Fresenius: The Wrong Way To Seek Capital Market Attention

Summary

• Fresenius management is reviewing its group structure to make sure capital markets give it more appreciation. We remain skeptical given its opaque disclosure.
• The outlook for FY12/2021 is less than robust, as we estimate flat net income and falling free cash flow generation YoY. Accounting government subsidies as revenues in FY12/2020 look odd.
• With adjusted free cash flow yield dropping to 6% from 10% YoY, we remain sellers of the shares.

Investment thesis

Fresenius (OTCPK:FSNUF) provides opaque free cash flow disclosure and management comments that a review of the company structure is underway to get a deserving valuation. The outlook for FY12/2021 is similarly vague at net income level. With our estimated free cash flow to drop YoY we remain sellers of the shares.

Our objectives

We aim to investigate the following:

• To assess CEO comment about the company structure being under review, and implying that the capital markets are not giving a level of appreciation the company deserves.
• The outlook for FY12/2021.

We will take each in turn.

Company structure

Previously we wrote about our concerns about company disclosure, namely a misleading cash flow statement with no distinction made between parent and large non-controlling interests. We did not think the company made enough effort to determine free cash flow that was attributable to Fresenius shareholders.

For FY12/2020 results, the pro forma versus our adjusted free cash flow figure looks as follows (taking net income attributable, and the pro rata amount based on shareholdings for operating cash flow and capex from group companies). The difference is palatable:

	Pro forma disclosure	Our attributable estimates
Net income (€m)	2,823	1,796
FCF (€m)	4,183	1,991
Current FCF yield (%)	21.0	10.0

Click to enlarge

Source: Company, created by author

It therefore came as a bit of a surprise when management reported FY12/2020 results with a comment by CEO Stephan Sturm about the company structure being under review. Sturm felt the need to ask whether the capital market is giving them the value that they deserve. Clearly he feels something is amiss.

If management were to believe that the shares are undervalued based on current pro forma disclosure which potentially overstates group free cash flow, we would respond that this measure was incorrect to begin with.

Whilst some analysts assess the complex group structure as being a discouragement for investors, we have no problems here as long as disclosure is fully transparent.

The company has said there are no plans for immediate changes, but we imagine all sorts of proposals are landing on management's desks from bankers to 'unlock' value.

Management has left the medium-term guidance of 5%-9% net income growth unchanged. This left us slightly confused as a cost-savings program worth €100 million per year by FY12/2023 should result in higher growth. However, any changes to the group structure may be instigated if it comes clear that medium term growth forecasts are unrealistic. We may get to hear about such proposals if operations in FY12/2021 are off to a poor start.

Outlook

Management gave an opaque guidance for FY12/2021 with sales to grow low-to-mid single digits YoY under constant currency, and net income said to be 'broadly stable'. A relative lack of conviction appears to come from a general understanding that the impact of the pandemic will still be felt in all business lines during H1 FY12/2021, wearing off into H2 FY12/2021.

There also appears to be the following issues to tackle in the shorter term. New production plans are on hold at Melrose Park following a Form 483. And into FY12/2021 the company stressed that it will see meaningfully less German government support in its hospital operation side - the majority of subsidies received in FY12/2020 have been booked as revenue. The accounting here sounds a little strange. For example under Dutch GAAP COVID-19 wage cost subsidies are under other operating income or deducting actual labor costs. This follows the principal of IAS20.

The longer term concern we have is for the biosimilar business where management still have projections of high triple digit sales by FY12/2024. Whilst we would not discount this possibility in its entirety, there needs be a fairly massive ramp-up in activity quickly if this was to be executed.

Valuation

On flat net income YoY for FY12/2021, the shares are trading on PER 10.9x. With capex we estimate it will remain at similar levels YoY, but working capital may become weaker YoY as the business aims to recover activity into H2 FY12/2021. With cash flow from operations set to fall YoY, free cash flow should follow a similar route - we concur with consensus free cash flow of €2,552 million pro forma (a decline of 39% YoY) - and on an adjusted basis €1,200 million (a decline of 40% YoY). The resultant adjusted cash flow yield is 6.0%.

Risks

A potential positive is a change to the group structure that would make Fresenius Medical Care (FMS) a 100% consolidated subsidiary. This would be a costly affair but would address the issue of having large non-controllable interests.

Conclusion

We believe the outlook for Fresenius should improve into H2 FY12/2021, but issues remain over disclosure and what we view as limited potential earnings from the sub-scale group companies Kabi, Helios and Vamed. Management commenting on deserved valuations for its business is not a positive indicator. With free cash flows set to fall YoY, we remain sellers of the shares.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Comments

[sly_badger]

What happens when spin off occurs? You receive the shares of other company etc? But I guess it affects overall picture, cash flow, you need to re-analyze each business then separately?

[maininvestor1010]

@Karreta Advisors Would it make sense to spin off Fresenius Kabi and/or North America Segment into their own stock offering so more US investors are not tied to Europe's political climate and other segments of FSE internationally? From FSE financial records, Fresenius Kabi (other than FMC) is the main producer for their revenue.

[heckinvest]

@Karreta Advisors Interesting points. Increasing the FMC stake might trigger a tender offer. Fresenius has already high debt and would have to issue part equity to buy out FMC shareholders. Merging should be comparatively simpler but its doubtful US investors want to be exposed to German and Spanish hospitals each of them with different politics involved. Overall I agree the stock has more downside than upside potential.

[Karreta Advisors]

@heckinvest Thank you for your thoughts. Very valid point over a tender offer. The healthcare industry is highly regulated but perhaps the US is the most difficult of all to operate in? Still, it may be a fairly big ask to become equity holders in European hospital assets.

[heckinvest]

@Karreta Advisors thanks for the update which reinforced your concerns in your prior article. Two questions; i) based on your own FCF calcs what are your fair value estimates? ii) if Sturm is hinting at a strategic review what are the most likely options? Spinning off Kabi or even FMC? Or separating hospital / dialysis center management from the infusion and biosimilar business?

[Karreta Advisors]

@heckinvest Thank you for your questions - i) fair value PBR 1.0x, so 16% downside which is not terrible but there we go ii) this is the big question - FMC has its own pressures with activists (Harris and Artisan) - the simplest solution is to for Fresenius SE to increase its stake in FMC. Making the stake in FMC from 32% to 50% is relatively easy, via debt they should be able to raise that amount (€4bn or so with a premium). But this might not solve the problem - a merger between the two sounds like a long term solution. Depending on the share swap ratio it might be better off to be long FMC, as that would be the target.

[marreukske]

Who are the main competitors of Fresenius that are better alternatives if i may ask ? Thx

[Dagoru]

@marreukske in Europe they have no competition, you would need to look in America.

Disclosure: I'm from Spain and long-term investor in Fresenius

[Karreta Advisors]

@marreukske Thank you for your question - the key peer is DaVita (DVA) in the US. There's a few issues with this one as well, but it's a well-known holding of Berkshire Hathaway.