A fair business at a great price can deliver returns just as attractive as a great business at a fair price. This is our current view of pharmaceutical giant Aspen Pharmacare. Having avoided it on valuation grounds for many years, the share price decline over the past two years and the expected risk/reward balance going forward have increased Aspen’s investment appeal. We therefore recently included the share in our portfolios.
Aspen Pharmacare is Africa’s largest manufacturer and distributor of pharmaceutical products. The group has a long history of acquisitive growth, which has transformed it from a South African-centric, generic and over-the-counter drug company into a specialised global pharmaceutical player. Aspen’s business can be divided into two roughly equal parts:
Sterile products, which are the more recent part of the business. Here Aspen has niche positions in anaesthetic and thrombosis drugs. These niche products require complex manufacturing capabilities which provide a greater ‘moat’ against competition than Aspen’s traditional business. Customers are typically hospitals.
Other commercial pharmaceuticals, consisting of the group’s regional brands. These include a wide range of both prescription and over-the-counter drugs in the branded generic space. This part of the portfolio is more tilted towards South Africa and other emerging markets.
SHIFT TOWARDS NICHE PRODUCTS
Aspen’s share-price difficulties over the past two years were driven by the group’s substantial investment in shifting its model away from low-moat generics distribution towards more specialised niche products, which should give it a more sustainable competitive advantage. To achieve this, Aspen invested heavily and took on substantial debt, to a point where the market was concerned about the sustainability of the balance sheet. As is often the case with acquisitive companies, Aspen eventually bit off more than it could chew.
This meant the historic business model of using debt to fund acquisitions, improving acquired brands and generating cash became less repeatable. With no material acquisitions likely over the medium term, the group’s growth expectations were adjusted down substantially, and with this, the price investors were willing to pay.
SHORING UP THE BALANCE SHEET
The R13 billion sale of the Asia-Pacific infant milk business has helped to shore up the balance sheet. Although debt remains high at R85 per share or 3.6 times earnings before interest, tax, depreciation and amortisation (EBITDA), it is now eminently manageable. We expect Aspen to reduce its debt to two times EBITDA within three years, at which point it could resume its acquisitive growth path or choose to grow organically through internal investment.
Most importantly, our analysis suggests Aspen’s underlying business remains both sustainable and highly cash generative. We expect Aspen to generate around R46 per share of free cash flow before paying off interest and debt over the next three years.
Aspen’s share price has dropped to R100 per share from its price of R150 per share a year ago, when we argued that it wasn’t cheap enough. It has now reached a level that we believe is sufficiently low to offer an asymmetric risk profile. In our view, all of the market’s negative concerns are reflected in the share price, while the market is ignoring the potential. The group now trades at a forward price-earnings (P/E) multiple of only seven times, compared to its peak in early 2015 of nearly 30 times.
This combination of lower price, increased comfort with the group’s ability to generate sustainable cash flows and more manageable debt means we’re now finding Aspen shares attractive.
The group’s naturally high levels of working capital mean the business doesn’t currently generate high returns on capital, so we don’t expect a return to the lofty earnings multiples of 2015. There is, however, ample room for the P/E multiple to rise to a more appropriate level of around 10 times in the short term and 12 to 14 times in the long term once the debt is lower and the earnings from the group’s investment in world-scale manufacturing facilities ramp up fully.
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