For Concordia Healthcare (NASDAQ:CXRX) investors, it has been an eventful, although somewhat painful ride since it announced the AMCo acquisition in September 2015. Share price has since been on a downward spiral trend, hovering over the C$25-$30 range over the last few weeks.
I believe there are risk and general investor sentiment factors that make any imminent rebound in share price unlikely. Upon detailed modeling of various growth scenarios, I have come to the conclusion that CXR has limited downside risk from here. The company operates like an LBO, with high leverage and strong deleveraging profile. Patient investors will be rewarded as debt is paid off. Similar to an LBO investor, you don't expect to exit in 1/2 years. There is no quick money here, and deleveraging will take time.
On a high level, much of the weakness in share price could be attributed to: 1) Broader industry challenges, with Valeant going down and comparison of Concordia to Valeant. 2) Investor sentiment towards roll-up strategy firms has deteriorated due to concerns around growth and ability to obtain favorable financing terms going forward (i.e. Mattress Firm another example.) 3) Debt concerns looming over CXR due to its 6.0x leverage and its ability to delever quickly. 4) AMCo performance (recent complications from Brexit). Over 60% of CXR's revenue will come from its International division. 5) Take-out rumors with several buyers walking away.
The article below aims to answer the above concerns to support my view that CXR has limited downside and it's a matter of time for the company to pay down debt.
CXR's business model is relatively straightforward to model. Management has provided guidance:
- Revenue: US$1020 - US$1060 million
- Adjusted EBITDA: US$610 - US$640 million (~60% margin)
- Adjusted EPS: US$6.29 - US$6.77
- Target debt: 5.5x EBITDA or below
- Constant currency assumption
- From Q1 transcript: "Low single-digit growth from our North America segment based on approximately equal parts pricing and volume growth; we expect our International segment will deliver over 60% of our total revenues with mid-teen growth coming from new product launches and pricing opportunities"
There should be little debate that CXR is undervalued at current share price, if these guidance were met in full and the company continue to perform going forward.
In order to assess the downside, I will use the following assumptions to stress test how the business will perform should things do not turn out as nicely:
- 0% revenue growth and 91%, same as Q1, from North America
- 5% revenue growth and 65% margin from AMCo, lower than 70% margin in Q1
- flat revenue and margin at Orphan Drugs
- 2016 GBP/USD at current strip at 1.3384
- 2017 GBP/USD at a very conservative est of 1.2000
- Do not take into account the natural hedges CXR has in place due to GBP debt
The table above shows the deleveraging profile of CXR over the next 5 years, under the extremely conservative assumptions above. 2016 debt paydown is delayed due to earn-out payments. However, the company is able to pay down debt consistently over the next 5 years and reach ~4.0x leverage within 5 years. There is no bankruptcy risk here, but deleveraging ability is severely delayed due to the pound depreciation and limited growth.
Some news mentioned bankruptcy risk, some even used imminent to describe. I do not see any bankruptcy risk, even under such conservative assumptions. Bridges will be paid off quickly, TL is due in 2021, 9.5% notes due in 2022, 7.0% notes due in 2023.
CXR could support 6.0x leverage because 1) ~60% EBITDA margin; 2) 10% cash taxes; 3) minimum NWC and cash on hand requirements.
In my opinion, 6.0x debt is not ideal, which suppresses the equity value in this company. However, there is no bankruptcy risk that I see at this point.
Based on my DCF, CXR is worth ~C$52. Based on 11% WACC, 0.5% terminal growth rate, 10% cash tax. All conservative assumptions.
Below are sensitivities to the DCF. Key takeaway is that DCF is yielding a much higher valuation than current share price.
Below is current trading of CXR. The company is trading at <5.0x forward P/E and 8.0x 2016 EV/EBITDA. Key takeaway is that as the company pays down debt, equity value will increase substantially in the 5-year time frame. Again, this shows that CXR has limited near-term catalyst, but as debt gets paid down equity value will rise significantly.
5. Take-Out Possibility
In my view, on a first look, CXR appears to be an LBO in the works by itself. Highly levered balance sheet, termed-out debt, extremely strong cash generation, stable cash flows that result in rapid deleveraging.
So why is there no deal? One reason is that there isn't as much juice from levering up the B/S anymore. 6.0x is high but manageable, assuming company guidance CXR 2016 interest coverage ratio stands at 1.6x, which might already be below the comfort level for many investors, even PE firms. Second reason is that Brexit is having significant headwinds for the company. Investors are taking on geopolitical risks that are not necessarily justified by the purchase price, due to disconnect between buyer/seller.
Since we are putting on the Private Equity hat, let's look at the IRR for CXR and sensitivities around growth rate.
IRR ranges from 20.1% under our downside case, to 34% under management case, assuming 1.200 USD/GBP. Below shows the sensitivity around FX with AMCo growth rate. Again, we are seeing ~30% under management case and pound at pre-Brexit level.
A PE investor could potentially refinance CXR's debt at more favorable terms, and interest savings will be used to fund growth pipelines and debt repayments.
How big is the impact of Brexit? Bottom line is: people still need drugs and Concordia products won't be affected in the next two years. Other concerns around trading pacts and access to other EU markets are hard to justify at this stage, given so much uncertainty around the eventual outcome and repercussions of UK leaving the EU. The outcome will be bore by not just Concordia, but every single company in the EU.
CXR's exposure to pound, however, could have immediate and profound effect on the company. Let's take a deeper dive.
CXR has over 60% of its revenue from AMCo. Company guided at 70% margin, I have assumed 65% in our downside case here. When management provided the guidance, GBP/USD was around ~1.5. Pro forma full-year GBP revenue for CXR is ~£420 million and EBITDA of £273 million.
Company gave some guidance on its 2016 pound liability exposure: "In 2016, these payment obligations include £5 million of principal and £30 million of interest payments in respect of the £500 million term loan, an earn-out of £144 million payable to the former owners of AMCo, and approximately £38 million related to purchase consideration liabilities associated with AMCo's prior acquisitions, subject to certain product performance metrics being achieved."
If you add up the above liabilities, 2016 net pound liability is about £217 million. CXR appears to be naturally hedged, to the large extent, in 2016. The problems is after 2016, what are the impact on cash flow and debt repayment? The £500 million term loan will continue to provide natural hedges of ~£30 million each year, earn-outs in pound will be mostly paid off in 2016, so the net exposure of ~£250 will be left open to swings in the FX market.
CXR could hedge, as it said in the press release, but hedging is not magic. You hedge at current forward rates, which already reflects the risk of further weakening in pound. You can only hedge away the additional shock that market has not perceived and priced into the hedging market. Also, if you hedge now, you are limiting yourself to any potential rebound in pound. Let's say if UK parliament decided to veto the vote, although unlikely, it would have harmed CXR instead.
7. Management Case
Below is the deleveraging profile under management case, assuming:
1) 5% revenue growth for North American division
2) 10% revenue growth
3) pound forecast of 1.30 USD/GBP after 2016.
In the upside case, CXR paid down debt much more quickly and estimated share price are pointing to much higher levels.
Think of CXR as an LBO that is publicly traded. P/E firms might not want to invest because their normal maneuvers are already deployed in this case. There is no bankruptcy risk here, and deleveraging is still optimistic even under extremely conservative assumptions. IRR is satisfactory at ~20% even under conservative assumptions, with potential upside from pound strengthening and revenue growth. My analysis above assumes 65% margin at AMCo, even though management guided at 70%, which provides another important potential lever.
Risk factors for CXR includes any unpredictable changes to its market and product, including competitive landscape, that could severely harm the cash flows. It's premature to price in Brexit impact given it's early stage and underlying healthcare market is relatively sheltered from market swings. Pound movements are significant, but limited in its impact shown above in various sensitivities.
The missing piece in this analysis is that I am not an expert in the off-patent drug business and have limited visibility into CXR's product portfolios. This articles assess CXR purely from a financial perspective using simplified growth assumptions.
Bottom line is that if CXR maintains its normal course of business with moderate to none growth rate among its portfolio of drugs and pound sink further to 1.2 territory, time will reward those that establish a position early and hold 2-3 years, much like investing from a private equity perspective.
Disclosure: I am/we are long CXRX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.