Foreign Financial Risk Emerging – Are Pharmaceuticals Hitting the Skids?

By CreditRiskMonitor

CreditRiskMonitor's proprietary FRISK® Stress Index recently indicated a spike in credit risk for the pharmaceutical manufacturing and drug delivery industry. In addition to weakening financial performance, certain companies with the pharmaceutical preparation industry are being negatively affected by high leverage and increased regulatory risk. These problems are impacting companies that exist both domestically and internationally.

To put it bluntly, if you are a business customer, supplier, or partner with a company in the pharmaceutical manufacturing and/or drug delivery industry, you need to stop and examine your credit risk exposure. More than 35% of the Fortune 1000 use CreditRiskMonitor’s service to do just that, with their research actions improving the accuracy of the proprietary FRISK® score. The FRISK® score predicts the risk of financial distress over the following 12 months, effectively flashing warnings signs that you shouldn't ignore.

A Big Trouble Spot

Currently, there are a handful of pharmaceutical businesses showing increased financial distress. Endo International (NASDAQ: ENDP), however, which is involved with drug development, manufacturing, and distribution, is among the riskiest. Over the last twelve months, the company's FRISK® score has slowly fallen from a 4 to a 1. While both of those scores are in the high-risk "red zone," a score of 1 is the lowest possible on the 1 (worst) to 10 (best) scale, suggesting a materially increased probability of financial distress, and even bankruptcy:

Exhibit 1 Endo International FRISK(R) Score

Endo's score of 1 reflects a statistical probability of bankruptcy between 10% and 50% within the next twelve months. This compares poorly against the industry average, presently hovering around a 7, which is fairly neutral – showing that the overall industry is in much better shape than Endo International. See the scoring reference chart below:

Does Endo Need Medicine?

Endo International's integrated business works on developing and selling both generic and specialty drugs from start to finish. Over the last few years, management at Endo International had been executing an aggressive business plan that involved a variety of acquisitions. The goal was to expand the drug company's product line, and in turn, generate higher sales revenue.

Unfortunately, the moves didn't play out as hoped, with industry competition and other headwinds getting in the way. One of the biggest problems is that the company's high margin product portfolio quickly eroded, where gross margins were cut in half over the last three years, going from 61% to 30% on a trailing twelve month basis. That led to a massive incremental decline in operating income, even after backing out one-time items related to impairments and restructuring. The negative trends don't appear to be changing for the better either. During the third quarter conference call, CEO Paul Campanelli explained that volume and pricing pressure would in all likelihood continue.

Taking a look at the company's credit profile shows a mixed picture. Endo International is highly levered, but current liquidity appears sufficient particularly as there are no major near-term debt maturities. Standard & Poor's credit rating puts the business at non-investment grade with a B+. That said, the outlook is negative, which means Endo International could be put on review for a downgrade at any time. On the positive side, current liquidity is supported by a sizable revolving credit facility. CFO Blaise Coleman emphasized that the company is not currently at risk of a covenant breach during the most recent conference call held on November 8th, 2016: 

"...our secured leverage covenant is less than 3.85 times adjusted EBITDA, and we're currently at 2.1 times. And we also have an interest coverage covenant, which the covenant is greater than 2.5 times, and we're currently at 3.8 times.” 

 

That's well and good, but those are "adjusted" numbers. Endo International now has fairly high leverage and a business model that's not performing nearly as well as it has historically. If we look at the raw data, the numbers aren't nearly as encouraging. For example, over the trailing twelve months through September, Endo reported approximately $563 million in EBITDA and $502 million in free cash flow. Given the net debt position of $7.73 billion, debt is roughly 13.7 times EBITDA and 15.4 times free cash flow.

And those aren't the only troubling numbers.  Endo International’s working capital position is declining rapidly, too. From the third quarter of 2015 to the third quarter of 2016, working capital decreased by approximately $1.25 billion. And while the cash ratio remained unchanged year over year in the September quarter, the quick ratio and the current ratio both fell, with the current ratio showing a steady sequential decline each quarter over the span: 

Exhibit 3 Endo's Liquidity Profile

Bottom Line

You won't find too many people surprised when a biotechnology company files for bankruptcy, since the financial risks are incredibly high due to the operational hurdles of research & development, FDA drug processing, finding a licensor, and so forth. However, heads are being turned by the credit risk developing in drug preparation space, particularly among the international operators. Endo International is an example of the type of company that counterparties need to watch closely. Although it appears to be weathering the storm right now, its financial risk is increasing. If the business' performance continues to spiral downward it will only get worse.

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The FRISK® score is calculated by a proprietary model that measures the degree of financial distress for a public company. The model has been back-tested over the last decade to predict 96% of public company bankruptcies. The score is enhanced by our subscriber base through crowd sourced behavioral data patterns. Provided below is the scoring chart that displays the statistical probability of bankruptcy within the next twelve months for each score category:

FRISK® Stress Index is a model that provides the average probability of failure for a group of companies (e.g. by industry, portfolio, or country) over the next 12 months. The level of risk is measured through a scale of 0 to 50, with 50 being the most risky.