we view a successful integration of Monsanto and the delivery of the expected medium-term EUR1.5 billion cost synergies as key to supporting FCF generation. This in turn would be key to retaining the 'A' rating, especially if the dividend policy remains unchanged. Hybrid Capital Increases Financial Flexibility: Fitch views hybrid debt now as a permanent feature of Bayer's capital structure to maximise investor reach as well as optimise funding mix and costs. Fitch rates the hybrid notes issued in 2015 two notches below Bayer's IDR (and hence assigning 50% equity credit) given their long-dated maturity, 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. DERIVATION SUMMARY Fitch continues to apply its global pharma rating approach to Bayer as over half of its pro-forma EBITDA is generated by the healthcare division. Its 'A' rating remains well-positioned in the global pharma universe, demonstrating a similar size to some of its higher-rated peers such as Novartis AG (AA/Negative), Roche Holdings Ltd. (AA/Stable) and significant scale advantages over UK peers AstraZeneca plc (A-/Negative) and GlaxoSmithKline plc (A/Stable). Nevertheless, Bayer's profitability is at the low end of its peer group, which reflects the company's diversified business model, including the specialty, agro-chemical and pharma businesses. While these add diversification and scale compared with peers, they also introduce greater cyclicality and structurally lower margins. Bayer's financial risk profile has improved post the company's 2014 peak caused by the USD14.1 billion acquisition of Merck&Co's consumer health activities. Despite a more cyclical business risk profile, Bayer has more stable FCF generation than other European pharma peers in the single-'A' rating category due to its strong internal cash generation and conservative capital allocation. Post completion of the Monsanto acquisition, Bayer's operating profile will be a combination of specialty chemicals (close to 50% of EBITDA) and of pharma (slightly above 50% of EBITDA). We project that the company's FFO-adjusted net leverage and FFO-fixed charge cover should trend respectively towards 3.0x and above 6.0x by 2020. We view these ratios as consistent with a high 'BBB' category rating. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Monsanto acquisition completes in 1H18; Covestro deconsolidated from September 2017 and fully divested by 2018 and USD19 billion equity contribution towards the USD66 billion acquisition price; - Satisfactory growth profile with like-for-like sales growing at CAGR of around 3%-4% up to 2020, driven by pharma innovation and the enlarged crop science division; - EBITDA margin trending towards 26%, expected to be structurally enhanced by the Monsanto integration and Covestro deconsolidation; - Bolt-on acquisitions of up to EUR2 billion p.a. post Monsanto completion and capex at 5.5% of sales; - No change in dividend policy; and - Moderate FX volatility (particularly in relation to Brazil, China, US) resulting in continuing FX risk RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Negative Rating Action -FFO adjusted net leverage above 2x on a continuing basis (2016: 1.8x), for example, as a result of a severe drop in EBITDA due to an adverse economic environment or a large debt-financed acquisitions or shareholder returns. -FFO fixed charge cover below 6x (2016: 7.7x). Upon completion of the Monsanto transaction, we will resolve the Rating Watch Negative and likely downgrade Bayer's ratings by a maximum 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. Future Developments That May, Individually or Collectively, Lead to Positive Rating Action A positive rating action is currently not envisaged. If the Monsanto 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; and -Commitment to a capital structure in line with a higher rating level LIQUIDITY Strong Liquidity: Bayer has been generating a liquidity buffer to help it finance the future USD66 billion acquisition of Monsanto. In November 2016 the company issued EUR4 billion in mandatory convertible notes and invested the proceeds in financial assets, mainly in bank deposits and money market funds. Available cash and marketable securities were EUR5 billion at end 2016, comfortably covering short-term debt maturities of EUR3.1 billion. Fitch conservatively uses 50% of the money market investments as readily available cash, as we assume investment horizons longer than three months (Bayer has not given any detail on its underlying investment policy). Hence we exclude assumed investments with a maturity from three to 12 months from our calculation of cash. We also consider EUR750 million of cash as restricted, either due to capital transfer restriction in Bayer's international operations or intra-year working capital swings. In addition as of December 2016 Bayer had undrawn committed bank facilities of EUR55 billion. These undrawn facilities included EUR50 billion (USD52.7 billion) bridge financing facilities and term loans for the planned acquisition of Monsanto maturing between 2019 and 2021, as well as a EUR3.5 billion syndicated facility maturing in 2020. Contact: Principal Analyst Pablo Mazzini Senior Director +44 20 3530 1021 Supervisory Analyst Frank Orthbandt Director +44 20 3530 1037 Fitch London 30 North Colonnade London E14 5GN Committee Chairperson Giulio Lombardi Senior Director +39 02 8790 87214 Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Summary of Financial Statement Adjustments - Fitch capitalises lease expenses using a factor of 8. We also adjust readily available cash by EUR750 million reflecting legally restricted cash and cash absorbed in intra-year working capital swings. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. 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