Mark Ingham’s high conviction buy call: Ever expensive Aspen suddenly cheap

After peaking at almost R450 early last year, the share price of Aspen Pharmacare has since been in steady retreat and is currently trading below R300. But while traders have been seeking shelter, independent investment analyst Mark Ingham is attracted by Mr Market’s depression. He now regards Aspen shares as an excellent buying opportunity, rating his call as “high conviction”. Ingham puts Aspen’s fair value at R390 a share which means the current price offers today’s buyers a significant margin of safety. In this in-depth interview Ingham unpacks the attraction of the R130bn market cap stock which has grown into a multinational operation with only around one fifth of its business in South Africa. – Alec Hogg

Mark_Ingham_Sept_2016

Independent Investment Analyst Mark Ingham joins us now from Johannesburg to talk Aspen, a stock often tagged as “too expensive” but after the reverse of the past couple years, maybe now’s the time to pounce?

Yes, I think so. It’s been one of my favourite stocks for a while. It’s had a very interesting journey over the last number of years. I did an exercise a while back Alec, and firstly the stock’s typically always been seen overvalued for more years than I care to recall and the path up was from stock price point of view has been somewhat scenic and in any one fiscal year there can be quite a large deviation in the price. If you go back to 2014, there was a 50 percent difference between the lowest price and the highest and there are various other examples of that too. Thus, it can be a little bit of a volatile share and I guess, Alec, that, that also speaks to the fact that some people question occasionally as to whether this truly is a growth stock and how the growth is acquired and there are two very opposing schools of thought here and I guess I’m on the more bullish school.

Let’s invert it and start with the bearish argument…

I think that’s a point that I have to take on board too when I decide the point of view I should take and the advice that I give to clients and the bearish school of thought tend to say well look the call of Aspen has been fairly sluggish over the years and therefore Aspen has had to acquire growth. Therefore, if you look at the business, if you unscramble the omelette so to speak and you remove the GSK deals, you remove the Nestlé deals, you remove the Merc deal and Sigma and so forth that the like-to-like numbers tend to be fairly sort of pedestrian. The bullish school of thought says “Well and good, but integration of very carefully acquired deals is part of the Aspen business model”. These are very carefully acquired, the company just doesn’t rush into these things and I think they’ve built some excellent relationships with partner companies over a good number of years.

Yes indeed there are aspects of the portfolio that would be considered X growth, but Aspen has been particularly good at partnering with ethically pharma giants such as GlaxoSmithKline and Astra Zeneca recently too and these are companies that are not only ethical pharma companies but the word ‘ethical’ is of course very important to them, so partnering with a company like Aspen who can in turn support and bolster their own ethical credentials is actually very important. So Aspen in many respects has become a go to company for companies that have product that is coming off patent, but which can be commercialised further.

Aspen has a terrific track record of commercialising products over a number of years and because it’s good at integrating and because there’s a strong people factor associated with the business, you can’t really unscramble the omelette because they do in fact manage to give a second lease on life to a number of products that have come into the stable and grown them in fact, to the extent in fact now that this company will shortly be reaching a R50bn revenue, whereas it wasn’t that many years ago when it was below R10bn.

A logo sits on display outside the offices of Aspen Pharmacare Holdings Ltd. in Durban, South Africa, on Tuesday, July 19, 2016. "Aspen believes absolutely that it can expand quickly into a market such as China, because the critical thing when it comes to medicine besides the price point is quality of the product," Stephen Saad, chief executive officer of Aspen Pharmacare Holdings Ltd., said. Photographer: Waldo Swiegers/Bloomberg
A logo sits on display outside the offices of Aspen Pharmacare Holdings Ltd. in Durban, South Africa, on Tuesday, July 19, 2016. “Aspen believes absolutely that it can expand quickly into a market such as China, because the critical thing when it comes to medicine besides the price point is quality of the product,” Stephen Saad, chief executive officer of Aspen Pharmacare Holdings Ltd., said. Photographer: Waldo Swiegers/Bloomberg

Aspen is also diversified very well outside of South Africa. What percentage of the group now is not in the country?

Alec, that’s a very good question because as recently as 2008, eight short years ago, South Africa accounted for almost 80 percent of revenue and 85 percent of profit. Those respective percentages fall below 20 percent going forward. It still has world class manufacturing capability in SA. It has not deserted SA by any stretch of the imagination and like a number of other companies that you’ve featured on your site, Alec, Aspen has been a great South African success story that’s taken a proven model and internationalised it.

It has a strong manufacturing capability here and it manufactures for a larger market, so you get the scale economies associated with batch manufacturing, but they’ve also particularly through deals that they’ve done with partners, ethical majors such as Glaxo, they have complimented that with the state of the art facilities in Europe, Latin America, and the US, so very much a global business and more recently it’s also entered into the US market, which of course is the largest pharma market in the world.

Photo credit: trekkyandy / Foter / CC BY-SA

So smart partnerships and deals with the pharmaceutical multinationals make this an easy business model to grasp. Aspen talks to global companies who had an exclusive licence now expiring, manufactures the products more efficiently, and giving them a second lease of life…

I think that’s it. They have a very commercial mind set and in the process both sides benefit hugely. Glaxo in fact, first came into partnership a good number of years ago and in a recent note I charted that chronology of how that relationship first started. It in fact has become a proven model to how they can partner with other companies and it’s only recently that Glaxo has exited the shareholding relationship, but the commercial relationship remains very strong. For example, they formed Aspen Japan in which GSK has a 25 percent shareholding and I think this also underscores the importance of what I refer to as a partnership of equals.

Taking the Glaxo story a little further, the multinational got involved seven years ago with an initial deal where Aspen needed to issue shares to Glaxo and to fulfil its side. Glaxo has since sold those shares – what kind of a profit did it make? 

The value of the transactions in 2009 money, Alec, was R4.6bn and they effectively invested that number in shares in lieu of cash. Let’s just remind ourselves, Aspen at the time couldn’t actually really afford to do the deal with cash, it didn’t have the balance sheet to actually do that. There was a transforming deal and the value of the deal was R4.6bn, but it only had equity of R4bn and a net debt of R4bn, so it had a 100 percent debt equity and so issuing the shares to Aspen at R66.80 at the time, it seems a long time ago now, given the fact that the share is close to R300, but it gave Aspen the currency to do the deal. Therefore, Glaxo was not a passive institutional shareholder and there was a strong commercial underpin to the deal.

Both sides prospered and in fact, the share price appreciation was so much that in November 2013 Glaxo sold a trans shift stock for just over R7bn leaving it with a smaller percentage down to 12 percent from 18 percent and that was done at R250 per share. In fact, the R7bn alone was 50 percent more than the value of the original deal and then further into 2015 and 2016 GSK once again sold down the shares. The intention was never to have a long-term shareholding in Aspen and of course the original deal was done in order to pay for the transaction. The internal rate of return that Aspen has achieved has been fantastic. If you look at the rate of return on the initial investments in Aspen shares it’s 37 percent and a lot of private equity investors would dearly love to get their hands on that sort of return.

A very strong outcome, both commercially in the way that the products have been given that new lease on life, but also financially it’s been an absolute win for the company and bear in mind that there was little of the risk associated with going about inventing new drug or trialling it and then hope it will give you a return. Roughly one in ten ethical drugs comes to market. This from a financial point of view was a real win for Glaxo and I think what’s good for the share now is that the unwind of this Glaxo holding removes any overhang, it improves free float and it possibly also gives them now the capacity to do a similar deal with another ethical major, if for instance, one of those majors may have been a little perturbed, say about the closeness of the relationship with Glaxo, that goes away now and therefore, it opens the possibility to further deals.

It sounds like a very good business model. I wonder why we aren’t seeing more of these kinds of transactions, not just in pharma, but elsewhere?

Yes, I think the Glaxo/Aspen deal was a little unique, but it has proven its worth Alec. Again, bear in mind that at the time Aspen didn’t have the cash ware with all in order to actually fund it. Indeed, the balance sheet at the moment is also fairly stretched and given the more recent deals that they have done that’s going to result in the debt increasing further to approximately R40bn from R33bn at year-end, but there’s no doubt that although Aspen has grown to be a very large company, it still has competitors in the generic pharma area that are slightly larger than it and I think it still remains relatively small compared to the ethical majors, so you’re absolutely right, Alec.

A GlaxoSmithKline logo is seen outside one of its buildings in west London, February 6, 2008. REUTERS/Toby Melville/File Photo
A GlaxoSmithKline logo is seen outside one of its buildings in west London.

For them, something that would be small and would take their eye off the ball, say for Glaxo when they’re focusing on developing new ethical drugs, for Aspen this is hugely important. They can really put shoulder to the wheel and make something of a product that otherwise would probably wither on the vine and they’ve done that to great success in virtually all of the territories where they operate, recognising of course that generic prescription, Alec, is becoming increasingly the first choice or the default option in many countries because of cost.

Aspen is a company that’s been built on deals, have they made any bad ones?

To the best of my knowledge, Alec, I don’t think there’s been any one particular deal that you could say has gone sour. We had some concerns possibly around Sigma in Australia a few years ago. The company hadn’t performed well, but in fact, under Aspen stewardship it’s done tremendously well. They’ve reinvented that business, there’s a sharp focus on the sales angle now with the manufacturing largely done in SA, so that was a business that was underperforming, which Aspen gave a good shot in the arm to and in fact, in virtually every deal that they’ve done since 2008, 2009, the deals have been value accretive and they’ve also been earnings accretive and so there’s been a steady increment each year to the improvement in EPS from the deals that they’ve done.

They’re very judicious in the way that they do deals. There are a number of possibilities out there, but they’re quite cautious about whom they do business with and how they do business and it has to be complimentary to what they’re doing. There have been one or two parts of the portfolio that they’ve sold off and I think that’s the right thing to do and so that in turn has realised cash for them. Therefore, there’s a really strong forensic focus that they have on doing what they think are commercially sensible deals.

They have to manage the balance sheet accordingly too. Throughout this period they’ve often had a fairly stretched balance sheet as a result of the significance of the deals that they’ve done. I can just cite the more recent deals that they’ve done with Astra and with Glaxo at $770mn and $350mn respectively and so these are deals that consume a significant amount of capital and they have to be thought through very carefully in order to achieve the returns that Aspen Management aspire to.

Also read: Bad news for Aspen, Adcock? Zuma sets up state-owned Pharma co.

They’re now going into the United States, the graveyard of many South African businesses. Well, Aspen is more of a multinational now than a South African business, but are you confident that they will swim against the tide?

Very good point, Alec and earlier this year Aspen acquired the intellectual property and the approved abbreviated new drug application in the United States in respect of finished dose form product called HPC, this is for the treatment of female cancers and Aspen manufactures the API, the active pharmaceutical ingredient for HPC and is a substantial supplier into the United States. The missing piece of the jigsaw there was a partner in America to distribute the HPC finished dose form and in May they concluded an exclusive agreement with ani Pharmaceuticals, Inc. Aspen supplies the HPC finished dose forms now and ani does the marketing for them.

So what it does is it brings the new commercial opportunity in that market. Of course, bearing in mind, Alec that it is a proverbial graveyard as you say, but I think the way that they’ve approached it is a fairly careful one and I think this forms, albeit relatively small at the moment, it forms a basis on which to build probably a bigger business as time goes through and get some very useful learnings.

A little bit like the way of Discovery after getting a hiding, if you recall, in the United States, has returned, but with a very different model with John Hancock doing their distribution. Just talking pharma, Adcock Ingram is an alternative to Aspen – is it a company that you would look at to put some of your investment into if you were looking at the pharma sector on the JSE?

I think there’s quite a process ahead for Adcock to come right. I think with Bidvest involvement we have seen the business recover somewhat. It’s improving profitability, but the business is relatively sub-scale in relation to its big rival, Aspen and there’s a significant difference in market cap between the two companies too and you’re looking at $130 odd billion market cap for Aspen now as opposed to $8bn for Adcock. I think Adcock has really had to focus back on the domestic market, quash its global expansion plans. It needs to get economies of scale, but Aspen has and it doesn’t.

Adcock is intrinsically not a bad business and possibly at some time it may be a good merger partner for another company, but for the time being, I think it’s going to be fairly pedestrian, is the actual sort of delivery and I think your share price performance from these levels is probably not going to be that great. I see the stock as being relatively, fairly valued at approximately R50.

The fair value that you have for Aspen is at least 20 percent higher than its current share price as you mentioned earlier, it’s around R300 now, your fair value R390. Just for a bit of insight, how do you get to a figure like that?

There’s a bit of science, a bit of guesswork and some artistry I think Alec, with all these things, and forecasting isn’t an exact science at the best of times, so one has to make a decision on the basis of scenarios, in other words, what if. That what if incorporates the fact that the anaesthetic business will become the largest single component earnings going forward. It opens up the Chinese market to them, which they’ve never been in before and that in itself is a very substantial market. There is further life in a number of the products that they have currently and I think they have a lot more mileage. Bear in mind that a number of these deals have been consummated only in the recent past and have still to optimise the returns that they bring.

There will be synergy savings as well and so the expectation is that Aspen is going to continue on the basis of what it’s already done and what it’s in the process of doing to grow earnings at a fairly sizeable clip, so for instance, you’re going to get a substantial increase in earnings this year to approximately 1600 cents per share and you’ll probably see double digit growth after that of the assumptions that I had made. There are a number of things to take account of, the demand characteristics and the various territories in which they operate and of course currency as well. Put that all into the mix, look at the cash flows that’ll be generated and my sense is that, that sort of number, round about R390 isn’t excessive.

It effectively means a forward P as we currently speak, Alec, of less than 18 times and I think back to the point that we started out with, stock has typically had a fairly rollercoaster type ride over the last number of years. I don’t see that stopping any time soon. I think it is a bit of a high conviction call and I think there is an element of fat built into that fair value number too, given the fact that not everything can of course always go right, but I think on the balance of actual probability, if we look at the excellence of the management team and we look at the drive that’s provided by Stephen and Gus, I think this is a company with a lot of legs to come.

Stephen Saad, Aspen CEO
Stephen Saad, Aspen CEO

Stephen meaning Stephen Saad and Gus Attridge, who still have substantial shareholdings themselves in the company and one can never underestimate the impact of having and entrepreneur starting a business and still staying with it.

Correct. I’ve always believed Alec, and I think it’s a feature that comes through in a number of your interviews and the articles that you feature, the people factor in any business is absolutely key. Steven has 12 percent of the stock, Gus has about five percent, the holdings there afterwards post the Glaxo sell down are quite widely dispersed between domestic and overseas shareholders and I think many of those shareholders see a fairly unique company in Aspen. There isn’t really a company quite like it anywhere in the world. On a forward basis it does look relatively expensive against some of its peer group and that would include ethical majors, but I think this is a growth company that deserves a growth rating and hence the fact that I think for new money coming in there’s still scope to make and above average return.

If we take your fair value of R390 and then put in a margin of safety of even as high as 20 percent you can buy the stock up to R330, so it’s still ten percent from where it currently is trying, it does look like a high conviction call.

Yes, that’s right. You know the stock at the moment is just over R290. We have seen the stock in fact, close to that fair value number more recently. It’s come all the way back. As I say, that is not untypical for the share price behaviour of this company and I think close to the Glaxo deal, things probably need to settle down and going forward I think for new money, you’re still getting a reasonable return on the assumption Alec, that there’s capital upside. Bear in mind that the dividend yield is quite modest. It’s only 0.8 percent, so this is a business that reinvests for growth.

It pays out a very modest cash dividend and therefore, people getting exposed to Aspen need to do so on the basis of the growth trajectory going forward and I think an understanding of the unique business model that Aspen has and the capability of management to implement that very well and to derive the returns that we’ve seen historically and which I think will be a feature of the business going forward. There is some head room Alec, from a balance sheet point of view for them to raise further capital going forward.

My sense is for the time being, as is typical with Aspen, they do these plethora deals to state on them, get them better down and them go onto the next lot of deals, but there is scope within the covenants and in the new debt sort of structuring arrangement that they’ve come to, to allow for them to borrow further capital if the right deal comes along and again as is always the case with Aspen, it has to be the right deal. So from a debt point of view, I feel that the company is fairly well-anchored. I think the capability to service the debt is there, there’s reasonable interest cover room there and so I think probably until 2018 or so it’s unlikely we’re going to see the deals of the magnitude that we’ve seen in the last two years or so.

• Mark Ingham is an independent Analyst.

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