Description

Fresenius SE is a quality business in the healthcare space that has grown at double-digits for the last decade. A failed acquisition of generic pharmaceutical manufacturer Akorn in mid-2018 and a downward revision of 2019 guidance and mid-term growth expectations have caused a 45% correction since the highs in mid 2017. The market falsely believes that the growth story is over while in reality the margins will contract a little going forward, mainly because of a higher level of investment in 2019. But looking to 2020 and beyond, the growth story is still alive. At less than 13x P/E, the stock approaches value territory. I believe the stock should rerate when it sets 2019 guidance and shows the growth potential hasn’t changed.

There is also some hidden value in their biosimilars business that currently detracts from earnings but should break even in 2022 and add to earnings in 2023.

During the correction in December bad news was penalized more severely which has exacerbated the sell-off. Fresenius management talks about a communication disaster. It is true that they have done a pretty lousy job setting expectations, as in mid-2018 they were still guiding for sales growth of 7.1%-10.3% per year and net income growth of 8.3%-12.6% to 2020. This has now been reset to MSD sales growth in 2019 with 0 net income growth, and MSD sales growth with slightly higher than MSD net income growth thereafter.

CEO Stephan Sturm has made it clear internally that he will resign if they were to disappoint on guidance again. He bought about half a million EUR worth of shares on the downturn, with other insiders buying another half million, all at prices of 39.00 – 42.50 EUR per share.

The Business

Fresenius is a collection of 4 different healthcare businesses that are managed quite independently.

1.     Kabi (30% of sales, 42% of EBIT)

Kabi is a provider of liquids to hospitals. These liquids include generic IV drugs, clinical nutrition (both paternal and enteral), infusion solutions and blood volume substitutes. They also sell some medical devices such as pumps that helps with the injection of the above.

Despite the majority of the business being the manufacturing of generic drugs, profit margins are high: 18% for Kabi but >40% for generic IV drugs. Generic IV drug pricing is volatile, but generally decreases LSD each year. This has been more than offset by existing volumes of existing drugs and a little over 10 drug launches each year. Margins are high because of the complex manufacturing process, less competition for Kabi and the fact that they sell directly to hospitals and do not have to go through MCK, ABC or CAH. Main competitor is Pfizer’s Hospira.

However, despite the positive characteristics of the industry, Kabi is overearning with >40% margins in IV drugs due to drug shortages, mainly caused by Pfizer. Once these shortages have been resolved, margins should return to ~35%. This should also impact volumes (see discussion below).

FRE is reluctant to split out details per drug. However, Kabi does 4.8b EUR in sales but only has 2 drugs earning >100m EUR, hence there is no dependency on any blockbuster drugs.

Kabi has been investing heavily in new production facilities. Kabi has just built a 250m USD facility in Melrose Park, near Chicago, to supply the US market. In their pre-filled syringe plant in Wilson, North Carolina, they are investing another 300m USD in the facility. There is another facility at Grand Island.

2.     Helios (38% of sales, 30% of EBIT)

Germany

Helios is a collection of 99 German hospitals and 23 post-acute care clinics. In 2017, Helios also acquired the Spanish hospital chain Quironsalud for 5.76b EUR. Quironsalud was previously owned by CVC Capital Partners and management. They own 43 hospitals and 39 outpatient facilities.

What is different with the US market, is that these hospitals generally have no bad debt expense as everyone in Germany and Spain is insured.

Similar to the US, the German market is dominated by a large number of very inefficient and unprofitable public hospitals. Until 2005, Helios was an independent company whose focus was the privatization of individual hospitals. After getting acquired by Fresenius in 2005 for 1.6b EUR, the focus has shifted to acquiring other chains of already privatized hospitals. Helios has grown through the acquisition of Humaine, Damp Holding and Rhön-Klinikum.

According to 2016 data from the German Federal Statistical Office, Germany has 1951 hospitals, of which 29% Public, 34% Non-Profit and the rest Private. Helios has a 4.5% market share. The largest peers are Asklepios (3.2b EUR in sales, 7.7% EBIT margins), Sana Kliniken (2.5b EUR in sales, 39 acute care hospitals, 5.5% EBIT margins) and Schön Kliniken (800m in sales, 3%-4% EBIT margins).

My confidence in Helios stems from their industry leading margins, which historically were ~12%, although going forward they might be closer to 10%-11%. This is far above their commercial peers. Non-commercial hospitals are mainly loss making. There are simply too many hospitals in Germany (suggesting to close down the local hospital will be career suicide for every local politician). This slows down the speed at which Germany can introduce new regulation. The industry cannot bear being made less profitable. Helios as the low cost provider should remain profitable.

Spain

The Spanish market is a little different. In Spain, 100% of the population has Universal Coverage, which is free. 20% has duplicative insurance which costs 770 EUR / year and is often a secondary employment benefit. The private insurance assures shorter waiting times, direct access to specialists and single rooms

The Spanish for profit hospital market has historically grown 4% per year, which quite significantly exceeded GDP in that period. Still, health care spending as a % of GDP is only 9% in Spain versus 11.3% in Germany or >15% in the US.

QuironSalud has more greenfield growth opportunities, including the opening of 5 new hospitals in the next 3 years. The drawback of the Spanish market is the relatively high level of DSO and limited growth in the public sector. Growth will have to come from the privately insured patients.

The average length of stay in Germany was 6.2 in 2017 (6.4 in 2016) versus 4.3 at Quironsalud. Germany also earns slightly lower margins (11.9%) than Spain (12.6%). There are few things in which Germans are less efficient than Spaniards, but healthcare seems to be one of them (measured in LOS, patients outcomes and margins to the hospital).

Germany has the highest hospital bed density in Europe with 8.1 beds per 1000 inhabitants, versus 3.0 in Spain.

Helios has its revenues split 45%/55% between H1/H2. Spain generally has a weak Q3 because some hospitals are not air-conditioned and elective surgery is planned outside the summer months.

In general, the hospital business is one where scale matters, as can be seen by the margins of Helios versus its German peers. The strategy to acquire hospitals for ~10x EV/EBITDA and to double or triple margins in a few years is one that makes sense. Consolidation in Germany and Spain should continue for many years to come.

Other / International

Fresenius also owns a hospital in Peru that does 90m USD in sales. They recently acquired the second largest private hospital in Medellin, Colombia, for 50m USD. This is a deviation from the announced plan to acquire platforms, rather than individual hospitals. Since scale matters, my expectation would be for them to do a larger acquisition in either Peru or Colombia and their current 2 hospitals are to ‘test the waters’. In particular, during their CMD in June, Helios CEO Francesco de Meo said he had already selected the people who would potentially manage their LatAm operations.

3.     Vamed (9% of sales, 4% of EBIT)

Vamed provides project management for hospitals and other health care facilities. This includes construction, maintenance, technical management. This is a capital light business. About half of sales is for services, i.e., recurring in nature.

At only 4% of EBIT, Vamed is not material to the investment thesis.

4.     Fresenius Medical (23% of sales, 24% of EBIT) 

Fresenius Medical is listed separately on both the DAX and NYSE. It is owned for 30.91% by Fresenius SE but fully consolidated because Fresenius SE is deemed to have control. Fresenius Medical, together with DaVita has a duopoly on the kidney dialysis market in the US. There was a recent write up on DaVita by Poms which does a good job at explaining the industry. My very simplistic take on the industry is that as a duopoly, DaVita and Fresenius Medical both seem to be overearning, but this has been the case for years. Furthermore, private insurers are paying many times more than Medicare / Medicaid patients per treatment. I don’t know whether this will be sustainable in the future.

Fresenius Medical both provides dialysis services and sells equipment. Sales are 82% Health Care Services and 18% Products.

They are currently working on the 2b USD acquisition of NxStage and expansion outside the US.

The problems that lead to guidance revision

1.     The German healthcare system is making a slow change towards quality-based care. This leads to 2 problems:

a.     In 2018, Germany introduced minimum quantity rules: you can only perform a certain procedure if you do a minimum of such procedures per year. Helios is trying to be ahead of this regulation. Their response is to ‘cluster’ sets of procedures in more specialized hospitals. 1 hospital will be specialized in hip replacement, another in oncology, etc. The result is that doctors get less variety in the procedures they do. Working for Helios is already a sacrifice: while some surgeons are happy working for the most prestigious hospital chain in Germany, they are doing less academic work and have for instance less influence on purchasing than would be the case in other hospitals. Now they also get less variety in their work.  There is a shortage of surgeons in Germany, so if they want to leave, they can get a new job the next day. As a result, 12 hospitals have seen the number of vacancies rise in late 2018. No surgeons means less patients can be planned for elective surgery.

b.     As mentioned, Spain has much shorter length-of-stay (LOS) than Germany. In an attempt to use best practices from Spain in Germany, Helios is currently working hard to reduce length of stay in Germany as well. If they reduce a 7-day treatment to 5 days, Fresenius gets paid the same. If they reduce the LOS from 2 to 1 day, they will be paid less, because 1 day does not qualify for in-patient treatment reimbursement rates.

Furthermore, reducing LOS is one step. Filling the then empty-beds is a second step, which so far has not happened. Fresenius expects to need 2-3 quarters before the empty beds are filled again. To attract more doctors and nurses, they say they will have to become a more attractive employer, which has more to do with respect for personnel than paying higher wages.

This is the only problem that I consider a structural headwind. Margins could be 1-2ppt lower than it has been in the past. Margins might go up again if in 2 years all hospitals are working in clusters. I find comfort in the industry leading margins of Helios: any more headwinds could bankrupt many other German hospitals.

Fresenius Kabi is investing heavily in its biosimilar business, which was acquired from Merck and is consolidated since September 2017. The portfolio includes 7 molecules which are in various stages of the approval process. FRE targets first sales in 2019 (Adalimumab in Europe), breakeven in 2022 and a high triple-digit million sales from 2023 onwards. Commercial details are scarce, but Kabi owed Merck 500m EUR in milestone payments and a % of sales in royalties that is ‘in line with industry norms’. Kabi earnings growth in 2018 would have been 5ppt higher if you exclude the costs to develop biosimilar. FRE says that biosimilars could add 3-4ppts to growth post 2022.

While this is cited as a reason for the lowered guidance, this is not a structural headwind.

3.     Further investments in home dialysis care for Fresenius Medical. FME is in the process of acquiring NxStage, which is a leader in products and services for home dialysis care. Over the next few years, FME expects to invest more in the roll-out of home care solutions, investments which of course run through the P&L and keep profitability in 2019 down. At least for the time being home care is not expected to cannibalize the main business. My guess (but I could be wrong here) is that with renal care being a significant cost to the healthcare system, the more expensive home dialysis will remain a niche market.

While this is cited as a reason for the lowered guidance, this is not a structural headwind.

4.     Roll-out of Fresenius Medical in China. So far this has happened mainly through M&A, but I can imagine that Chinese renal clinics might need further investments that do run through the P&L.

FME acquired 70% in KangNiDaisi Medical Investment in Guangzhou and 55% in Henan Aishen Hospital Management Co and Aishen Beijing Hospital Management Co, which together are building 13 dialysis centers and a renal hospital. They also acquired 60% in Daqing Kangda Dialysis Center in Heilongjiang province. The acquisitions follow the purchase of Yunnan Kunming Wuhua Healthcare Hospital in April 2017, and the acquisition of a 70% share of Sichuan Hejiang Kangcheng Renal Hospital in June 2018 as well as the acquisition of a 70% share of Sichuan Ziyang Zhongxin Hospital, both located in the Sichuan province.

While this is cited as a reason for the lowered guidance, this is not a structural headwind.

5.    Ever since Fresenius acquired Kabi (the called APP Pharmaceuticals) in 2008 they have benefited from drug shortages, caused by more stringent FDA quality requirements. This problem peaked in 2011 with 110 drugs on the FDA drug shortage list, but this has since come down. 1.5 years ago this shortage restarted because Pfizer’s McPherson manufacturing facility being ‘under observation’ by the FDA. At some point, these problems will be solved. Fresenius assumes there are no more drug shortages in 2019 leading to a 1 time decline in sales volumes and margins (from ~42% to ~35%). Pfizer actually talks about problems persisting until 2019.

In any case, such a correction is a 1 time step-down in sales and does not impact long term growth potential.

6.    The Akorn acquisition. This is less of an issue right now, but has brought negative headlines during 2018. In early 2017 Fresenius decided to back out of its 4.7b USD acquisition of US based Akorn because they had received an anonymous tip that Akorn had several data integrity issues. Fresenius’ decision to walk away from the deal was contested by Akorn.

In December a Delaware court ruled in Fresenius’ favour and this chapter has now finished.

Valuation

Fresenius SE currently trades at a little below 13x 2018-2019 earnings. What would you pay for a defensive healthcare business that manages to grow earnings HSD? How about when it grows LDD after 2023 when the biosimilar business starts contributing to earnings? What if growth gets supplemented by accretive M&A as it has in the past?

Historically it has traded at a P/E of 22x (5 year average) or high teens if you include 2009-2012. I think rerating could earn you ~50%, while earnings growth could add 10% growth per year and dividends add another 2%. At that valuation, I can afford to wait 2-3 years for the story to play out and still earn a decent return.

Leverage is at 2.75x Net Debt / EBITDA but absent any major acquisitions this should come down a bit.

I hope I will be able to answer all questions in case there are any. It’s a complicated business with lots of moving parts and I’m no healthcare expert. I’ve spoken various times with Fresenius SE Investor Relations and management, but still have to talk to Fresenius Medical’s IR, so might have a little less information on their business.

Catalyst

On February 20^th 2019 Fresenius will provide more detail on their guidance. They believe they have done a bad job informing the markets back in December. Their goal will be to bring across the message that double-digit net income growth is still far from over.

No further catalysts in 1H2019, but the company should return to growth in 2020, so when firm guidance is given for 2020, probably in 4Q2019 this could also function as a catalyst.

A potentially resumption of M&A could bring a rerating, but for the moment I’m happy that their not pursuing external growth at any cost.