July 2001 Rating Methodology

Moody's Approach To Rating The Global Pharmaceutical Industry

Contact Phone
New York
David Neuhaus 1.212.553.1653
Michael Levesque
Diane Vargas
Richard Stephan
Tokyo
Chieko Matsuda 81.3.3593.0922
Frankfurt
Heiko Neumann 49.69.2.42.84.0

MOODY'S APPROACH TO RATING THE GLOBAL

PHARMACEUTICAL INDUSTRY
Rating Methodology

• The pharmaceutical industry presents investors with an unusually strong credit profile — 5
out of 9 Aaa rated industrial companies are focused in this sector. Strong profits, high
growth rates, significant barriers to entry, and favorable demographics all contribute to the
sustained creditworthiness of companies within this industry.
• The key factors that differentiate credit quality within the sector include the quality of the
product portfolio, exposure to patent expirations and competing products, management
strategy and acumen, geographic market participation, the ability to bring new products to
market, and capital structure.
• In the last year the sector has rapidly increased its use of debt markets, raising money for
Rating Methodology

numerous reasons, including; acquisitions, litigation-related payments, extending maturities,

tapping offshore funds, and managing income. In the last 12 months, over $14 billion in debt
was issued by this sector.
• Overall, the industry remains strong, but some emerging issues could put downward pressure
on ratings. These include increased government regulation, increased competition, industry
consolidation, and pricing pressures derived from managed-care’s efforts to control costs.

continued on page 3
 List Of Global Pharmaceutical Ratings
Sr. Unsec/Sr Implied
Pharmaceutical Companies Long-term Rating Short-Term Debt Outlook

Investment Grade:
Bristol-Myers Squibb Co. Aaa P-1 Under Review: Possible Downgrade
Johnson & Johnson Aaa P-1 Stable
Merck & Co. Aaa P-1 Stable
Novartis Aaa P-1 Stable
Pfizer Inc. Aaa P-1 Stable
Abbott Laboratories Aa1 P-1 Stable
AstraZeneca PLC Aa2 P-1 Stable
GlaxoSmithKline plc Aa2 P-1 Stable
Schering-Plough Corp. (P)Aa2 P-1 Stable
Lilly (Eli) & Co. Aa3 P-1 Stable
Yamanouchi Pharmaceutical Aa3 — Stable
Daiichi Pharmaceutical Co., Ltd. [2] A1 — Stable
Eisai Co., Ltd. A1 — Stable
Pharmacia Corp. A1 P-1 Positive
Sankyo Co., Ltd. A1 — Stable
Amgen Inc. A2 P-1 Stable
Fujisawa Pharmaceutical Co. Ltd. A2 — Stable
Aventis S.A. A3 P-1 Stable
Allergan, Inc. A3 P-2 Stable
American Home Products A3 P-2 Stable
Chugai Pharmaceutical Co., Ltd. A3 — Stable
Genentech, Inc. [1] A3 — Stable
Shionogi & Co., Ltd. A3 — Negative
Tanabe Seiyaku Co., Ltd. A3 — Stable
Chiron Corporation Baa1 — Stable
Elan Corporation, plc [1] Baa2 — Positive
Kyowa Hakko Kogyo Co., Ltd Baa2 — Negative
Takeda Chemical Industries N/A P-1 —

Speculative Grade:
Watson Pharmaceuticals, Inc. Ba1 — Positive
King Pharmaceuticals, Inc. Ba2 — Stable
Biovail Corporation International Ba3 — Stable
ICN Pharmaceuticals, Inc. Ba3 — Stable
[1] Subordinated debt.
[2] Long-term Issuer Rating

Authors Senior Associate Senior Production Associate

David Neuhaus William Lebron John Tzanos
Michael Levesque

© Copyright 2001 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS
COPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE
REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR
ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR
WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of
human or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes no
representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.
Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,
any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in
connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,
indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the
possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained
herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO
WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF
ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other
opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must
accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may
consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (including
corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to
MOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.

2 Moody’s Rating Methodology

 Why Are There So Many Highly Rated Pharmaceutical Companies?
The pharmaceutical industry could not include multiple Aaa rated companies without the solid support of a
number of favorable characteristics. We monitor these traits on a regular basis to ensure that the underlying
support for strong credit ratings of the sector is likely to be maintained over a minimum three year horizon.
• The industry has shown a consistent ability to maintain high gross profit margins (in excess of 70%
for many companies) and ROS figures in the xx range. Further, the introduction of new products,
ability to raise prices and expanding markets translates into steady earnings growth for the estab-
lished participants.
• Many companies in the industry posses strong balance sheets, bolstered by relatively large cash posi-
tions, and low debt levels. Financial flexibility is gained through cash holdings and good access to
debt and equity markets.
• The inexorable aging of the population, particularly in the US, is a highly favorable and predictable
characteristic that supports the growing consumption of many pharmaceutical products, particularly
in the hypertension, diabetes (type II) and cholesterol-management therapeutic categories. The
potent combination of aging baby boomers, increasing longevity, and rising health expectations,
translates into the accelerating consumption of drug products.
• The ability to protect intellectual property for extended periods provides the pharmaceutical indus-
try a substantial barrier to entry and supports the sustainability of high gross margins, once a new
product has been brought to market.
• A hallmark of the higher rated credits is the existence of products in multiple therapeutic categories,
resulting in a diversified revenue stream, despite being considered a single industry. The degree of
correlation across categories is generally quite low. Several of these companies are also diversified
into non-pharma businesses, such as medical devices, consumer products, and animal healthcare.
• The substantial increase in managed care benefits for pharmaceuticals has increased the overall
usage of drugs, and improved the likelihood of long-term compliance with prescription regimens,
further contributing to the predictability of cash flows within the industry.
Of course, the sector is not without risks; these including patent expirations, a lengthy and expensive
R&D process, product safety issues, potentially looming pricing pressures related to managed care or gov-
ernmental influence, and event risk associated with potential acquisitions.

What Differentiates Ratings Within The Sector?

Debt ratings within the sector run from Aaa (Bristol-Myers Squibb, Johnson & Johnson, Merck, Novartis,
and Pfizer) down through the speculative grade ratings. The primary differentiating factor is the quality of
the underlying business, measured by breadth of product, exposure to patent expiration, and management
strength — balance sheets are an important, but secondary, consideration. However, in this sector, bal-
ance sheet strength tends to correlate with ratings, rather than drive them.

Product Line-Up — First Stop In Our Credit Assessment

More than any other single factor, a company’s product line-up has a greatest bearing on its relative credit
quality. The portfolio of products and their position and within their respective therapeutic categories is a
reflection of a company’s strategy, R&D success, marketing prowess, ability to in-license quality products,
and potential to generate sustainable cashflows.
From a "big-picture" perspective, a company’s ability to develop and market top-candidates in multiple
therapeutic categories usually signifies the breadth of coverage of its sales-force, which often makes a compa-
ny an appealing candidate to in-license and market new products from smaller and international companies.
As therapeutic classes become increasingly crowded, the importance of having products ranked among
the top 2-3 will increase. Purchasing groups/PBM’s are increasingly negotiating deals that provide
enhanced coverage the top products in a given category, while leaving other products off the formulary or
subject to higher co-pays.

Moody’s Rating Methodology 3

 The strength of a particular product’s franchise is also considered by Moody’s. As many block-buster
products are approaching the end of the patent life, many companies are seeking to extend the franchise
into "next-generation" products as a strategy for competing with new generic competition. In many cases
the new product is not considered significantly different from its predecessor at the molecular level, but
may present dosing advantages (extended release versions), or modest improvement in efficacy. Examples
of next generation strategies include (old product — new product) Prilosec — Nexium, Claritin —
Clarinex, Glucophage — Glucophage XR and Prozac — Sarifem.
Moody’s also monitors the potential for therapeutic substitution (which is the substitution of a differ-
ent chemical entity with comparable therapeutic benefits). When this occurs, companies can also be
exposed to patent expiration risks associated with competitor’s products in the therapeutic category. As
new generic products are introduced, this trend may accelerate as a way for consumers and managed care
companies to reduce expenditures. For example, upon the availability of generic versions of AstraZeneca’s
Prilosec (for gastrointestinal disorders), the demand and pricing for competitor products like AHP’s
Protonix or Abbott’s Prevacid could potentially be affected.

Product Concentration Risk Is Important

Product concentration is a critical differentiating factor across the ratings spectrum. The top rated Aaa
companies typically demonstrate limited product concentration — for example Lipitor contributed 17%
of Pfizer’s 2000 revenues. Further down the ratings spectrum, the degree of concentration tends to
increase — Schering Plough (Aa2) derives 31% of revenues from Claritin, Amgen (A2) derived 88% of
2000 revenues from Neupogen and Epogen.
The degree of product concentration relates directly to our views of the degree of event risk stemming
from a number of sources, including: new competition, patent expiration or intellectual property litiga-
tion, adverse safety developments, and government regulation. Product diversity also provides a degree of
protection from the risk that a competing drug may gain approval and, due to superior efficacy, dosing,
and/or side effects, rapidly capture a significant share of the market.

Non-Pharma Operations Provide Diversity

Although the trend among most large pharmaceutical companies has been to pare operations to a core
pharmaceutical focus, several companies still maintain significant OTC or medical device businesses.
Because pharmaceutical development and commercialization s is a high-risk, high-reward business,
Moody’s typically views favorably the diversity of revenues and cash flows provided by such operations.
Primary examples are Johnson & Johnson, American Home Products, and Abbott Laboratories.
Meanwhile, Bristol-Myers Squibb is divesting/spinning-off its Clairol (personal care) and Zimmer (ortho-
pedic products) businesses, reducing its diversity of operations.

Patent Protection Allows Companies To Maintain Premium Pricing

The ability to protect intellectual property using patents is an important factor in the overall credit quality
of the pharmaceutical industry. In assessing the overall risk level of a particular company, Moody’s will con-
sider, for each major product, the underlying U.S. and international patents, the expected expiration of the
patents, and the anticipated timing of generic competition. Moody’s also considers that as products near the
end of their "official" patent lives, companies have a number of options for extending the life of the patent.
This can include performing pediatric trials, which usually provide a 6 month period of added protection,
and filing additional patents that, for example, cover manufacturing processes. Recent negative publicity
concerning these strategies, including safety concerns, could, however, ultimately cause a backlash.
Moodys’ recognizes that some core/profitable products possess considerable barriers to entry that are
not tied specifically to patents. A notable example is American Home Product’s Premarin family of estro-
gen replacement products.
Moody’s considers the risks associated with post-patent transition plans., such as the introduction of
new formulations (the Claritin to Clarinex switch), new combination therapies (Glucophage/Glucovance),
and new dosing regimens. Although these strategies offer companies an effective mechanism to maintain
market share and pricing, the risks associated with the transition are often challenging. We believe that the
ultimate success of such strategies is highly uncertain, and will heavily depend on the ability to demonstrate
to both physicians and payors that the newer formulations have major advantages in efficacy and/or safety.
And as discussed earlier, when considering patent issues for a particular drug, Moodys’ will consider
the patent situation for potential therapeutic equivalents, reflecting a concern that cheaper competing
generic products could be introduced.

4 Moody’s Rating Methodology

The Pipeline — A Window On The Future
In recent years, litigation over patents and several high-profile delays in introducing new products has
underscored the importance of a drug pipeline — and the ability to marshal new products from pre-clini-
cal trials through to a New Drug Application (NDA) and ultimately to the pharmacy shelf. A well-stocked
pipeline and the ability to successfully introduce new products and line extensions are important qualita-
tive rating considerations. These characteristics will gain increasing prominence over the next few years as
patent expirations accelerate and companies need to develop new compounds and implement other strate-
gies to defend key markets.
In assessing a company’s pipeline, Moody’s will consider the overall commitment to research, the
potential contribution of drugs in the latter stages of development, and the competitive landscape for indi-
vidual products. Potential synergies with a company’s existing portfolio of products and the anticipated
sales channels are also considered. Line extensions and combination-therapy products, that are based on
already approved drugs with established efficacy and known side-effects, can contribute favorably in a rat-
ings assessment. However, related patent issues may override the perceived benefit.
The ability to bring new products to market takes on additional importance in situations where compa-
nies are confronted by patent expirations and /or new competition and seek to either extend the life of
existing products through new formulations and combination therapies, or develop products that would
provide consumers an switch-product. An example is Schering-Plough’s strategy to introduce Clarinex
(desloratadine) as a replacement for Claritin (loratadine); desloratadine is an active metabolite of loratadine.
In situations involving patent expirations on key products, the distribution of pipeline products across
the 3 phases of development (I, II, III) and those that have already been submitted to regulatory authori-
ties for approval, becomes considerably more important, with considerably more emphasis given to the
later stage products. A primary example is Eli Lilly (Aa3), which has 3 new products currently awaiting
FDA approval, helping to mitigate the expected revenue loss associated with the impending availability of
generic versions of Prozac.

Management Acumen And Strategy Are Factored Into The Ratings Assessment
Measuring the "quality" of management and reflecting that quality in a debt rating is highly subjective and
difficult, yet is among the most important aspects of a rating. In a stable, profitable, soundly financed compa-
ny, one of the few factors that can contribute to a rapid, unexpected ratings "event" is management. Hence it
is critical to understand management’s motivation, and range of strategic options that may be pursued at any
given time. In recent years, the pharmaceutical industry has seen a wave of mergers — creating a new breed
of mega-pharma companies, coupled with a shift away from diversified healthcare/chemical companies.
Management’s commitment to R&D and demonstrated ability to bring new products through the
"pipeline" is important, as it supports both the long term success of the company, but also lessens the
pressures to make large acquisitions to keep the sales force fully utilized. In recent months, the proposed
acquisition of DuPont’s pharma business by Bristol-Myers Squibb and the purchase of BASF’s pharma-
ceuticals business by Abott Labs, both cash transactions, are examples of potentially negative credit events
that were driven in part by strategies to enhance growth rates. Also, an underutilized sales force may lead
to sub-optimal in-licensing transactions, with potential negative impact on morale and profitability.

Accounting Differences — Recent Changes In U.S. Increase Conformity

Accounting differences between U.S. and foreign companies continues to require close attention. The
recent change in U.S. GAAP, which eliminates the ability to account for acquisitions as a "pooling-of-
interests", will reduce some of the larger differences. As per FAS141acquisitions after June 30, 2001 will
now be accounted for in the US using the purchase method of accounting. While goodwill is likely to
become a significant balance sheet account, especially in this industry, under U.S. GAAP, companies will
no longer need to amortize goodwill. They will however need to periodically review the account and take
charges to reflect any impairment of value.
In foreign countries, the ability to continue to account for certain mergers under pooling of interest
accounting could generate continued differences in balance sheet leverage calculations and income figures,
and will be monitored on a case-by-case basis.

Moody’s Rating Methodology 5

Geographic Considerations — U.S., Europe And Japan Still Dominate
Exposure to multiple geographic markets, either through in-house sales force or through licensing arrange-
ments is also an important credit consideration. The level of price controls, patent protection, and market
growth can differ widely from country to country. Overall, participation in the U.S. market is viewed most
positively due to the size of the market and limited degree of government-imposed price controls.
Percentage Growth
2000 Sales Percentage year-over-year
US$Bn Global Sales % constant dollar
North America $ 152.8 48.2% 14%
Europe 75.3 23.7% 8%
Japan 51.5 16.2% 3%
Latin America 18.9 6.0% 9%
Asia (ex Japan), 18.7 5.9% 10%
Africa & Australia
Total $ 317.2 100.0% 10%
Source: IMS Health

Market practices and dynamics and regulatory environments vary widely by country. The three most
important pharmaceutical markets are the United States, Europe and Japan.
In addition to its large scale and favorable demographics, the pricing in the U.S. market also has the
benefit of being largely unregulated, and it presents the established ability to protect patent rights.
Although certain trends in this market, such as the possibility of a Medicare drug benefit, could place
downward pressure on the overall profitability of the industry, Moody’s continues to view the U.S. as a
very attractive market.
The size of the U.S. market also presents a significant hurdle for potential new entrants, including
many of the large foreign producers. A large and effective sales force is often a necessary prerequisite to
maximize the profitability of certain drugs (Pfizer’s global sales-force totals nearly 22,000 representatives,
of which one-third provide coverage in the U.S.). Many companies opt to license products to the compa-
nies with established salesforces, rather than take on the added risk and cost of developing its own; thus
providing an additional stream of new products for the major U.S. companies, such as Merck and Pfizer.
Foreign companies that have developed extensive U.S. sales teams include GlaxoSmithkline.
A company’s international strategy is also considered, in particular with regards to Japan and Europe.
Both of these markets, while more regulated than the U.S., present companies with attractive demograph-
ics, the ability to protect patents, and favorable pharmaceutical consumption profiles. In Japan, government
plans to reform the health care system by 2002 and although Moody’s does not expect significant near-term
impacts, changes in drug pricing mechanisms could place downward pressure on prices. International phar-
maceutical companies are also increasing their participation in the Japanese market through both acquisi-
tions and joint marketing efforts. This trend could place pressure on domestic companies to increase R&D
expenditures and expand joint marketing efforts to maintain their competitive position.

Share Repurchases — Expected To Continue

Pharma companies are regular repurchasers of shares, and Moody’s is often asked to consider the impact
of alternative levels of buybacks on debt ratings. Moody’s recognizes the inefficiency of holding large cash
balances, and the shareholder focus of buybacks, and in general is not negatively disposed towards conser-
vatively implemented buyback programs. The key considerations that we will assess are the 1) source of
funds being used, 2) the impact on a company’s capital structure as a result of the buyback, 3) the imple-
mentation period, and 4) the underlying health of the business at the time of the buyback.
To maintain a given ratings level, Moody’s prefers that the source of funds be from either the exercise
of options or free cash flow. In either case, the impact on capital structure and credit quality is usually
minimal. To the extent that a share buyback diminishes a firm’s equity account or is completed using bor-
rowed funds, it can have significant impact on a firm’s capital structure, and potentially limit its overall
financial flexibility. The result may signal a change in management’s financial philosophy and can have
negative ratings impact. Finally, Moody’s considers a healthy underlying business as better able to support
sustained share buybacks without adverse ratings consequences. Therefore, while a large share buyback
program in and of itself might not impact a rating, it could contribute to a more negative view if other
issues are present (e.g. patent expirations, product delays, safety issues).

6 Moody’s Rating Methodology

Cash — How We Look At It Depends On The Situation
Many pharmaceutical companies carry relatively large balances of cash and short-term marketable securi-
ties, ranging up to the $7.8 billion held by Pfizer at q1/01. Recently, Moody’s has also noticed a trend
among smaller companies, such as Allergan (A3) and Chiron (Baa1) to increase cash holdings by issuing
debt securities, despite not having a specific immediate use for the proceeds. In some cases, it is possible
that cash is being raised to generate positive net interest income, in support of R&D and marketing efforts.
The impact on credit quality of holding cash is not as uniformly positive as one might think. At one
end of the spectrum, cash may be generated from operations in offshore tax jurisdictions such as Ireland,
and held on the balance sheet indefinitely, pending the a favorable tax "event" that would allow a company
to bring it back to the United States and at the other end of the spectrum, the cash may have been raised
to opportunistically pre-fund potential acquisitions.
Moodys’ will evaluate each company on a case by case basis, considering the location of the funds, the
likelihood of pursuing debt-financed acquisitions, and management’s overall objectives and past financial
practices. Cash can form a core part of a company’s financial liquidity, particularly in support of commer-
cial paper borrowings that are often the primary method of accessing untaxed foreign funds.

Credit Metrics — What Ratios Do We Use?

In conjunction with a detailed assessment of a company’s business, Moody’s credit ratings analysis always
relies on a comparative analysis of selected ratios and credit metrics. Comparisons are made against other
comparably rated companies within the healthcare industries, but also against companies in unrelated sec-
tors. Starting from our fundamental assessment of the underlying business — the product portfolio, the
pipeline and the competitive landscape, we forecast the revenue, earnings and cashflow stream over a 3 to
5 year period. This forecast is then related to a company’s financial structure through such ratios as
retained cash flow to total debt, EBIT to interest expense, and growth rates of revenue and/or cash flow.
Companies in the pharmaceutical industry have high levels of cash — often offset by corresponding
short term debt (usually in situations where cash is generated by overseas operations under lower tax rates
than in the US.) For these companies, we will also consider ratios on a net debt basis. However, this
adjustment is made on a case-by-case basis, and is done only after considering the expected use of cash,
and past management actions.
Most of the ratios used in our analysis are on based on forecasted results and utilize cashflow-based
metrics. However, we do consider various balance sheet ratios, such as debt to capital, especially when we
see a company management targeting specific balance-sheet-based ratios. In considering these ratios, we
assess how a particular target level relates to other cash-flow based ratios. We also consider how manage-
ment actions, such as share repurchases, relate to leverage ratios.

Generic Drug Producters Considered As A Sub-Sector

Producers of generic drugs can be considered a derivative sector to the producers of "branded" prescrip-
tion products. For growth, generic producers rely primarily on the pipeline of products that are expected
to lose patent protection. The ability to develop generic products, be "first-to-market", add value to the
products through formulations and drug delivery mechanisms, maintain low production costs, and contest
the legal challenges of the branded companies, are key factors (in addition to the financial structure) con-
sidered by Moody’s in the rating assessment of generic producers.
In the coming years, these companies have significant opportunities to grow, owing to the large num-
ber of drugs that will lose patent protection, and the desire of managed care companies and other payors
to reduce the rate of pharmaceutical expenditures. Despite these opportunities, from a ratings perspective,
this sub-sector is considered higher risk, as it lacks several key credit attributes — namely, the barrier to
entry provided by patents, high gross margins, and strong balance sheets. However, the companies that
Moody’s rates that have significant generic product portfolios balance their product portfolios with brand-
ed products. These include Watson Pharmaceuticals, Inc. and Biovail Corporation.

Moody’s Rating Methodology 7

Moody's Approach To Rating The Global Pharmaceutical Industry
Rating Methodology

To order reprints of this report (100 copies minimum), please call 1.212.553.1658.
Report Number: 69397