Aspen share view

Aspen Pharmacare Holdings Limited is a South Africa-based pharmaceutical company. The company, through its subsidiaries, manufactures branded and generic pharmaceutical products as well as infant milk nutritionals and consumer healthcare products in selected territories, operating primarily in the healthcare industry. The company supplies branded and generic pharmaceuticals to approximately 150 countries worldwide. It operates in South Africa, Asia Pacific, Europe CIS, Latin America, Sub-Saharan Africa, and the rest of the world. Its generic products include anti-depressants, analgesics, anti-hypertensives, bronchodilators, anti-bacterials, anti-gout agents, anti-inflammatory agents, anti-fungal agents, anti-histamines decongestants, gastro-intestinal agents, dermatologicals and anti-retrovirals.

Cons

1)    Substantial increase in financial risk: Aspen has a negative tangible value and a high net debt-to-equity ratio. Aspen sold the Infant Milk Formula (IMF) business for R11.2 billion versus market expectations of R28 billion. This highlighted Aspen’s acute requirements for cash to plug the debt repayment schedule. The free cash profile suggests that Aspen will experience substantial annual free cash flow deficits. The sale of IMF reduces the deficit, but it is still very high. As a result, a rights issue is possible and even probable.

2)    Slowdown in growth: Aspen has grown through acquisition to deliver 26% p.a. growth in Normalised Headline Earnings per share between 1999 and 2018. The market was spooked when management guided for 1-4% revenue growth in the financial year of 2019, which, when coupled with vulnerable margins from lost manufacturing contracts, burgeoning working capital and pricing pressure in developed markets, makes a strong earnings growth recovery doubtful.

3)    Conflated strategy: Aspen styled itself as a high growth emerging markets (EM) generic pharmaceutical business. In the last three years to 2018, Aspen concluded several deals that have reduced EM exposure to about 56%, which diluted the growth outlook. These acquisitions were driven by Aspen’s strategic decision to diversify away from its core branded generic business due to intense pricing competition from Indian and Chinese generic players. As a result, it made six acquisitions in off-patent therapeutic areas, resulting in extremely high gearing levels. The increase in ethical/branded drugs exposes the business to regulatory surveillance with downward pressure on pricing as a result. Competition is also stiff in the developed markets. In EMs, they have to spend a lot to build distribution.

4)    Not meeting the cost of capital: The market has been expecting growth to bail Aspen out of returns that do not meet the cost of capital. With growth uncertain, the focus is back on the poor returns. Despite a low blended cost of capital, Aspen is not meeting the cost of capital, or barely doing so.

Pros

1)    Operational efficiency: Aspen operates 26 integrated manufacturing facilities at 18 sites across six continents. This allows it to leverage its scale to reduce production costs, thereby protecting gross margins. (This is key as it operates in a regulated industry where price increases are often gazetted by government.)

2)    Competitive moat: Aspen focuses primarily on niche products such as anti-coagulants, anaesthetics, high potency drugs and cytotoxics. These specialised products are difficult to manufacture, which protects Aspen from the threat of Asian competitors that tend to focus on simple, long production run products like antibiotics. Its products are highly cash-generative and are usually post-patent, which reduces the risk of a revenue fall-off from generic competition. All product portfolios are supported by a globally integrated, end-to-end value chain, which spans product development, manufacturing, distribution and regulatory compliance.

3)    Strength of management: The business has a strong long-term track record of earnings delivery, returns and cash flow. It is managed by entrepreneurial managers Stephen Saad (CEO)  and Gus Attridge (deputy CEO). Together they own 16% of the company, which aligns their interests  with that of shareholders. Stephen Saad has not sold a single share since the business first listed in 1997.

4)    Reduced financial risk: The sale of assets has reduced gearing substantially with the gearing ratio expected to fall to 3.7×. Furthermore, APN has a stated focus to reduce leverage even further, targeting a gearing ratio of below 3x in the medium term. This will be achieved by, inter alia, improving cash flow generation. The business will be over its capex hump soon and will also unlock working capital, and make selected disposals where it believes a JV partner is better able to realise value (similar to what they’ve done with IMF).

5)    Growth prospects: While it operates in a highly regulated industry, this risk is mitigated to some extent by its extensive geographic footprints with key markets Latin America, Europe (East and West), South Africa, the rest of Africa and Australasia. It is possible for Aspen to unlock value by bedding down the recent anti-coagulant and anaesthetic acquisitions and simplifying (and thereby reducing the costs of) the current complex manufacturing process. As both products are primarily dispensed within hospitals, it bolsters the product basket that sales representatives can use to call on specialists.

Questions and Conclusions

Aspen seems to have reached an inflection point.

In a bear case scenario, it will not be able to generate sufficient free cash flow to pay down excess debt and its disposals of assets will weaken growth prospects. Aspen will not be able to significantly grow the portfolio of products it has acquired. It will struggle to effectively manage the complex manufacturing processes it has taken on with the new therapeutic areas. As a result, a dilutive rights issue may occur. In any event, there will not be upward earnings revisions and Aspen does not deserve a high rating anymore given its poor returns, high leverage and low expected growth. A performance turnaround is possible but not likely, requiring meticulous execution by a very impatient management team that has stumbled in the recent past.

In a bull case scenario, the high level of indebtedness has peaked during this period, and Aspen will reduce its gearing. As a result, a rights issue will not be required. Aspen’s earnings performance has been broadly in line with market expectations and its operational performance has been as guided. Aspen will be able to maintain its margins and grow its earnings as it beds down its acquisitions, reduces costs and leverages its operational capability. In addition, much of the execution risk has been priced into the stock. There is a significant margin of safety given the low price to earnings (Aspen trades on a 1-year forward PE multiple of about 6×) and therefore offers significant optionality and upside potential.

Conclusions: The upside risk and downside risk are now finely balanced. A lot of uncertainty remains. While upside potential is certainly possible, it comes with a great deal of execution, operational and financial risk, and so it is equally possible that the market has priced Aspen appropriately at its current low valuation.