Description

The Company

Fagron is a Netherlands-based company (although its registered office and listing is in Belgium) focused on pharmaceutical compounding.  The company has undergone a significant restructuring over the past few years, divesting a number of medical/dental businesses (with the last one done in March), to reshape itself into a global drug compounding leader.  Drug compounding is essentially taking a drug ingredient (e.g. a painkiller) and preparing it in a form different from the usual pill form (e.g. a topical cream).  Such compounds are useful if a patient is unable to take the traditional form (e.g. a patient that is addicted to a painkiller would benefit from a topical application, or a patient that can’t open her jaw to swallow a pill would benefit from a drug in solution she could drink through a straw).

Drug Compounding

Drug compounding is a big business around the world—and in fact in Brazil where Fagron has a significant amount of sales, a large percentage of all drugs are actually compounded by a pharmacist rather than being made in pill form.  Part of the reason for that is that these are generic drugs whose ingredients are cheap and pharmacists don’t charge a lot to make the drug.  In Brazil a prescription would cost $15-20 whether it was compounded or not.  In addition a lot of the compounded drugs taken in Brazil are OTC type items like vitamins or diet supplements.

In the US however, despite many of the ingredients being very cheap, the difference in cost between a normal drug and a compounded drug can be on the order of hundreds of percent.  For example, a painkiller that might cost $10 could cost hundreds of dollars in compounded form.  Some topical pain creams have been selling for upwards of $5000 (and in some instances much higher).   There are two main reasons for this discrepancy.

First, pricing hasn’t been well policed due to the moral hazard of a reimbursed market.  Unlike Brazil, which is a cash market where the customer pays, the US is a reimbursement market.  For the most part, when one fills a prescription in the US it is one’s insurance that foots the bill (via the intermediary Pharmacy Benefits Manager (PBM)).  The value of costs incurred by the patient therefore needs to be checked by the insurer.  For regular prescriptions, the PBM sends a bill to the insurer who then assesses what the true cost is (via NDC number) and determines whether the price they’re reimbursing is the correct one.  With compounding however, the true cost is more opaque because compounds by definition are unique formulations prescribed for specific patients. But since compound drugs are a small part of PBMs/Insurers’ overall pharmacy bills, rather than spend money and effort on cost control, they tend to just reimburse as billed.  As a result the cost of compound drugs has been able to climb faster than regular drugs.

Second, prior to 2012 industry billing standards simply required claims to list the main ingredient in each compound drug.  In an effort to make things more transparent however, industry billing standards were changed in 2012 to require each ingredient to be listed along with its cost and reimbursement would be based on these costs plus a markup.  Ironically, this created perverse incentives which have led to an enormous increase in the amount spent on compound drugs.

The costs of raw materials (APIs) for compounding are not regulated and the wholesalers of the APIs have the liberty to set the average wholesale price (AWP) for pharmacies, which can be different from what the pharmacist actually pays them. One can find wildly different AWPs for the same APIs from different wholesalers.   Yet basing reimbursement on unregulated AWPs gives wholesalers an incentive to consistently increase AWPs to provide a lucrative opportunity for their customers.  According to one compound pharmacist I spoke to, API wholesalers offered to increase their stated AWPs to many multiples of what he actually pays, if he agreed to buy all his APIs from them.  Furthermore, with the 2012 standard basing reimbursement on each ingredient, pharmacists have been adding more raw materials (without additional efficacy) to each drug.  A commonly cited example is the addition of Fluticasone, the active ingredient in Flonase nasal spray for allergies, to topical pain creams since its AWP is $1000/g while its acquisition cost is just a fraction of that.

Despite all of this, this hasn’t been much of a problem for anyone.  Patients don’t care because they’re not paying, PBMs don’t care because they just get paid for paying claims, and insurers don’t care because this has been but a rounding error in their overall pharmacy cost.

. . . Well, they didn’t care until recently.

Earlier last year Express Scripts, the largest PBM in the US, decided to address the rapid increase in their compounded drug costs.  According to them, since neither doctors nor patients bear the cost of medications, and since compound pharmacies have been able to basically charge what they like, the compound pharmacies have had their salesforces reach out to doctors to push alternative, compounded versions of the drugs they prescribe.  And since there’s no cost to the doctors or to their patients, the doctors are happy to recommend these alternatives even when benefits are small (and are far outweighed by the cost). [In addition doctors sometimes have been given stakes in these pharmacies].  As a result the penetration of compounded drugs increased dramatically, and with the pharmacies also increasing their prices, Express Scripts’ spend on compound drugs rose from $28m in Q1 2012 to $171m in Q1 2014.  Similarly, in 2013, the Department of Defense’s Tricare spent $259 million on compounded prescriptions, which more than tripled in 2014 to $746 million. A rounding error no more.

The PBMs suggest that the vast majority of compound drug prescriptions are not in fact necessary and have only been driven by the compounding pharmacies’ incentives and the moral hazard of a reimbursement system.  Express Scripts suggested to the insurers that they no longer reimburse the majority of compounded drugs since they believe there are very few instances where the traditional drug is not good enough.  Other PBMs followed suit, and are either refusing to reimburse or limiting reimbursement to a certain amount. (Express Scripts notes that the average prescription price for compounded drugs has risen from $90 to $1,100 in 2 years).

This is of course very bad for the compounding industry, and some pharmacies are fighting back.  Two pharmacies filed a suit against Express Scripts in Texas.  They claim that these drugs are not only useful but essential, and that Express Scripts has no right to deny reimbursement.  Interestingly enough they note that should Express Scripts’ plan be upheld they will be out of business.

While there are some important needs for drug compounding, and while it definitely is in the interests of Express Scripts to downplay these, it is hard to believe that average prescription costs can go up tenfold, and overall compound drug costs can go from $28m to $171m without some abnormal practices going on.  Research into the efficacy of many compounded drugs confirms the claims of PBMs and suggests that the usefulness of compounded drugs is limited to niche circumstances and their explosive growth is unwarranted.

In addition, the difference in the prices of compound drugs in the US and Brazil is certainly caused by the moral hazard of a reimbursed system (as is the price difference with all our healthcare costs).  But once the ultimate payer is focused on it there is surely a high likelihood that costs will come down significantly.

To date, almost all of the major PBMs have indicated that they will cut their spending on compounded drugs.  According to a smaller PBM with whom I spoke, this all really started coming to a head over the past year and it has taken the past 6-8 months to get clients to agree.  Some of these clients have had to get the go ahead from insurers before they could include in their riders that they won’t cover/will limit/will require preauthorization for compound prescriptions and so they expect cutbacks to really start as this year progresses.  Express Scripts implemented their program in the last quarter of last year and has apparently (according to an industry contact) seen a dramatic y-o-y decline in spending for clients who have signed up for their solution.  ESI began to implement their new compounds management program for its Medicare Part D plan sponsors in February 2015.  In their March 2015 Drug Trends Report ESI stated that they expected spend for compound medications to decline sharply (-45%) in 2015.

Fagron’s Compounding Business

Through a number of divestments and acquisitions, Fagron has restructured itself into a pharmaceutical compounding pureplay with operations primarily in Europe, Latin America and the US.  Fagron, formerly the name of the compounding  segment, replaced Arseus as the name of the company in early January, reflecting the transformation of the company’s business.

Fagron has performed well over the past 8 years, growing organically and by acquisition, and improving margins along the way.

However, the table above fails to show two important elements.  First, the unusual definition of organic growth utilized by the company; Second, the large contribution from the US in the last few years.

The company’s definition of organic growth includes the revenue growth of acquired companies in the year of acquisition.  So, for example, in 2008 when the company acquired ~15% growth, if those acquisitions grew 20% in that year (including revenue synergies such as adding Fagron branded products which are an important element of M&A) that would overstate organic growth by 3%.

Since 2010, the company has spent an estimated €275m to go from zero US sales to become a leader in US compounding.   Currently US drug compounding is approximately 30% of Fagron’s business and I believe that the proportion of profits is far higher (the company doesn’t disclose regional margins but one can see this in the tax rate progression, the margin progression and speaking to industry insiders).

The company does not make it easy to determine historical segment sales and growth by geography, but one can back into it by using sales by country disclosures in the Annual Report, geographic sales breakdowns in conference presentations and press releases for acquisitions.

The United States appears to be the driver for the vast majority of the company’s organic growth in the last two years.

Fagron entered the US in June 2010 with the purchase of Gallipot, a wholesaler of APIs which had sales of approximately €9m in 2009.  This grew to €9.7m in 2011.  From 2012-14 another four acquisitions were made and organic growth picked up significantly.

This is in contrast to the European and South American businesses whose growth has been hampered by austerity and economic turbulence.

The company claims its US growth has been exclusively driven by increased volumes (for example in their 12/11/2014 market update call) and not from any dramatic price increases seen within the industry.  This is either not true, or provides little comfort.  On the wholesale side (~45% of US sales), average wholesale prices for “worst offender” APIs (now on exclusion lists of ESI and other PBMs) supplied by Fagron increased dramatically in 2012 and 2013.

(Data is from Medi-Cal’s pharmacy fee rates for APIs  with Fagron’s NDC number and unfortunately these haven’t been updated since mid-2013)

And while AWPs don’t necessarily reflect actual prices, to the extent AWP increases incentivize pharmacies to push compound drugs (along with the 2012 rules change incentivizing the inclusion of an increasing number of APIs in each drug) these volume gains are likely to be rolled back under the scrutiny of PBMs.  Volumes have also come from sales of bases, which pharmacists could get reimbursed after the 2012 rules change at AWPs more than 3 times the cost.  Eight of ESI’s 25 worst offenders are bases. Without the AWP arbitrage pharmacists will have no incentive to purchase bases.

On the retail side excessively priced compound drugs are a key element of Fagron’s sales.  Fagron entered into this segment through the 2014 acquisition of “Pharmacy Services, Inc.”   Interestingly, “Pharmacy Services, Inc.” is not the actual name of the acquired company but the actual name was not revealed for “competitive reasons” (whatever those may be) according to the company.  Nevertheless industry participants told me that it was no secret that the company acquired was Bellevue, which was then confirmed by the company when I called and asked them.

The reason for the name change is more likely because Bellevue is a leader in topical pain creams, which has been the primary offender in the ballooning cost of compound medications.  The majority of the top 25 ingredients included in the Express Scripts Compound Management exclusion list, representing almost 80% of current compound spending, are utilized for topical pain.

According to industry participants with whom I’ve spoken, Bellevue indulges in aggressive sales practices and pushes their pain creams through their highly incentivized salesforce.  They also apparently pay doctors to prescribe their creams, and while I could not find any such doctors I did find a podiatrist that is a paid sales rep for Bellevue.  While an anonymous message board doesn’t do much in terms of establishing facts, for those without access to expert networks, the posts on Cafepharma (the leading drug and medical rep forum) can give you a flavor of the types of things I’ve been told by industry experts.

http://www.cafepharma.com/boards/showthread.php?t=568328

http://www.cafepharma.com/boards/showthread.php?p=5294554

Recently, the CFO of Fagron admitted that they are seeing price and volume pressure in pain medication, although he claims that other segments like dermatology, hormone replacement, and non-reimbursed compounds are performing very well.   While those segments may cushion the fall, pharmacists with whom I’ve spoken suggest that the true underlying growth in compound drugs is mid-single digits and pain cream sales are likely to return to pre-2012 levels (50% below where they are now).  Fagron was able to produce a decent Q1 in terms of sales, however channel checks reveal that things have subsequently become more difficult for them on both the retail side (price pressure especially in pain management) and on the wholesale side (a number of their customers have been forced to shut down as reimbursement rates have declined).

Ultimately, it is clear that a large amount of this company’s growth has been the result of aggressive sales and pricing practices (both by them and their customers) and this is not only unlikely to continue but will very likely reverse.  For a company that is priced for growth, and which guides to (and has consensus estimates for) ~10% organic growth there is likely quite a way to fall.  Furthermore, with a spectacular margin trend resulting from strong sales and pricing increases, the effect on the bottom line will be far greater.

The stock trades at 29.0x trailing EPS and 14.2x EBITDA.  On my 2016e numbers multiples are 21.9x EPS and 13.7x EBITDA (including the strong EUR-USD move of ~19% v. 2014).  It is very unlikely that the company will be able to achieve 10% organic growth if the PBMs refuse to reimburse them.  Patients are unlikely to opt for a suspended solution of their acid reflux medication instead of the pill when this means they will be the ones paying many hundreds of more dollars for it.

In addition to the high valuation, the company is also very levered and is pushing their covenants.  Their Net Debt:EBITDA covenant is at 3.25x and including the EBITDA from their latest acquisition the company is at ~3.15x my 2015e EBITDA.  This limits the company’s ability to grow by acquisition and to acquire more “organic growth.”  The roll-up strategy is an important part of the story and so this will disappoint shareholders.  The company actually stated on their 4Q call that proceeds from the Corilus sale (which was done in March at a lower price than expected) as well as FCF and acquired EBITDA, gave them €100m of firepower for acquisitions.   However, their average historical multiple for acquisitions has been 7.5x and if they spend €100m acquiring €13.3m of EBITDA rather than paying down debt, the decline in their US business is likely to lead to a covenant breach.  Furthermore, when the company did acquire AnazaoHealth in May for ~€45m they raised equity for 40% of the transaction value.

Red Flags

To cap off the compelling case above—there are a number of other red flags that should be considered.

1)      The CEO flies privately when he travels— quite unusual for a $1bn market cap company.

2)      The company has done a tremendous amount of M&A to restructure, making their financials pretty intransparent (and allowing them to juice organic growth with their rather liberal definition).   I am reminded of Jim Chanos’s view that acquisition accounting is the biggest source of manipulation in the stock market today.

3)      The majority of industry experts I’ve spoken to have told me things like Fagron is “unscrupulous,” and that the head of the US business shouldn’t be trusted

4)      The company issues misleading press releases to downplay the risks of reimbursement changes

·         For example, read: https://us.fagron.com/en-us/company/news/fagron-north-america-applauds-tricare-decision-supporting-access-compounds. This certainly makes it sound like a “decision” had been made by the Department of Defense health care program to not require prior authorization for compound medicine.  Unfortunately the Uniform Beneficiary Advisory Panel (BAP) is not a decision maker but is simply the representative of their plan’s beneficiaries which gave their (unsurprising) opinion that they should continue to be able to get reimbursed for these drugs as usual.  In contrast the P&T committee, which is responsible for developing the DoD’s drug policy, unanimously recommended prior authorization criteria.  The ultimate decision will be made by the Defense Health Agency director who has stated that he supports the P&T recommendation although won’t approve it until they address the concerns of the BAP.

5)      Insider selling—one of the best short indicators.  Over the past year and a half the CEO and CFO have been big sellers including a recent €3m sale by the CFO in April (combined with the exercise of €2.5m worth of options).  The CEO and CFO did purchase 30,000 (~€1m) and 10,000 (~€370k) shares respectively in the open market last April but these were in a discounted private placement from the exiting private equity owner.  In addition, the CEO bought 50,000 shares (~€1.5m) to reassure the market after a broker downgrade.  Stock sales in the last year and a half by the CEO and CFO totaled 361,186 shares (~€14m) and 135,300 shares (~€5m) respectively.

Risks to the Short Thesis:

One risk to the short thesis is the sterile business.  The business is currently small (~€13m 2015e sales) but has been growing rapidly due to drug shortages and a decline in supply due to new FDA registration requirements (pricing is apparently up >25% this year).  The company is currently expanding their capacity considerably which will result in substantial growth.  While I have modeled some quite punchy numbers (reflecting an increase in both pricing and capacity), the CFO suggested this can become a €40m business by 2016 and as much as €200m over the next few years.  I am not too worried that that is the case for two reasons.  First, the company is investing €13m in the expansion, and the IRR would be insane if they achieved those targets (and I know at least one bulge bracket PE firm that is investing in the space and so if returns are that high they will surely be competed away).  Second, in May the company acquired a sterile pharmacy for 6x EBITDA which is probably a more realistic indication of the growth and returns of the sterile business than are the optimistic words of the CFO.

Other risks are:

1)      That the company is able to continue to do acquisitions and obfuscate any problems they have in the US.  This is mitigated by the lack of debt headroom.

2)      That the rise in compounding has in fact been the result of its efficacy and necessity and industry growth will be high going forward.  Research suggests this is certainly not the case.

3)      That PBMs are unable to convince clients to limit reimbursement for compound drugs.  However, ESI has apparently already convinced the majority of their clients to sign up.

4)      That PBMs are able to limit reimbursement but to a still quite high level.  ESI has apparently cut their reimbursement dramatically since the start of their program.

5)      That the USD-Eur continues to be a tailwind.

Financials and Valuation:

In the financials below I have conservatively estimated a 6% decline in US wholesale and retail sales in 2015 and a 5% decline in 2016, as well as a 4% decline (each year) in US EBITDA margin (which I estimate based on triangulating statements since it’s not disclosed) as prices for APIs and compounds decline, and some compounds disappear.  The 10% is conservative as my recent conversations with experts suggests that in the past few months ESI has been able to cut their compounding spend by almost 40% y-o-y (and indeed ESI expects a 45% decline in spending in 2015).   I suspect the extent of the sales decline will be very large, thinking about examples like the reform in the fee differential between physician-dispensed repackaged drugs in California which decreased volumes and amounts paid by over 90%.  And the decline in EBITDA will be more dramatic considering the operating deleverage from price decreases.  Sterile is the remaining 20% of the US business (after recent acquisition) and is by all accounts a good business with growth opportunities, and which the company is focused on building out. My estimates for this are on the high end of expectations set from conversations with pharmacies and PE players in this space.   I have estimated growth in Europe and Brazil at 5% and 8% respectively which is the high end of industry research report estimates (while Brazil is going through a recession two competitors recently went out of business allowing Fagron to take share).  Nevertheless there have been rumors of increased scrutiny on compounding reimbursement in some markets, most notably in the Netherlands, which accounts for >20% of Fagron’s total sales. This could provide further downside to the above figures, as would an extended recession in Brazil (which is a cash market).

The result is 2015 and 2016 P/E ratios of 21.6x and 21.8x, and EV/EBITDA ratios of 15.9x and 16.1x.  In addition this leaves me with a Net Debt:EBITDA above the current covenant in 2016.  There are no real comps for the company, but for a company growing MSD, without strong barriers to entry, regulatory pressure, and three turns of leverage, a mid-teens P/E is appropriate if not generous.  In addition, when the market’s expectations of growth don’t materialize disappointed shareholders will penalize the stock heavily.  (And if the covenant comes into play the results will be dramatic).  Thus I have a price target of €30.51 reflecting a 15x P/E multiple on my 2015e EPS, and a downside of 31%.

Catalyst

Catalysts:

1)      Negative newsflow around compounding reimbursement

2)      Earnings misses as a result of lower reimbursement for compounding

3)      Potential covenant breach