Fitch Assigns First-Time ‘BB-‘ Rating to MedImpact; Outlook Positive

CHICAGO--(BUSINESS WIRE)-- Fitch Ratings has assigned a 'BB-' Issuer Default Rating to MedImpact Holdings, Inc. and its issuing subsidiary, MI OpCo Holdings, Inc. The Rating Outlook is Positive.

A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

Smaller Scale in Consolidated Industry: MedImpact is a top-5 pharmacy benefit manager (PBM) but is significantly smaller than its three largest competitors. Significant size differences are less pronounced than revenues imply (due to differing accounting policies and varied business mixes), but is nevertheless meaningful in a largely consolidated industry where scale is very important.

Differentiated, Independent Business Model: Unlike nearly all its peers, MedImpact does not own its own fulfilment/dispensing capabilities (i.e. mail-order or specialty pharmacies). The firm's differentiated approach to avoiding conflicts of interest is the most radical among major PBMs and could position the firm to win new business in the midst of possible disruptive industry shifts in the 2017-2019 timeframe. The strategy could also disadvantage MedImpact, however, to the extent potential new customers continue to demand mail-order and/or specialty pharmacy offerings from their PBMs.

Stable Operations, Cash Flows: Because of their long-dated contracts and often diverse customer bases, PBMs usually have good insight into future business wins/losses and associated cash flows. Although stable and more than sufficient to cover term loan amortization, absolute cash flow dollars are somewhat light compared with peers, with FCF as a percentage of EBITDA expected to approximate 35% (>60% for its largest peer, Express Scripts).

Moderate Leverage to Decline: Term loan amortization and decent EBITDA growth are expected to contribute to de-leveraging over the ratings horizon. Gross debt/EBITDA and adjusted debt/FFO are expected to decline to 1.7x and 2.9x, respectively, by year-end 2018, from 2.4x and 3.7x at year-end 2016. Debt leverage metrics are roughly in line with those at 'BBB' rated competitor Express Scripts.

Private Ownership: MedImpact is 100% owned by its founder/CEO and a small number of other management employees. However, Fitch does not foresee adverse effects to operations or capital deployment as a result, as the CEO is well-respected as a thought-leader in the industry and as capital deployed for share repurchases and ultimate parent dividends has been relatively modest.

RATING SENSITIVITIES

MedImpact's 'BB-' IDR considers the company's smaller scale, somewhat light absolute cash flows, and lack of very large customers, offset by relatively low debt leverage, stable cash flows, and the expectation that growth will outpace the overall PBM industry. The Positive Outlook represents Fitch's expectation for de-leveraging in 2017-2018 and for possible industry developments that lead to new customer wins for MedImpact.

Future developments that could, individually or collectively, contribute to the consideration of an upgrade to 'BB' include:

--An expectation for gross debt/EBITDA and adjusted debt/FFO to be sustained around or below 2x and 3x, respectively;

--Successful renewal of top customer contracts in 2017 (excluding two known lost contracts), with support for growth expectations from those existing customers;

--The addition of new customers of size validating MedImpact's differentiated business strategy.

Future developments that could, individually or collectively, contribute to the consideration of a rating downgrade to 'B+' include:

--An expectation for gross debt/EBITDA and adjusted debt/FFO to be sustained above 3x and 4x, respectively;

--The loss of top PBM customers suggesting an invalidation of MedImpact's differentiated business strategy;

--Margin deterioration or a shift in capital allocation that pressures cash flows and/or liquidity in light of increasing term loan amortization payments.

KEY ASSUMPTIONS

--Soft revenue growth in 2016-2017 due to the loss of two key customers, improving in 2018-2019 under the assumption of client retention and new client wins;

--Stable margins, incrementally lower than 2015, with modest margin improvement possible in 2017-2018 due to the termination of lower-margin clients, with upside potential as the company more deeply penetrates its current customers with higher-margin services;

--Debt leverage reduction to 1.7x at YE2018 from EBITDA growth ($16 million in both 2017 and 2018) and term loan amortization ($20 million in both 2017 and 2018);

--No material M&A;

--Modest cash deployed for dividends ($2 million annually) and net share repurchases ($5 million) at MedImpact Holdings.

LIQUIDITY & DEBT MATURITIES

Ample Liquidity, Stable Cash Flows: Cash on hand routinely outpaces annual debt maturities, though lower cash balances have been held since 4Q15. Liquidity is supported by stable cash generation and negative working capital, both characteristic of the PBM industry, and decently strong capital market access.

Reduced Interest Costs: The new $400 million term loan borrowed in July 2016 carries an applicable margin of 225 bps, compared to 475 bps under the previously negotiated term loan. The previous term loan refinanced 10.5% unsecured notes.

Manageable Debt Maturities: MedImpact's only material debt maturities over the next four years are term loan amortization payments, approximately as follows: $20 million in 2017 and 2018, $25 million in 2019, and $35 million in 2020.

The company has not maintained a revolving credit facility since 2014. All unrestricted cash is considered 'readily available'.

TWO LOST CUSTOMERS TO STALL ORGANIC GROWTH IN 2016-2017

MedImpact's revenues have nearly doubled and margins improved more than 500 bps from 2012 to 2015. Such strong performance is the result of new business and growth from existing customers. According to MedImpact, it processed 229 million claims for its top-20 customers in 2015 compared to 107 million in 2012, leading to an increase in revenues of $139 million.

However, two of MedImpacts top-10 customers by revenue have decided not to renew their contracts with the firm. Contract losses will affect 2016 and 2017 results, reducing top-line growth but with a less pronounced EBITDA impact. Notably, only two of MedImpact's current top-10 PBM customers have more than two years remaining on their current contracts. Average PBM contract are three-five years in length. Current customer renewals will be vital to maintaining growth and profit margins in the near- to medium-term.

INDUSTRY EVOLUTIONS MAY FAVOR MEDIMPACT; SMALLER SCALE, BUSINESS MODEL COULD DISADVANTAGE

MedImpact's "conflict-free" business model (i.e. does not own fulfilment/dispensing) could position the firm well to benefit from underlying pressures and trends within the U.S. drug channel. MedImpact asserts that a PBM business that does not operate its own pharmacies - particularly in specialty - can better address issues related to a recently heightened focus on pharmaceutical pricing, with continued calls for increased overall transparency, and rising cost trend associated with expensive specialty therapies. Overall weak satisfaction with major PBMs, pending large-scale health insurance mergers, and the upcoming expiration of many of the largest PBM contracts could provide opportunities for significant shifts in the industry.

As the largest managed care organizations (MCOs) continue to merge, Fitch expects regional MCOs to increasingly seek to provide more customized programs for their members in order to retain and win new business. MedImpact's flexible approach to formulary management and "conflict-free" model make the firm an attractive partner for the 425 regional MCOs that provide coverage to fewer than one million lives (per CMS).

While we expect the firm to continue to add smaller regional MCOs, the addition of a major managed care customer would provide a strong validation of MedImpact's business strategy. Fitch does not expect the firm to dramatically give up on price just to win such a contract and, in fact, winning large contracts is not a part of MedImpact's outlined growth strategy. At this time, we are unsure if MedImpact's smaller scale and lack of in-house mail-order capabilities might prevent such business wins. We view the ability to leverage scale in negotiating drug pricing and to provide efficient mail-order services as cornerstones of today's PBM offerings.

NASCENT SPECIALTY OFFERING COULD STRENGTHEN VALUE PROPOSITION

MedImpact is marketing its relatively new MedDirect specialty program offering for current clients in an attempt to win new ones. The program is run in partnership with specialty pharmacies run by four firms: US Bioservices (owned by AmerisourceBergen, a pharma distributor), Walgreens, Humana, and Commcare (owned by Premier). Walgreens is by far the largest of the four partners but still much smaller than the specialty pharmacy networks run by CVS Health and Express Scripts. Interestingly, Walgreens recently struck a deal with Prime Therapeutics, one of MedImpact's peers, to combine their mail-order and specialty pharmacy businesses under a new, jointly-owned company.

The "hub" offerings in MedDirect seem similar to those offered by other major PBMs, except without the potential or apparent conflict of interest inherent in those PBMs owning their own specialty pharmacies. Mail-order services are offered either through the above mentioned partners or through smaller independent mail-order providers. A robust specialty solution at least keeps MedImpact in-step with its major competitors, opening the doors to possible new customers who may have been kept from joining MedImpact because they required a more robust specialty pharmaceutical dispensing platform.

FULL LIST OF RATING ACTIONS

Fitch has assigned the following ratings:

MedImpact Holdings, Inc.

--Long-Term IDR 'BB-';

MI OpCo Holdings, Inc.

--Long-Term IDR 'BB-';

--Senior secured term loan 'BB+/RR1'.

Date of Relevant Rating Committee: Nov. 3, 2016

Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor include:

--Fitch excludes expenses related to stock-based compensation from EBITDA calculations.

--Cash paid for interest for the 2015 year-end period at MedImpact Holdings, Inc. was adjusted for amounts Fitch does not deem as cash interest, including early redemption premiums and (re)finance fees.

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

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 05 Apr 2016)

https://www.fitchratings.com/site/re/879564

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