Two months ago, Pfizer (PFE) signaled interest in selling or spinning off some of its so-called ‘non-core’ businesses - those that are not involved in brand-name pharmaceuticals. These would include the nutritionals, consumer health and animal health units, and possibly a generics operation. A business that makes capsules has already been sold (back story here and here).
The rationale for this notion, of course, would be to unlock the underlying value in each entity and reward shareholders. But one Wall Street credit analyst cautions that divesting non-pharma businesses comes with risks. “Unless companies use the proceeds from asset sales to repay debt, or unless the businesses being sold are underperforming expectations and are a distraction to management, the credit implications of a divestiture are often negative,” writes Michael Levesque, a senior VP at Moody’s Investor Service.
To wit, he says credit quality can be hurt by reducing the size and diversity of the overall company. Look at it this way: a drugmaker may believe shedding ‘non-core’ units is a good strategic move, but Levesque counters that remaining revenue may be disproportionately concentrated in a relatively small number of big-selling meds, especially when these face patent expirations and patent challenges.
Meanwhile, the businesses not engaged in brand-name meds may provide more stable sources of revenue. Typically, he writes, these have “lower R&D risk, less exposure to patent risk and reduced litigation threats. Selling these assets, therefore, leaves the company more concentrated in the business line that has a riskier credit profile.” This is the thinking that Johnson & Johnson (JNJ) uses for its three-legged approach - drugs, devices and consumer health items (although J&J execs never imagined the consumer health unit would be so scarred and scandalized by recalls).
Levesque goes on to write that the use of proceeds is “critical.” As a credit analyst, he wants to see proceeds from a sale to reduce debt. “In most cases, however, companies would be more likely to use asset-sale proceeds for shareholder initiatives, including stock buybacks,” he observes. Not surprisingly, he points to Pfizer as an example. The drugmaker plans to use some proceeds from the sale of its Capsugel unit to fund incremental buybacks beyond its original goals for this year.
To illustrate the risks of divestiture, Levesque points to Bristol-Myers Squibb (BMY) as an example of a drugmaker that sold non-core assets and wound up with a higher risk profile than its peers. Revenue streams have become “highly concentrated in its three top-selling products,” he notes. Why? Over the past three years, the drugmaker sold its medical-imaging unit, the ConvaTec medical devices business and then sold and split-off its Mead-Johnson nutritionals business.
He points out that, while the medical-imaging unit faced withering possibilities due to a key patent expiration, both ConvaTec and Mead-Johnson were steady, reliable cash-flow generators. Fast forward to 2010, and Bristol-Myers’ top three and top five brand-name meds represented about 55 percent and 68 percent of sales, respectively. This was a higher proportion than what was reported by its peers and, he writes, significantly higher than in 20007, on a comparable revenue base.
He concedes, however, that there has been no impact, so far, on the drugmaker’s A2 credit rating thanks to three factors offsetting credit risks. First, Bristol-Myers primarily used proceeds to bolster cash on hand and make smaller strategic acquisitions, rather than repurchase “substantial” amounts of stock. Second, pipeline successes exceeded expectations. And the drugmaker late last year reduced debt by $750 million through a bond tender offer.
Other than divestitures, what else might be attempted?
Levesque posits that drugmakers may consider splitting their brand-name operations into what he calls mature and growth units, an option he calls a “far more radical strategy.” However, he cautions this would have even more negative credit implications than a series of straightforward divestitures.
Mature meds, of course, are those nearing patent expiration or already face generic competition but still generate significant revenue. Growth meds are those under development and specialty products, such as biologics. These don’t face the same generic threat, but he writes, the operating risks would be higher than the mature business, “primarily because of pipeline execution risk and smaller scale, implying a credit profile with lower financial leverage.”
In any event, he sees credit quality for either business on a standalone basis “as potentially weaker than that of the combined entity.” For the mature biz, credit risks would increase due to reduced scale and business diversity, and fewer growth prospects. “Financial leverage could also increase after the split, and the segment might be used as a vehicle to fund acquisitions of other mature businesses,” he writes. “This segment also would likely be the one to fund significant cash payouts to shareholders.”
As for the growth business, there would also be reduced scale and diversity, but there would be a risk of product-development setbacks and heavy competition in emerging areas within oncology and biotech.