Fitch Ratings says that, whilst underlying credit fundamentals remain strong, the outlook for the European pharmaceutical industry is negative due to a number of key industry challenges facing the sector.

These include the upcoming patent expiry cliff during 2010-2013, where the agency notes that, in particular, GlaxoSmithKline and Sanofi-Aventis are proportionally over exposed with their product lines compared to their European rated peers; government cost containment measures on healthcare spending that are likely to be increased due to the current economic crisis; the continued longer approval times for new drugs due to greater scepticism on drug safety standards; and finally continued competitive pressures from generic drug makers.

To counter these challenges, Fitch believes that European pharmaceutical companies might be tempted to respond with debt financed acquisitions during 2009, which would create downward pressure on ratings.

"In the short-term, European pharmaceutical companies' cost cutting measures should compensate for the margin pressure resulting from these industry challenges whilst, in the medium-to long-term, Fitch notes that lower operating profitability and cash flow generation is likely to be seen for all market players," says Britta Holt, Director in Fitch Ratings.

European pharmaceutical players are likely to continue with cost cutting measures, while governmental cost containment policies are expected to lead to more risk-sharing deals for European pharmaceutical companies in order to insure reimbursement of their products. Additionally, tough generic competition is expected to lead to a continued high number of authorised generic drugs coming on to the market.

Fitch believes that acquisitions are likely to be pursued in order to prepare for the upcoming patent cliff (by acquiring pipeline) or in order to increase diversification into other, less high risk but less profitable, healthcare areas, as seen by Novartis (Alcon). In order to ensure solid sales growth, European pharmaceutical companies are also likely to increase their presence in the higher growth, but lower profitability developing markets.

Overall, the rated European pharmaceutical companies are expected to continue to benefit from their well diversified product portfolios, good geographical diversification with a relatively low percentage of US sales at risk through patent expiries by 2013, relatively full product pipelines and high profitability. Although tough industry challenges will have to be faced over the next years, the European pharmaceutical industry is expected to continue to remain one of Fitch's highest rated industries in Europe, due to superior cash flow generation, high cash balances, strong liquidity and solid growth prospects, driven by high unmet medical needs, favourable demographics, technology advances and the existence of chronic diseases.

Among European drug makers rated publicly by Fitch, only GlaxoSmithKline PLC (AA- (AA minus) /F1) has a Negative Outlook, reflecting the group's large share buyback programme, and ongoing acquisition appetite. Roche's Holding Ltd's ('AA' /F1+) ratings were placed on Rating Watch Negative in July, following the group's announcement of its USD44bn bid for US pharmaceutical company Genentech. AstraZeneca Plc's, Sanofi-Aventis SA's (AA- (AA minus)/F1+) and Bayer's ('A-' (A minus)/F2) Stable Outlooks reflect the relative headroom in their current ratings. With the exception for a potential acquisition of a non-Nestle minority stake in Alcon, Novartis's (AA/F1+) ratings fully reflect the Alcon acquisition, although Fitch notes the company now does not have headroom for any further material acquisitions.