Nov 8 - Overview -- U.S. pharmaceutical contract manufacturer Patheon Inc. recently announced a plan to acquire Banner Pharmacaps from VION N.V. for $255 million. -- Patheon intends to fund the purchase through a new $565 million term loan B and a new $85 million revolver, undrawn at close, which will also refinance existing debt. -- We are affirming our 'B+' corporate credit rating. We are also assigning the company's new senior secured credit facility our 'B+' issue-level rating with a recovery rating of '4'. -- The rating outlook is negative, reflecting integration risk. Rating Action On Nov. 8, 2012, Standard & Poor's Ratings Services affirmed its 'B+' corporate credit rating on Research Triangle Park, N.C.-based pharmaceutical contract manufacturer Patheon Inc. following the company's announcement that it will issue new debt to fund an acquisition and to repay existing debt. The rating outlook remains negative. At the same time, we assigned the company's proposed new senior secured credit facilities (consisting of a $565 million term loan B and $85 million revolver) our 'B+' issue-level rating with a recovery rating of '4', indicating our expectation for average (30% to 50%) recovery in the event of a payment default. Rationale We continue to view the company's financial risk profile as "aggressive," despite the increase in debt. While we measure pro forma leverage at 5.4x, pro forma for the acquisition debt and inclusion of EBITDA from Banner, but excluding pro forma cost savings or acquisition synergies, we expect that leverage will decline to the low-4x range by the end of fiscal-year 2013. Free cash flow is expected to be positive. We continue to view the business profile as "weak," which reflects the company's inconsistent but improving operating performance in the competitive and highly fragmented pharmaceutical contract manufacturing business, as well as the company's need to integrate Banner's operations following the acquisition. While the Banner acquisition adds some scale, we do not believe that the improvement in scale alone warrants a stronger business risk score. Patheon's new management has been successful in rationalizing capacity and signing new business, and in leveraging revenue growth into gross margin improvement. While these improvements have allowed Patheon to generate modest positive free cash flow in the second half of 2012, we still expect full-year discretionary cash flow to be negative due to heavy consulting spending in the first half of the year. Pro forma the acquisition and debt refinancing, adjusted leverage is about 5.4x, inconsistent with our assessment of an aggressive financial risk profile. However, we expect Patheon to reduce leverage to the low-4x level over the next year and to generate funds from operations to total debt in the low double digits in fiscal-year 2013 and modestly positive free cash flow after about $55 million in expected capital spending. This expectation reflects our belief that the company will generate mid-single-digit pro forma revenue growth in fiscal-year 2013, and that EBITDA margins will expand about 250 basis points next year, resulting in 2013 EBITDA of more than $140 million. This largely reflects the full-year impact of the operational improvements realized in the second half of fiscal-year 2012. Our assessment of Patheon's business risk profile as weak reflects our view that the CMO industry is capital intensive, highly fragmented, and competitive; that the company has a short track record in generating positive free cash flow; and that the company needs to quickly integrate the Banner acquisition while completing its internal operating improvement plan. In addition, while the pro forma entity will be the No. 2 player in softgels behind industry leader Catalent Pharma, softgels represent a relatively small portion of the broader solid oral dosage market. These factors are only partially offset by Patheon's positioning as a market leader in each of its two existing major market segments and its well-established customer relationships (including relationships with 18 of the 20 largest global pharmaceutical companies and nine of the 10 largest global biotechnology companies). Our assessment also considers the recent improvement in revenues and operating margins, the diversity of the company's service offerings, and our expectation that long-term demand for Patheon's services will continue to grow at a low- to mid-single-digit rate. Liquidity Our assessment of Patheon's liquidity profile as "adequate" incorporates the following expectations and assumptions: -- Sources of cash should exceed mandatory uses over the next 12 to 24 months. -- Sources of cash include about $85 million in availability under the new revolving credit line and about $60 million in expected funds from operations. -- Ongoing uses of cash include minimal working capital usage and about $55 million in annual capital expenditures (about half of which is expansionary). -- Following the refinancing, Patheon has no near-term debt maturities and no financial maintenance covenants. -- We expect liquidity to exceed needs, even if EBITDA declines by 20%. -- Given the company's cash balances and available revolver capacity, we do not believe Patheon can absorb, without refinancing, a high-impact, low-probability event. Recovery analysis We are assigning Patheon's proposed new senior secured credit facilities our 'B+' issue-level rating with a recovery rating of '4', indicating our expectation for average (30% to 50%) recovery in the event of payment default. Outlook Prior to the acquisition announcement, our negative outlook reflected our view that Patheon was in the early stages of an operating turnaround, and that 2012 would be a transformative year for the company. While Patheon has now produced two quarters of improved operating results, the company has now introduced new elements of business risk with the Banner acquisition. While the acquisition adds some business diversity, we view this acquisition as transformative, and debt levels are increasing at a somewhat fragile period in the company's recovery. While we expect Patheon to generate over 30% pro forma EBITDA growth in fiscal-year 2013, this forecast is not without risks, particularly because the company must now integrate newly acquired Banner while at the same time completing its internal turnaround plan. If Patheon is able to manage the integration and to grow revenues in the low to mid-single digits while expanding margins around 100 basis points and generating positive free operating cash flow, we could consider an outlook revision to stable. We could consider a lower rating if Patheon is unable to reduce leverage and generate positive free operating cash flow over the next four quarters. We believe that this could occur if the company experiences any difficulties in integrating the Banner acquisition, or if the company is unable to sustain the operating improvements realized over the last two quarters, resulting in margin deterioration. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Ratings Affirmed Patheon Inc. Corporate Credit Rating B+/Negative/-- Senior secured notes B+ Recovery Rating 4 Senior secured revolving loan BB Recovery Rating 1 New Rating Patheon Inc. Senior Secured $565M fltg rate term B loan due 2019 B+ Recovery Rating 4 $85M fltg rate revolver loan due 2017 B+ Recovery Rating 4 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. 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