Pharma 2022 Outlook: Shifting to M/P

• We shift our recommendation on IG Pharma to Market perform (from Underperform) to start 2022. Pharma trades ~21 bp tight to the US IG Index. The sector enjoys stable operating fundamentals, strong free cash flow generation, and conservative leverage (albeit elevated versus past periods).
• The sector is expected to deliver mid-single digit revenue growth through 2026 on the back of accelerated FDA approvals, particularly for biologics, oncology therapies and orphan drugs. Patent losses will mount come the middle part of the decade, beginning with Humira’s loss of exclusivity in 2023.
• The sector appears to have dodged punitive drug price legislation despite Democratic control of the White House and Congress. Drug pricing provisions within the Build Back Better Act look highly manageable versus earlier proposals, particularly with respect to Medicare negotiating authority.
• We expect the sector to be active with bolt-on M&A in preparation for future patent losses. Management teams have signaled an interest in M&A activity, particularly for mid/late-stage pipeline assets in innovative areas such as oncology and immunology. We see lower odds of transformative M&A within the space.
• We see the potential for leverage to drift modestly higher in 2022. The sector carries gross and net leverage of 1.8x and 1.2x, respectively (3Q21-LTM). We expect bolt-on M&A and shareholder rewards to push leverage higher by YE22, partially offset by FCF generation and debt reduction programs for companies such as ABBV, BMY and VTRS.
• We expect an increase in new issuance activity in 2022. We forecast $45-55 bn of Pharma new issuance (vs $34 bn in 2021) attributable to modestly heavier refinancing activity and M&A. M&A represents the obvious wildcard, particularly for bolt-on deals which can be heavily cash financed. We expect larger bolt-ons to be debt financed given the attractive rate environment.

We are shifting our recommendation on IG Pharma to M/P (from U/P) to start 2022. The sector currently trades ~21 bp tight to the US IG Index, which compares to a 5Y average differential of ~26 bp. While this relationship suggests some potential for Pharma outperformance in the year ahead, we believe an active M&A roster, the looming threat of patent expirations, and an uptick in shareholder rewards will mitigate the relative spread tightening opportunity.

We expect stable operating fundamentals in IG Pharma in 2022 on the back of accelerated FDA approvals – particularly for oncology medicines and orphan drugs – and new drug uptake. While patent exposure will ramp materially in the mid-2020s, we gauge only moderate risk in 2022. We also see limited legislative risk given the watered-down drug pricing provisions included in the Build Back Better Act and the approaching mid-term elections.

We anticipate strong credit fundamentals in the year ahead but see an upward bias to leverage. Management teams have been explicit about their M&A intentions – particularly given looming patent expirations – though we expect a focus on bolt-on deals, primarily for mid/late-stage pipeline assets. We also expect shareholder rewards