Description

Fagron is a dominant player within a unique niche of the pharmaceutical industry.  It trades on the Brussels stock exchange under the ticker FAGR.  The company distributes and manufacturers compounded medicine.  Compounded medication are drugs that are mixed and prepared for specific patients.  Compounding a drug means changing the amount or source of a drug’s Active Pharmaceutical Ingredient (API) or format of delivery (i.e. pill, cream, lollipop for children).  Compounding is a niche that makes up 2-3% of total scripts and is gradually taking share as our population ages and as medicine become targeted.  Drug shortage also drives demand.

FAGR operates in three regions.  In Europe and South America FAGR’s main business is distribution of APIs to pharmacies.  FAGR controls 50-75% of the market in Europe and 90% of the market in Brazil.   Europe is growing LSD and Brazil HSD in terms of volume and LDD in terms of value.  In the USA, FAGR sells API to pharmacies but also operates manufacturing facilities for sterile-to-sterile compounding solutions.  Sterile solutions are sold to doctor offices and to hospitals.

Distribution at scale of APIs for compounding purposes is a very good business: FAGR supplies around 150,000 unique APIs to hundreds of thousands of pharmacies across its regions of operations.  Since compounding makes up just 2-3% of scripts, Pharmacies (and payers where relevant) have no real economic incentive to invest in robust supply chain processes and connect with API providers to negotiate prices directly. Hence FAGR benefits from robust pricing power as evident by tangible returns on capital of over 60% that are supported by blended EBITDA margins of 21-22% (and up to 26-27% in FAGR’s most mature regions). Capex is just 3.5% of sales.  

Not only is FAGR a high-quality business with end demand that is very resilient to macro-economic cycles, but the company also benefits from favorable growth prospects.  The company targets organic growth of 8-9%, margin expansion of 20-30bps per year, and deploys capital for small tuck-in acquisitions that have generated LDD after-tax returns.   All in FAGR is a compounding machine that should grow eps at 18-20% per annum for the next five years.  FAGR’s ability to grow organically at high single digits is supported by structural growth in its South American markets (where compounding is growing HSD thanks to improvement in income and consummate spend on healthcare), and from the USA business that is growing at high-teens rates. The USA benefits from hospitals outsourcing their compounding medicine operations due to increasing regulatory burdens and from small sterile compounders exiting the market for the same reasons.

  The company trades for just 17X normalized earnings in 2020 (fully loaded with SBC).  Until recently FAGR was controlled by a European PE firm that bailed the company in 2016 after a disastrous acquisition done in the USA (in a subset of the market where FAGR no longer operates today).  The PE firm bought into FAGR at 4-5 euros per share and last month sold out of its position at 16.5-17 euros.  The PE ownership was an overhang on the valuation of FAGR both from a liquidity standpoint and as an expected selling event.  Now that this overhang is behind us, we expect FAGR to rerate toward 20X PE, which we see as an undemanding multiple for a defensive compounder growing EPS at high teens to 20%.    Notice that the events that transpired in the USA back in 2015 when FAGR’s shares tumbled are completely behind the company - the old management team that drove bad decisions is out for a while now and the troubled business was shutdown.

Risks: regulatory pressure in North America is increasing as the FDA spends a great deal of effort to make sure sterile compounding providers comply with best manufacturing practices (CGMP). While this trend benefits FAGR by pushing out small players away from the market and driving hospitals to buy from FAGR instead of compounding their in-house pharmacies, it also serves as tail risk should the FDA decide to shut down any of FAGR’s facilities. An additional risk relates to currency exposures to the Brazilian real given that Brazil makes up ~15% of EBITDA.

Catalyst

Improved liquidity brings in incremental buyers seeking to own a high quality defensive compounder.