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Fitch Affirms McKesson at 'BBB+'; Outlook Stable

MCK | December 16, 2016

Fitch Ratings has affirmed the ratings of McKesson Corp. (NYSE: MCK), including the Long-Term Issuer Default Rating (IDR) at 'BBB+'. The Rating Outlook is Stable.

A full list of ratings, which apply to approximately $8.1 billion of debt outstanding at Sept. 30, 2016, follows at the end of this release.

KEY RATING DRIVERS

Stable Operations, Low Margins

The credit profiles of MCK and its peers benefit from stable operating profiles and consistent cash generation. Steady pharmaceutical demand, an oligopolistic drug distribution industry in the U.S. and, for the most part, in Western Europe, and relative insulation from most drug pricing and regulatory pressures, support strong ratings despite very low margins.

Increased Competitive Pressures

The recent repricing of certain independent pharmacy GPO contracts in 2016 represent another weakening of MCK's competitive positioning, albeit also affecting MCK's peers, following key losses in calendar 2015 (or pending losses)as many of its largest customers (Rite Aid, Omnicare, Target, OptumRx) were involved in key M&A transactions. This weakened positioning is most evident in MCK's generic sourcing scale, which Fitch now estimates as lagging that of both Walgreens-AmerisourceBergen and CVS Health-Cardinal Health and, in Fitch's view, contributed to the generic sourcing JV with Wal-Mart rather than Wal-Mart simply becoming a party to MCK's generic purchasing.

Leading Market Positions

MCK is expected to continue to hold top market positions (#1 or close #2) in pharmaceutical and non-acute care medical distribution, including of specialty pharmaceuticals, in both the U.S. and Canada. The firm's European business is also market-leading in distribution and pharmacy operations.

Solid Liquidity, Cash Generation

MCK maintains a solid liquidity position, supported by strong cash flows and strong access to capital markets. Fitch expects annual FFO and FCF to exceed $3 billion and $2 billion, respectively, but notes that FCF can be affected by large working capital swings inherent to large healthcare distributors.

Non-U.S. Operations More Risky

Fitch generally sees non-U.S. drug channels - particularly in Europe - as less stable and higher risk than in the U.S., especially given the diversity of regulatory and reimbursement systems. But inorganic growth opportunities are more prevalent in markets outside the U.S., so MCK's presence in Europe is important for long-term growth prospects.

RATING SENSITIVITIES

Maintenance of MCK's 'BBB+' IDR considers gross debt/EBITDA generally in the range of 1.4x to 2x, with continued strong and steady cash flows, accompanied by stable or modestly expanding underlying margins. Cash flows and liquidity are strong for the rating category. Flexibility is expected to be ample but limited in calendar 2017.

Negative rating actions are not expected to explicitly result from recent shifts in the industry's competitive and pricing dynamics - namely lower branded inflation and key contract losses/revisions - though MCK's margins could be pressured compared to peers. A downgrade to 'BBB' could be driven by material debt-funded acquisitions or share repurchases, or more significant margin pressures than are currently expected, resulting in gross debt/EBITDA expected to be sustained at or above 2x. Cash generation and liquidity in a reasonable stress scenario could still support absolute debt repayment, so a downgrade would most likely be tied to management's capital deployment decision-making.

A positive rating action is not currently anticipated over the ratings horizon. Fitch does not expect MCK to reduce gross debt/EBITDA to 1.4x or below, although cash generation and internal liquidity are expected to be more than sufficient to do so.

KEY ASSUMPTIONS

Fitch's Ratings Case forecast incorporates the following assumptions:

Top line growth of 4% in fiscal 2017 and decline of 2% in 2018.

Growth in 2017 is supported by the expanded Albertsons and Rite Aid contracts, recent acquisitions, specialty, and stability in med-surg, offset by lost business (OptumRx, Omnicare generics, Target generics). Revenue decline of 2% in fiscal 2018 is mostly the result of the expected loss of Rite Aid distribution volumes gradually in the first half of the fiscal year, offset by the addition of Walmart generics. Fitch forecasts assume the loss of Rite Aid and the addition of Wal-Mart generics both in MCK's fiscal 1Q'2018.

Ramping margin pressures in fiscal 2017 - 2018.

Margin pressure is most acute from lost generic volumes, lower branded price appreciation, and heightened competitive pressures particularly among independent pharmacy customers, leading to double-digit EBITDA margin declines in both fiscal 2017 and 2018. Continuing margin pressures in fiscal 2018 are offset somewhat by ongoing cost reduction programs, and upside is possible depending on the timing and pacing of Wal-Mart generics onboarding.

FCF Approximating $2.8 billion in Fiscal 2017 and $2.2 Billion in 2018. FFO is expected to approximate $3 billion in both years.

An expectation for a meaningfully positive working capital benefit, especially in 2017, supports cash generation despite declining absolute EBITDA. Notably, working capital is subject to large day-to-day swings which could cause FCF to fluctuate. Cash flows will be aided over in coming years from proceeds related to the divestiture of certain technology businesses ($1.25 billion expected in early fiscal 2018 from initial transaction).

Relatively Steady Debt Balances, Yielding Gross Debt/EBITDA Around 1.9x in 2017 - 2018

Fitch does not expect MCK to use FCF for meaningful long-term debt reduction over the ratings horizon, instead allocating the majority of discretionary FCF to M&A and share repurchase activity.

LIQUIDITY & DEBT STRUCTURE

Strong Liquidity

MCK maintains a strong liquidity position. The firm's new $3.5 billion revolver, which replaced its previous revolvers and A/R facilities, provides ample liquidity for working capital and other temporary financing requirements. Fitch assumes major drug distributors seek to keep $1 billion to $2 billion of cash available for day-to-day operations. All U.S. cash ($2.6 billion) is considered Readily Available. Access to external liquidity is adequate.

Well-Laddered Maturities

Debt maturities are relatively well-laddered and manageable, with no more than $1.6 billion is due in any one year (2017), although about half of total debt matures in the next 2.5 years. FCF is expected to routinely outpace debt maturities, leaving flexibility for M&A or share repurchase activity. Fitch expects debt maturities to be refinanced, including by the possible issuance of non-US debt obligations, from fiscal 2017 onward.

FULL LIST OF RATING ACTIONS

--Long-term IDR at 'BBB+';

--Short-term IDR at 'F2';

--Senior unsecured bank facility at 'BBB+';

--Senior unsecured notes at 'BBB+'

--Commercial Paper at 'F2'.

Date of Relevant Rating Committee: 15 December 2016

No material financial statement adjustments were made other than those customary within U.S. Corporates (i.e. the removal of non-cash expenses, such as stock-based compensation expense, from the calculation of EBITDA).

Additional information is available on www.fitchratings.com.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1016692

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https://www.fitchratings.com/regulatory

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