Fitch Affirms Covidien's 'A' IDR; Removes Negative Watch; Assigns Negative
NEW YORK -- July 1, 2013
Fitch Ratings has affirmed Covidien International Finance S.A.'s (CIFSA's)
Issuer Default Rating (IDR) at 'A'. Fitch has also removed the Negative Watch
and assigned a Negative Rating Outlook. The rating actions follow the
company's spin-off of its pharmaceutical business and apply to approximately
$5.1 billion of debt outstanding as of March 29, 2013.
KEY RATING DRIVERS
--The Negative Outlook reflects Fitch's uncertainty regarding debt leverage
(total debt/EBITDA) post the spin-off of the company's pharmaceuticals
business, as significant debt reduction in the near term appears unlikely
given the company's acquisitive posture and cash deployment strategy.
--Fitch estimates that the remaining medical device segment should offer the
company higher growth prospects, although Fitch believes some volume and
margin headwinds will persist. In addition, Covidien's product portfolio will
be less diversified post spin-off.
--Fitch believes the spin-off only modestly reduces Covidien's liabilities,
which are significant because of the Tyco-related tax settlement obligations
that the company faces.
--Fitch anticipates that Covidien will continue to adhere to its recently
communicated and more aggressive cash deployment strategy following the
spin-off, which targets returning at least 50% of free cash flow (before
dividends) to shareholders. The company's previous target was a more
conservative range of 25% - 40%.
--Fitch expects the company will benefit from adequate liquidity through free
cash flow generation and ready access to bank credit and capital markets.
SPIN-OFF OF PHARMACEUTICALS SEGMENT
Covidien has completed the planned tax-free spin-off of its pharmaceuticals
segment, named Mallinckrodt Pharmaceuticals (Mallinckrodt). The Negative
Rating Outlook reflects the uncertainties regarding the debt leverage at which
legacy Covidien will operate during the next 18 - 24 months.
BALANCE SHEET MANAGEMENT EXPECTATIONS
Covidien's 'A' IDR is based on the expectation that gross debt leverage
remains at 1.5x or below with temporary spikes tolerable for funding for large
acquisitions. Fitch projects that pro forma leverage could reach 1.8x if debt
remains relatively constant. Fitch questions the company's ability and
commitment to leverage reduction post the spin-off and thinks leverage could
exceed 1.5x through 2015.
Covidien's medical devices segment will now contribute about 80% of total
sales. Fitch thinks that the more favorable organic growth profile of the
devices business could potentially support a slightly more conservative
management of the balance sheet. However, management has recently become more
aggressive in its capital deployment policy, increasing the target for cash
returns to shareholders to a minimum of 50% of pre-dividend free cash flow
(FCF) versus a previous policy of 25% - 40%. Furthermore, Fitch expects
Covidien to continue to grow the medical devices business through acquisitions
that could add debt to the capital structure.
BUSINESS OUTLOOK POST-SPIN-OFF
The loss of the pharmaceuticals segment has mixed implications for Covidien's
bondholders. This segment has lower growth prospects than the company's
medical devices segment and includes some commoditized product lines, which
are a drag on profitability. However, the pharmaceuticals business is also
stable and cash generative. Overall, Fitch thinks the more favorable growth
profile of the medical devices segment will largely offset the negative
implications of the spin-off on the business profile over the long term.
Nevertheless, organic sales growth in the medical devices business is facing
some volume and pricing headwinds in the developed markets for healthcare
products and services, as well as negative foreign exchange during Covidien's
fiscal 2013. Excluding the impact of foreign exchange, Fitch expects
mid-single digit organic growth for the devices business in fiscal 2013, which
is largely due to Covidien's favorable product mix built by the company's
productive device-development and acquisition efforts. The company has a
highly diversified product portfolio, which addresses relatively high growth
areas such as minimally invasive surgery. The low-cost consumable nature of
some of its major product lines also mitigates some demand pressure. Growth in
EBITDA should slightly outpace the top-line as margin expansion will continue
to be aided by mix shift to the faster growth, higher margin devices segment.
While medical procedure volumes are somewhat cyclical with the economy,
favorable demographic shifts worldwide, rapid uptake of medical technologies
in emerging markets, and the anticipated increase in covered lives through
U.S. healthcare reform in 2014 will support higher medical spending and
procedure volumes. Pricing will continue to be under pressure due to fiscal
pressures in the U.S. and Eurozone. The end users of Covidien's devices,
including hospitals, physicians and surgery centers, will attempt to pass
pressure on government healthcare reimbursement rates through to suppliers.
Commoditized products will face the strongest pricing headwinds, so solid
uptake of new product launches will be important for Covidien's revenue growth
and margin improvement.
EFFECT ON COVIDIEN'S LIABILITIES
Some of Covidien's liabilities other than debt are reduced as a result of the
spin-off. These include some environmental clean-up and pension liabilities
that are associated with the pharmaceuticals segment. These items are
relatively small however, and the reduction will not be transformational to
Covidien's balance sheet. Fitch currently assumes that Covidien will retain
nearly all of the liability for the legacy tax liabilities dating prior to the
company's split from Tyco International in 2007, which are more sizable than
the environment and pension liabilities.
Fitch believes that there has been good progress in addressing these
liabilities. All substantial legal liabilities have been resolved. As noted
above, Covidien does continue to have significant financial exposure to
settlement of tax issues from prior to the spin-off, the ongoing settlement of
which will continue to impact FCF generation, probably for several years to
While Fitch believes that Covidien has sufficient financial flexibility to
meet the tax settlement obligations without negatively affecting its credit
profile, the timing of such payments could temporarily stress the company's
balance sheet. Covidien's March 29, 2013 balance sheet reflects a total of
$1.69 billion in non-current liabilities for future tax payments, of which
$1.34 billion relates to tax obligations from prior to the 2007 separation.
Covidien is responsible for 42% of the tax payments related to periods prior
to the separation, and Tyco International and TE Connectivity are responsible
for the other 58%. Covidien also has a $614 million liability for its portion
of the other companies' tax settlement payments, yielding a total liability of
about $1.9 billion for the pre-separation tax settlement payments.
The liability is offset by a $617 million receivable from the other companies,
reflecting their portion of Covidien's anticipated settlement payments. The
three companies are jointly and severally liable for the tax obligations under
the tax sharing agreement. Fitch believes that the other two companies also
have the financial resources necessary to meet the tax settlement obligations.
MORE AGGRESSIVE CAPITAL DEPLOYMENT POLICY
Covidien generated about $1.8 billion of FCF before dividends (cash from
operations less capital expenditures) during the latest 12-month (LTM) period,
ended March 29, 2013. During 2012, the company increased its stated
pre-dividend FCF shareholder pay-out target to a minimum of 50% from a
previous 25% - 40%. In years without significant acquisition activity, the
company expects to exceed the 50% target. Despite spending nearly $1.1 billion
on net acquisitions during the most recent LTM, Covidien exceeded the payout
target, returning roughly 94% of pre-dividend FCF through dividends and share
repurchases during the year.
The targeted payout percentage is a shift to a more aggressive financial
policy and constrains Covidien's 'A' credit profile to the extent that it
prevents leverage reduction in the near- to intermediate term. The recently
more aggressive capital deployment has contributed to higher debt leverage, as
the company increased debt by $742 million during the LTM period, ended March
29, 2013, resulting in debt to EBITDA of 1.5x versus 1.3x a 12 months earlier.
Covidien's ample liquidity is a key support of its credit profile. Fitch
projects ongoing, post-spin-off, pre-dividend FCF generation for Covidien of
around $1.7 billion to $1.9 billion annually, plus Covidien is expected to
retain approximately $750 million cash (at the spin-off) from Mallinckrodt's
$900 million debt issuance. However, at least 50% of this aggregate cash
inflow is targeted for shareholder returns (as previously mentioned). Cash
generation could also be slightly lumpy due to the uncertain timing of cash
payments for the settlement of legacy Tyco tax liabilities. Otherwise
liquidity at March 29, 2013 was supported by the company's $1.5B CP program
(backed by a $1.5 billion credit revolver, $250 million outstanding) and $1.7
billion of cash on hand. Debt maturities are manageable, with a cumulative $1
billion of notes maturities in 2015.
Fitch believes that Covidien may have some financial incentive to maintain a
solid 'A' category rating in order to maintain its access to the tier-I CP
market, although the company's large cash balances and its ability to access
international cash without adverse tax implications lessen its reliance on CP
as a short-term funding source. While the company does access the CP market on
an ongoing basis, the amount of CP outstanding in the capital structure is
The resolution of the Negative Rating Outlook will follow increased clarity on
how remaining Covidien will operate post spin-off. The business profile of
remaining Covidien is consistent with the 'A' IDR, since the stronger growth
profile and higher margins of the medical devices segment offset the negative
implications of the loss of business diversification provided by the
pharmaceuticals segment. However, a one-notch downgrade to 'A-' could result,
if Fitch believes Covidien intends to manage its balance sheet more
aggressively post the spin-off, with gross debt leverage maintained above
A positive rating action is relatively unlikely, but could result from a
commitment to maintenance of gross debt leverage at 1.3x or below.
DEBT ISSUE RATINGS
Fitch has affirmed Covidien's ratings as follows:
--IDR at 'A';
--Short-term IDR at 'F1'.
Covidien International Finance S.A. (CIFSA)
--IDR at 'A';
--Short-term IDR at 'F1'.
--Commercial paper program at 'F1';
--Credit facility at 'A';
--Senior unsecured notes at 'A'.
The Rating Outlook is Negative.
CIFSA, which is the obligor of Covidien's debt, is a wholly owned subsidiary
of Covidien plc. CIFSA directly or indirectly owns all of the operating
subsidiaries of Covidien, issues debt, and performs treasury operations for
Covidien, otherwise it conducts no independent business operations of its own.
CIFSA's senior notes are fully and unconditionally guaranteed by both Covidien
Ltd. and Covidien plc. Covidien plc replaced Covidien Ltd. as the ultimate
parent company in June 2009.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 8, 2012).
Applicable Criteria and Related Research:
Corporate Rating Methodology
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