U.K.-Based Pharma Group GlaxoSmithKline Outlook Revised To Negative On Acquisition Of Tesaro; 'A+/A-1' Ratings Affirmed

  • U.K.-based pharmaceutical group GlaxoSmithKline PLC (GSK) has agreed to acquire biopharmaceutical company Tesaro for $5.1 billion (about £4.0 billion). GSK simultaneously announced a 300 basis-point squeeze of its pharmaceutical operating margin in 2020.
  • We have revised downward our leverage forecasts for GSK, which were already low for the current ratings.
  • We are therefore revising our outlook on GSK to negative from stable and affirming our 'A+/A-1' long- and short-term issuer credit ratings on the group.
  • The negative outlook reflects our view that GSK's S&P Global Ratings-adjusted leverage could exceed 3.0x in both 2019 and 2020 as we expect that the acquisition of Tesaro will temporarily weaken GSK's EBITDA while increasing its debt by £4.0 billion.
PARIS (S&P Global Ratings) Dec. 6, 2018--S&P Global Ratings said today that it 
revised its outlook on U.K.-based pharmaceutical group GlaxoSmithKline PLC 
(GSK) to negative from stable. At the same time, we affirmed our 'A+' 
long-term and 'A-1' short-term issuer credit ratings on GSK and our issue 
ratings on GSK's debt.

The outlook revision follows GSK's agreement to acquire biopharmaceutical 
company Tesaro and highlights the negative effect of the acquisition on GSK's 
leverage. Although we expect GSK to deleverage to below 3.0x at year-end 2018, 
the maximum level commensurate with current ratings, we consider that the 
acquisition could push the group's leverage back over 3.0x again from 2019. 
There are four reasons for this:

  • GSK had very little headroom under the current ratings for the Tesaro acquisition, as we expect leverage to be in the 2.9x-3.0x range at year-end 2018.
  • The cost of the acquisition exceeds the cash proceeds that GSK expects from the disposal of Horlicks.
  • We do not expect Tesaro, a loss-making company, to be accretive to GSK's profits over the next two years. GSK has announced that its pharmaceutical operating margin will weaken by 300 basis points (bps) in 2020, as the group will simultaneously increase its research and development (R&D) investments and beef up its sales force.
  • Owing to an aggressive dividend policy, GSK is slow to deleverage after acquisitions.
The acquisition of Tesaro signals GSK's renewed ambitions in the key oncology 
franchise, which the group had almost exited in 2015 after an asset swap with 
Novartis AG. Through the acquisition, GSK is acquiring a molecule called 
Zejula, which is already approved as a second-line maintenance treatment for 
platinum-sensitive ovarian cancer, and which is under review for approval in 
both the U.S. and Europe as a treatment for adult patients with recurrent 
ovarian cancer. Tesaro is also seeking approval for Zejula as a first-line 
maintenance treatment for ovarian cancer, with trials already underway. 

Such approvals would create a larger market opportunity for the drug. Zejula's 
different mechanism of action gives GSK expertise that it could use in 
developing drugs for other cancer types as well, such as lung and breast 
cancer. Although Zejula has blockbuster potential, it will not be 
profit-accretive until 2023 and success still depends on upcoming filings. 
This acquisition therefore contains a degree of risk. 

We still view GSK's business risk profile as excellent. Specifically, we note 
the very strong uptake of the group's shingles vaccines; the continuous 
expansion of the group's two major HIV drugs; and the better performance than 
we expected of Advair, the group's blockbuster respiratory drug, as generic 
competition has seen severe delays. 

GSK's financial profile is primarily characterized by substantial free cash 
flow, but almost no discretionary cash flow, as GSK pays out about £4 billion 
of dividends every year (excluding minorities). Our guideline for the current 
ratings is leverage of below 3.0x, a target that the group has not achieved in 
the past few years, but should reach in 2018, albeit with limited headroom. 

We note that GSK expects to receive approximately £2.4 billion of net proceeds 
from the announced divestment of Horlicks and other consumer health care 
nutrition products to Unilever PLC, and the merger of GSK Consumer Healthcare 
Ltd. (GSK India) with Hindustan Unilever Ltd. These proceeds should partially 
offset the about £4.0 billion-equivalent required to acquire Tesaro. 

Still, we anticipate that GSK's debt will increase next year, while the 
initial dilutive impact of Tesaro, as well as increased investments in R&D and 
selling, general, and administrative (SG&A) expenses, will weaken EBITDA. 

In our base case for GSK, we assume:
  • A low-single-digit top line increase in 2018, reflecting the resilience of Advair and strong performance from Shingrix, Tivicay, and Triumeq.
  • A slight increase in adjusted EBITDA margins in 2018, reflecting higher sales and the impact of past cost-cutting initiatives.
  • Lower adjusted EBITDA in both 2019 and 2020, reflecting higher SG&A expenses and the dilutive impact of Tesaro.
  • Capital expenditures (capex) of about £1.7 billion per year.
  • The acquisition of Tesaro for £4.0 billion and the divestiture of Horlicks for £2.4 billion, net of tax.
  • Unchanged financial policies and dividend payout ratios in line with recent years.
  • No additional bolt-on acquisitions, but some additional divestitures are possible.
Based on these assumptions, we arrive at the following credit measures for 
GSK:
  • Adjusted debt to EBITDA of about 2.9x in 2018 and about 3.2x in 2019.
  • Free operating cash flow to debt of about 17% in 2018 and 2019.
  • Discretionary cash flow to debt of below 5% in 2018 and 2019.
We assess GSK's liquidity as strong, reflecting our opinion that, over the 
next 24 months, the combined group's liquidity sources should cover its uses 
by over 1.5x. We also consider GSK's strong standing in the debt capital 
markets as supportive of its liquidity position. 

Principal Liquidity Sources
  • Cash on the balance sheet of about £3.8 billion on Sept. 30, 2018.
  • Our assumption of cash flow from operations of about £6 billion-£7 billion over the next 12-18 months.
  • An undrawn, centrally available, committed credit facility of £1.9 billion maturing in September 2021.
  • An additional $2.5 billion line maturing in September 2019, but with a one-year extension option.
  • A decrease in working capital, primarily in the fourth quarter.
  • Our assessment that GSK has well-established, solid relationships with its banks, and that it has a generally high standing in the credit markets and prudent risk management.
Principal Liquidity Uses
  • Short-term debt due in the next 12 months of about £2.9 billion on Sept. 30, 2018.
  • Annual capex of about £1.7 billion in 2018.
  • Dividends of about £4 billion (excluding minorities).
The negative outlook reflects our view that GSK may fail to maintain its 
leverage below 3.0x on a five-year basis. The group has impaired its 
deleveraging by acquiring Tesaro and we are uncertain about GSK's ability to 
restore a financial profile that is commensurate with the current ratings. The 
300-bps margin squeeze that GSK has announced for the pharmaceutical division 
will likely drag down future earnings for at least two years. 

We could lower our ratings on GSK if the group does not maintain its adjusted 
leverage below 3.0x. In our base case, the group's leverage should be close to 
2.9x in 2018, but should exceed 3.0x in 2019. A steeper decline than we expect 
in sales of Advair next year, combined with slower development of the group's 
new products than we expect, may cause a downgrade to 'A'. Any evidence of a 
potential delay in the filing of Tesaro's products under development would 
also jeopardize the ratings. GSK's financial metrics are extremely low for the 
current ratings and there is no more headroom for additional acquisitions.

We could revise the outlook to stable if we saw tangible signs of deleveraging 
by 2020, as well as a firm commitment to maintain debt to EBITDA sustainably 
below 3x. As GSK is prioritizing shareholder returns, this would mean the 
combination of robust trading, a reversal of the negative working capital 
trend in evidence over the last nine months, as well as the favorable 
development of Tesaro's product pipeline. Specifically, we will monitor 
whether Zejula is approved as a first-line maintenance treatment for ovarian 
cancer. Additional disposals beyond that of Horlicks would also help in 
restoring a stable outlook.