Description

Investment Thesis

CareRx is Canada’s largest provider of pharmacy services to long-term care and retirement homes. The company rolled up the industry through five acquisitions from 2020-2022, growing from 30,000 beds serviced to 94,000. Revenue rose from $125 million to $370 million while the share count quintupled. CareRx now has 19% market share compared with the #2 player Medisystem at 10% owned by Shoppers Drug Mart/Loblaw. CareRx delivered disappointing financial results over the past 12-18 months driven by the loss of a large contract (Extendicare) to Medisystem and labour issues. As recently as mid-2021, analysts had been expecting adj. EBITDA in the mid-$40 million range for 2022. Actual results came in at $32.2 million in 2022 and are tracking to $27-$28 million for 2023.

CareRx should see an inflection in its financial results over the next 1-2 years while its valuation multiple is at multi-year lows. Specifically: (1) CareRx appointed industry veteran Puneet Khanna as CEO in April and he has brought a focus on better integrating the acquired operations, including the introduction of lean initiatives to reduce labour costs, (2) the company will renegotiate its formulary agreement in H2 2024, boosting EBITDA by $3-$4 million, and (3) according to management, the company has locked up its 15 largest customers through at least 2026 while the Extendicare contract becomes available in H1 2025. Management is targeting double-digit EBITDA margins exiting 2024, implying high-$30 million vs. a $150 million enterprise value (lease expenses are $5 million annually, so after lease, adj. EBITDA would be in the mid-to-low 30s). On a FCF basis (discussed below), I would expect the company to generate about $15 million of pre-tax FCF in 2025 and the company has tax losses of $70 million, leaving them with minimal net debt exiting 2026 (vs. ~2x today). Upside on the stock could be 100% over 2-3 years on EBITDA growth, FCF generation, and a valuation re-rate while downside is protected at least over the next couple years by customer lock-ups through 2026 and the non-cyclical nature of the business. The major risk is a government fee cut, but even if Ontario moves ahead with the announced reduction in capitation fees, the hit to revenue is a manageable $3 million.

CareRx is seen by many investors as a low-quality business because governments have repeatedly cut compensation to the industry. For example, in 2018, CareRx saw a 42% reduction in its EBITDA from a combination of lower reimbursement rates in Alberta (where the company was concentrated at the time) and nationwide changes to generic drug pricing. I see some cause for optimism that government attitudes may be shifting. Specifically, management told me there wasn’t previously much of an industry group because there was no clear number one player. CareRx is now of a size where they can afford to invest more in government relations and they are optimistic about seeing a return on these efforts. In particular, they expect the planned reduction in Ontario capitation fees for 2024, which has already been postponed twice, will again be pushed out or cancelled entirely (Ontario is two-thirds of revenue). Further, BC’s reimbursement rates got so low that Rexall exited the business without a buyer leaving customers scrambling to find another service provider. Some homes accepted a lower service level while others in rural parts of the province could not find a willing replacement. In response, management says that the BC government increased reimbursement rates over 50% with additional increases to come.

CareRx should also enjoy the benefits of its greater scale moving forward, whether through initiatives like the formulary renegotiation or increased automation. From a topline perspective, CareRx is well positioned to benefit from the expected doubling of beds in long-term care facilities over the next 15 years.

Business Overview and Valuation

CareRx services 94,000 beds in long-term care facilities across Canada from 26 fulfillment centres. Because patients in long-term care facilities have complex medication needs (the average patient is on 10 medications), prescriptions must be filled regularly (so that they can be adjusted) and delivered in a format that is easy to administer. CareRx employs high volume filling machines in some of its centers, recently purchasing two BD Rowa machines for its Oakville dispensary at a cost of $1.4 million each. CareRx also provides support within the homes in the form of clinical pharmacists, medication cabinets and technology.

CareRx receives a single digit percentage mark-up on the drugs it dispenses as well as a service fee. The vast majority of revenue comes from the government through public drug plans. Though drug prices and service fees are fixed by government, CareRx does rebate some of the economics back to home operators while also receiving rebates on some generic pharmaceuticals. Customer rebates can take multiple forms including a per bed fee, a profit share arrangement for larger customers, or an up-front contract execution fee. On the generic side, roughly 40% of CareRx drugs by revenue are generic. In cases where there are competing manufacturers of the same generic, CareRx can receive a rebate for listing one of the generics on its formulary. Management suggested to me that one of the main reasons Shoppers remains in the space is so that they can leverage the significant volumes from its institutional business across its retail pharmacy footprint for larger rebates.

Management has guided to EBITDA margins reaching double-digits exiting 2024. Assuming there will be some revenue growth in-line with the overall industry, adj. EBITDA should be in the high-$30 million range in 2025. The company spends about $8 million per year on maintenance capex, $5 million on leases and I estimate will pay about $6 million on its debt following a refinancing concluding imminently. Amortization of upfront customer rebates averages $5 million per year. The company has tax shields of about $70 million and the CFO guided that he expects these to shield income for about three years (implying in excess of $20 million of pre-tax cash flow annually). For 2025, I estimate the company will generate a pre-tax FCF yield of 15% (or 11% tax-effected). If pre-tax income hits $20 million (in-line with guidance provided by the CFO on tax shield usage) and the company wins back the Extendicare contract, EBITDA could push closer to $50 million and CareRx could generate a 20%+ tax-effected FCF yield on 2026.

I expect CareRx will use its cash flow to de-lever and complete smaller tuck-in deals. Management says there are some opportunities to purchase pharmacies serving 5-10k beds in Ontario which I estimate would cost $10-$15 million to acquire. With the roll-up effectively complete, there is little logic to maintaining the public listing.

Catalyst

Improved EBITDA through lean initiatives and new formulary agreement.

Potential win-back of Extendicare in H1 2025.

Return of positive bed growth in H1 '24, in-line with industry growth.