S&P Cuts Baxter International Rating

The downgrade follows a series of downward revisions to the medical products giant's earnings forecasts

On Jan. 13, 2004, Standard & Poor's Ratings Services lowered its corporate credit and senior unsecured debt ratings on Baxter International (BAX ) to 'A-' from 'A'. At the same time, Standard & Poor's lowered the company's short-term commercial paper rating to A-2' from 'A-1'. The outlook remains negative. At Sept. 30, 2003, the large medical products manufacturer had $4.9 billion of debt outstanding.

The downgrade follows a series of downward revisions to Baxter's earnings forecasts, most recently on Dec. 22, 2003.

Despite the underlying strength of Baxter's business lines, the earnings revisions raise Standard & Poor's concerns about Baxter management's ability to consistently judge the competitive landscape for important core product lines, such as plasma-derived products and hemophilia treatments, and to invest productively in its business. In addition, it is still unclear to what extent restructuring and divestiture initiatives undertaken in 2002 and 2003 will restore profitability to the underperforming plasma and renal lines.

Another concern is the rate of market acceptance of ADVATE, the company's new premium-priced plasma/albumin-free anti-hemophilic factor (recombinant), introduced in 2003. Baxter and other manufacturers have significantly expanded their capacity for manufacturing the current mainstay anti-hemophilia product, recombinant Factor VIII. Such expanded capacity for the older product, taken into consideration with factors that affect the rate at which patients switch to a new treatment, could inhibit the newer product's sales.

Baxter is currently carrying a significant inventory of ADVATE, albeit at a relatively low-cost basis. Still, in the longer term, ADVATE sales growth could be considerable, given the limited market penetration of recombinants and stringent federal regulations, and could more than offset lower sales of existing recombinant and plasma-derived products, which are in excess supply and face pricing pressures.

The investment-grade ratings of Deerfield, Ill.-based Baxter International Inc. reflect the company's operating strength as a leading diversified medical products manufacturer with relatively noncyclical and entrenched primary product lines that generate strong cash flow. Extensive worldwide operations, well-established distribution channels, and low-cost manufacturing have enabled it to sustain this profile. Baxter also generates considerable cash flow and maintains a moderate financial profile. These strengths largely offset the risks of participating in an industry that is intensely competitive and that, for certain products, faces relatively fast-paced innovation cycles.

Baxter develops, manufactures, and distributes products for medication delivery (43% of 2003 sales), bioscience applications (37%), and dialysis treatment (21%). The company now commits around 8% of sales to R&D, about average for the sector, and supplements its investment with occasional small-to-midsize acquisitions in core lines.

In 2003, Baxter's historically conservative financial profile was tested by large, somewhat unexpected payment obligations in the form of nearly $1.3 billion of maturing equity forward purchase contracts and $800 million of convertible debentures put to the company by bondholders. To meet these and pay for certain smaller acquisitions, Baxter issued nearly $2.35 billion of equity and equity-like instruments, and $600 million of new debt.

Although the equity-related issues represented capital that might otherwise have been productively invested in the business, Baxter's discipline and facility in meeting its obligations spoke to the company's underlying business strength and its financial flexibility. The ratings assume that total debt to total capital will average between 30% and 40% in the future. They also assume that Baxter will not enter into any further equity forward purchase agreements.

In coming quarters, Baxter's sales and cash flow could benefit from rising ADVATE sales, intravenous solutions and nutritional products, generic and branded premixed drugs and drug delivery products, inhaled anesthesia and critical care products, and vaccines. Greater market acceptance of peritoneal dialysis products outside the U.S. could also aid revenues.

Baxter earns a large recurring revenue stream from consumable and disposable products. This supports strong and relatively predictable cash flow and should, together with sales of new products, enable Baxter to sustain attractive operating margins averaging in the mid-20% area, return on permanent capital in the 20% area, EBITDA interest coverage in the mid-teens, and funds from operations to total debt above 30%. Still, unrecognized employee options expenses and a relatively high 10% assumed return on pension assets somewhat temper earnings quality.

Liquidity: Baxter's liquidity is relatively strong and diversified among several sources:

• Robust operating cash flow, which exceeded $1.4 billion in the 12 months ended Sept. 30, 2003;

• Several hundred million dollars in cash and short-term investments;

• $1.4 billion in senior unsecured revolving bank credit facilities maturing in October 2004 and November 2007 (Standard & Poor's rates Baxter's senior unsecured credit facilities 'A', the same as the company's corporate credit rating. Based on the vitality of Baxter's broad product portfolio, Standard & Poor's believes there is a strong likelihood of substantial principal recovery should Baxter default or go bankrupt. But because the bank facilities are unsecured, lenders will fare the same as other senior unsecured creditors in the event of a default. The facilities are used primarily to back short-term commercial paper programs that are now rated 'A-2'); and

• $399 million of unused capacity to issue new securities under an SEC Rule 415 shelf filing.

Still, as of Dec. 31, 2002, the company had a number of contingent, but not firm, financial obligations that could in time require a portion of these resources:

• Approximately $309 million of prospective loan guarantees and risk-sharing provisions given to employees to purchase company stock;

• An obligation of up to $220 million if property leased under two operating lease agreements is sold for less than the lessor's investment;

• Up to $292 million of payments if businesses acquired in the past achieve certain regulatory approval and sales milestones;

• Nearly $150 million of unfunded payments if joint development and commercialization arrangements with third parties achieve contractually specified milestones; and

• Several pending, but longer term, product-liability lawsuits.

Baxter also reported a large increase (to $1.2 billion from $466 million) in the unfunded status of its post-retirement pension and other benefit obligations at year-end 2002, and took a $509 million related reduction in shareholder equity. The company contributed $86 million in 2003 to meet mandated funding requirements.

Without a dramatic improvement in market trends, Baxter may have to dedicate a greater portion of its future cash flow to fund these obligations. Furthermore, Baxter's ownership, mainly through its employee pension plan (and at no initial cost to the plan), of more than 10% of the shares of its R&D partner, Cerus Corp., raises concerns. However, this holding currently represents less than one percent of total plan assets.

Outlook: The negative outlook reflects the potential for a downgrade in the event that Baxter is unable to restore a higher level of operating profitability, sustainably deleverage, and follow more measured and conservative business and financial policies.

From Standard & Poor's RatingsDirect

    Before it's here, it's on the Bloomberg Terminal.