July 2001

Rating Methodology

Phone

New York

David Neuhaus Michael Levesque Diane Vargas Richard Stephan

1.212.553.1653

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.

Moody's Approach To Rating The Global Pharmaceutical Industry

Contact

• 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.

• 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

Rating Methodology

• In the last year the sector has rapidly increased its use of debt markets, raising money for 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.

List Of Global Pharmaceutical Ratings Pharmaceutical Companies

Sr. Unsec/Sr Implied Long-term Rating Short-Term Debt

Outlook

Investment Grade: Bristol-Myers Squibb Co. Johnson & Johnson Merck & Co. Novartis Pfizer Inc. Abbott Laboratories AstraZeneca PLC GlaxoSmithKline plc Schering-Plough Corp. Lilly (Eli) & Co. Yamanouchi Pharmaceutical Daiichi Pharmaceutical Co., Ltd. [2] Eisai Co., Ltd. Pharmacia Corp. Sankyo Co., Ltd. Amgen Inc. Fujisawa Pharmaceutical Co. Ltd. Aventis S.A. Allergan, Inc. American Home Products Chugai Pharmaceutical Co., Ltd. Genentech, Inc. [1] Shionogi & Co., Ltd. Tanabe Seiyaku Co., Ltd. Chiron Corporation Elan Corporation, plc [1] Kyowa Hakko Kogyo Co., Ltd Takeda Chemical Industries

Aaa Aaa Aaa Aaa Aaa Aa1 Aa2 Aa2 (P)Aa2 Aa3 Aa3 A1 A1 A1 A1 A2 A2 A3 A3 A3 A3 A3 A3 A3 Baa1 Baa2 Baa2 N/A

P-1 P-1 P-1 P-1 P-1 P-1 P-1 P-1 P-1 P-1 — — — P-1 — P-1 — P-1 P-2 P-2 — — — — — — — P-1

Under Review: Possible Downgrade Stable Stable Stable Stable Stable Stable Stable Stable Stable Stable Stable Stable Positive Stable Stable Stable Stable Stable Stable Stable Stable Negative Stable Stable Positive Negative —

Ba1 Ba2 Ba3 Ba3

— — — —

Positive Stable Stable Stable

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

Authors

Senior Associate

Senior Production Associate

David Neuhaus Michael Levesque

William Lebron

John Tzanos

© 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 established participants. • Many companies in the industry posses strong balance sheets, bolstered by relatively large cash positions, 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 industry 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 governmental 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, balance 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 company 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 different 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 litigation, 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 (orthopedic 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 consider, 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 estrogen 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-clinical 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 qualitative 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 strategies 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 individual 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 ratings 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 companies 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 authorities 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 company, 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 pharmaceuticals 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-ofinterests", 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 arrangements 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. 2000 Sales US$Bn

Percentage Global Sales %

Percentage Growth year-over-year constant dollar

North America Europe Japan Latin America Asia (ex Japan), Africa & Australia

$ 152.8 75.3 51.5 18.9 18.7

48.2% 23.7% 16.2% 6.0% 5.9%

14% 8% 3% 9% 10%

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 companies 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 demographics, 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 pharmaceutical companies are also increasing their participation in the Japanese market through both acquisitions 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 conservatively 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 implementation 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 borrowed 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 securities, 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 commercial 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 sectors. 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 management 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" prescription 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) considered 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 number 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 branded 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