Description

DISCLAIMER: The writer of this note, related persons, and / or or entities ("Writer") currently holds a long position in this security. The Writer makes no representation that it will continue to hold positions in the securities of the issuer. The Writer is likely to buy or sell securities of this issuer and makes no representation or undertaking that Writer will inform the reader or anyone else prior to or after making such transactions. While the Writer has tried to present facts it believes are accurate, the Writer makes no representation as to the accuracy or completeness of any information contained in this note and disclaims any obligation to update such information. The views expressed in this note are the opinion of the Writer, which may change at any time. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Writer harmless and hereby waives any causes of action against Wrtier related to the below note.  This note should not be construed as a recommendation to buy or sell any security. 

Investment / Thesis Summary

I believe that Grifols S.A. (“Grifols” or the “Company”), an owner / operator of critical and countercyclical healthcare infrastructure provides long term investors with one of the best risk-adjusted return opportunities in the market. I am long NASDAQ-listed Grifols American Depository Shares (NASDAQ: GRFS), which I will refer to both as the “B Shares” going forward. The B Shares have a 1 : 1 exchange ratio into Grifols’ Class B participating preferred shares (BME: GRF.P). I believe the B Shares will easily generate a 17% – 18% IRR over a ~4.25-year hold in exchange for what I believe to be a low risk of permanent capital impairment (and several free options with high upside).

Grifols is an 80-year old business that is vertically integrated, quasi family-owned and operated, and commands number one market share in most of its key products within the arcane hemoderivatives industry. Grifols principally procures, researches, manufactures, and sells therapeutic products derived from human blood (plasma). The Company sells essential, non-discretionary products that often have no viable substitute in treating a range of chronic, acute, and rare medical conditions such as autoimmune diseases, genetic mutations, viruses, and traumatic injuries. Grifols generates normalized mid-teens returns on capital and deploys modest leverage and is the epitome of a compounding machine – Since the B shares were publicly listed in 2011, they have delivered a ~14.5% IRR (including dividends, but excluding reinvestment). Grifols possesses a rare combination of (i) countercyclicality and defensiveness, (ii) long term secular growth trends, (iii) a rational, oligopolistic market structure with high barriers to entry and (iv) strong pricing power.

Grifols is a “boring” compounder, the Company consistently generates high owner earnings, re-invests heavily at attractive rates over the long run, and amplifies returns by deploying moderate leverage (currently at peak leverage of ~5.1x with corporate debt coupons / yields ranging from 1.625% – 3.000%; net leverage was ~4.0x until Grifols’ recently used a fair amount of its balance sheet cash for a bolt-on acquisition that hasn’t yet contributed to EBITDA). Grifols has grown revenue every year and unadjusted EBITDA in all but three years since 2000. In the three “down” years, YOY EBITDA declines ranged from 2% - 7%.

At today’s prices, I believe the market more than prices in Grifols’ principal downside risks and overlooks many attractive opportunities ahead of the Company. The market supposedly acknowledges that Grifols should generate HSD revenue growth, LDD EBITDA growth (operating leverage), and MDD earnings growth (from deleveraging) over the intermediate term (based on Bloomberg estimates and the fact that the sell side’s average price target is 33% higher than current prices). Yet Grifols never really recovered from the COVID sell-off and appears to be a victim of bad technicals and misplaced fears surrounding new competitive treatments to two of Grifols’ best-selling therapies. The biggest major sell-side detractor is JP Morgan’s Spain team who has a hold rating and a YE 2020 price target that is 24% higher than current prices while utilizing a draconian large spread between A and B Shares versus historical levels (only on the sell-side can someone have a price target that implies a 67% IRR and not be a buyer). Additionally, the market either overlooks or misunderstands several key facts:

• Long term earnings power
  • Extraordinarily high barriers to entry
  • TAM size / longevity of the industry’s secular tailwinds
  • Per capita plasma therapy consumption in European and emerging markets is a fraction of that in U.S. / Canada / Australia
  • Secular gross margin tailwinds
• Uncorrelated revenue growth and countercyclical margins (revenue grew 12% p.a. and gross margins expanded ~930 bps from 2006 – 2008)
• Aligned, strong owner-operator with a tremendous capital allocation track record
• A recent JV and bolt-on acquisition that will both prove to be highly accretive
• Several material free options – One of which is the fact that I believe the Company is the single highest probability bet to produce a safe, viable, and scalable first line COVID-19 treatment. Note that I DO NOT think this constitutes the free option with the most upside
• The B Shares’ current discount of 35% to Class A share price will likely compress / normalize over time to its 25% average observed over the past ~10 years. As the Company de-levers this could compress as low as 10% due to yield parity

To quote Seth Klarman, “We worry top-down, but we invest bottom-up.” I worry about the potential inflationary consequences associated with the unprecedented, central bank-enabled Keynesian policies being employed by nearly all developed nations’ governments. If inflation / stagflation run hot, I want to own assets like Grifols that command strong pricing power, sell essential goods that exhibit uncorrelated and secular demand tailwinds, possess countercyclical supply chains (i.e. can produce goods cheaper when “the tide goes out”), and employ modest leverage.

Note – Most of Grifols’ cash flows are generated in USD, but the Company’s reporting currency is EUR and so is my financial analysis. Anywhere I refer to USD on a current or forward-looking basis, I have assumed a EUR : USD FX rate of €1.00 : $1.13 (the prevailing FX rate when I began this write-up).

Share Class Considerations

Ceteris paribus, the B Shares have both (i) slightly better economic terms than Grifols’ Class A (common) voting shares and (ii) superior capital structure priority and minority rights than most public Class B shares. These terms were negotiated by Cerberus in 2011 in connection with Grifols’ ~€2.7bn acquisition of Talecris. Cerberus exited the B shares in 2013.

The punchline is that the B shares have no voting power, receive an extra €0.01 annual dividend non-cumulative), and otherwise have the same economic ownership in Grifols as the Class A shares. The B Shares are ~6.5x less liquid than Class A (judging from recent volume). Technically, the B Shares are participating preferred shares that have a liquidation preference and redemption rights to protect minority shareholders in the event of a takeover bid, but I do not expect the business to be sold or liquidated (the co-CEOs are part of the Grifols’ family, the Company’s namesake and long-time owners of over ~36% of the Class A voting shares).

The B shares trade at a ~35% discount to the Class A shares, which is wide compared to historically observed pricing, which is illustrated and discussed below.

•  Since the B shares’ IPO (6/2/2011), the spread has only been wider on ~2% of days
• ~88% of those days occurred after 3/15/2020, the beginning of COVID panic selling. The other 12% of the days all occurred in 2011
•  Median spread since 2011 is ~25% (even when excluding the anomaly of 2020 pricing action)
•  The widest discount observed was 48% (3/18/2020)

Plasma-Derived Therapeutics

Human blood composition varies between individuals, but is rich in biological material and effectively comprised of plasma (~55%), red blood cells (~42%), and white blood cells / platelets (~3%). Plasma is the liquid that carries the cells and their proteins throughout the body and is made of ~90% water / ~10% proteins and blood clotting factors. There are several main types of plasma proteins:

(i)                 Albumin (~60%) – Regulates fluid (blood) pressure so other proteins and cells stay within blood vessels and do not leak into tissues

(ii)               Immunoglobulin (“IG”) (~15%) – Antibodies that neutralize infections, bacteria, and viruses

(iii)             Coagulation / Blood Clotting Factors (~1%) – Form and regulate blood clotting

(iv)              Other (~24%) – Enzymes, hormones, and other proteins that regulate bodily functions

There are more than ~3k proteins found in plasma, but only 20 are used for concentrated plasma-derived therapies, providing a very long runway for Grifols and the industry to both (i) isolate and research new proteins and (ii) receive approval to use existing, isolated proteins to treat more diseases (also known as “indications”). It can require hundreds to over a thousand individual plasma donations to treat one patient annually, depending on the patient’s condition.

Plasma therapies are typically used to replace missing or deficient proteins found in an individual’s plasma due to chronic (autoimmune and genetic diseases) and acute conditions (blood loss, surgeries, burns, etc.). Most of the chronic diseases that IG treats are rare, therefore the IG-based products often qualify for orphan drug designations. Furthermore, the autoimmune diseases that IG is used to treat are currently non-curable and IG is by far the most superior treatment option (competition is primarily corticosteroids, which are less effective and generally have negative long-term side effects). As such, plasma therapies are critical to healthcare systems and included on the World Health Organization’s List of Essential Medicines.

Plasma therapy products exhibit several attractive economic characteristics relative to other biotechnology and pharma products:

•  Plasma proteins are unique, thus do not face generic drug competition and typically encounter limited competition from substitute products
  • Oligopolistic industry structure limits competition from other plasma-derived proteins and increases barriers to entry (entrants cannot compete without collecting their own plamsa, a highly regulated and capital intensive process)
  • Potential competitors have lower incentives to attempt to enter the market
    • To compete in an indication already treated by an IG brand, a new potential drug or protein must (i) demonstrate clinical superiority to the current standard of care or (ii) demonstrate clinical equivalence / dependability and lower costs
    • There is a higher hurdle to obtain a second orphan approval (7-year exclusivity) in an indication where an orphan drug approval was awarded in the past
    • The Orphan Drug Tax Credit was halved as part of U.S. tax reform in 2017
• Plasma-derived proteins are not directly patentable and do not possess “patent cliff” risk
• Less indication / disease concentration (IG is used to treat 350+ autoimmune diseases)
• Many autoimmune diseases are heterogenous, which makes plasma-derived therapy less susceptible to complete displacement. Even if a new treatment is generally superior, it likely will not deliver superior results in all patients
• Patient switching costs are high. Absent discovery of a full-blown cure, doctors are reticent to switch an immunodeficient / autoimmune patient from an established, effective treatment protocol (many of these patients are frail and the human immune system is sensitive)
  • Doctors and hospitals / infusion clinics are economically incentivized to prescribe in-vein IG infusions, because they can bill high margin, recurring revenue for administering the treatment

Plasma is a biologic, not a conventional pharmaceutical, therefore no two plasma-derived therapies are exactly alike and patient responsiveness and side effect tolerance varies across different plasma-derived products. Given their inherent uniqueness, regulators have defined plasma therapies as sole-source biologic products – no generics or exact substitute products exist. Significant differences between products and lack of substitution / interchangeability provides Grifols and plasma protein manufacturers with strong pricing power relative to their customers (hospitals / GPOs, pharmacies / PBMs, physician offices, etc.).

Plasma-derived protein products cannot be patented since plasma and its proteins are naturally occurring. Therefore, competitive advantages in the industry are built around scale, manufacturing efficiencies, regulatory / safety record, regulatory approvals, and proprietary formulation methods. For example, due to proprietary manufacturing processes and formulation methods, two different “brands” of IG made by different plasma producers are not interchangeable and will possess different protein concentrations, effective half-lives, absorption / bioavailability profiles, patient efficacy, side effects / tolerability, shelf-lives, and administration methods (vein infusion, under skin infusion, etc.). Furthermore, the two IG brands may not be FDA / EMA approval for treatment of the same indications. Medical guidelines also call for doctors to craft the optimal plasma protein treatment to the patient by considering the aforementioned product properties / administration routes, patient conditions, patient responsiveness, and side effect tolerance, which may include performing complex diagnostic procedures to uncover the optimal treatment for each patient.

Patients that rely upon plasma-derived therapy for 350+ chronic autoimmune diseases generally require regular infusions or injections to extend their lifespan (up to 60 years in some patient populations) and reduce physical limitations that would otherwise hamper occupational, educational, and social progression. This economic model creates generally long-lived and highly recurring revenue for Grifols and is also lucrative for hospitals / infusion clinics / doctors, who are compensated to administer intravenous IG products (direct-into-vein infusions) for patients on a recurring basis.

Furthermore, many autoimmune diseases are highly heterogenous, meaning the mechanism of the disease is difficult to trace and the severity and number of symptoms can differ significantly by patient (e.g. some people who suffer from Multiple Sclerosis take medication and the disease barely affects their lifestyle, while others take the same medication but are still wheelchair bound).

Business Model Overview

1. Grifols compensates individual donors $35 – $50 and collects plasma at Grifols-owned collection centers. This entails strict donor qualifications, screenings, virus testing, and quality assurance
2. Plasma is frozen and stored for 60 days to allow adequate time for retrieval and destruction of any plasma donation detected to have a latent infection or disqualified donor
3. Plasma is shipped to a Grifols fractionation facility
4. Fractionation plants (akin to a refinery) pool the collected plasma and then extract the desired proteins in a specific order by subjecting the plasma and its byproducts to a combination of different temperatures, pH, pressure, and alcohol concentrations over various periods of time
5. Each class of isolated protein is moved / shipped to its separate purification facility, where it is converted into a “fraction” (raw protein paste)
6. Refined proteins are shipped (where demand dictates) for final processing
   1. e. g. Sometimes North Carolina plant fractions must be used as raw material to create finished goods in the Barcelona for use in Europe. It has taken Grifols decades to obtain the necessary licenses to operate a flexible, low cost, global manufacturing footprint in this fashion across all of its fractionation, purification, and packing plants
   2. Fractions are converted into finished goods / therapeutic products, tested, packed, and distributed mostly to hospitals and pharmacies (but also to physician offices, infusion clinics, home healthcare providers, and directly to patients)

Different viral inactivation / removal processes, safety diagnostics, and testing is completed throughout fractionation and purification to ensure patient safety and regulatory compliance. Plasma-derived therapies are produced in small batches due to the relatively small patient population served and high safety regulations through multiple steps of the process. Plasma-derived therapies and are also long-tailed goods, it takes Grifols an average of 10 months to collect and convert raw plasma into finished goods under this highly regulated and technical process.

Last Liter Economics

The hemoderivatives business is characterized by high fixed costs (~4x higher than conventional pharmaceutical / biological drugs manufacturers). Expenses related to collecting and testing plasma represent the single largest cost for Grifols and other industry participants (these expenses are captured in COGS, which is ~2 / 3 fixed). Production costs for plasma-derived therapies remain relatively constant regardless of how many different therapies are produced from the plasma. Therefore, it is crucial to maximize revenue per liter of plasma collected by manufacturing as many therapies as possible from each liter of plasma collected. Grifols management states that they aim to harvest at least three proteins / therapies from each liter of plasma collected.

Grifols generates more revenue and the highest incremental margins on the first liter it produces compared to the last liter it produces. IG is Grifols’ and the industry’s “last liter” (i.e. most important) product, since it commands the highest value (3x – 4x the value of albumin, which is the industry’s secondary “last liter” product). Grifols will collect and process as much plasma as it can, up to the last liter that they can sell as IG. Therefore, (i) IG demand determines the supply of the other plasma-derived proteins (since there are a fixed number of proteins in each liter of plasma) and (ii) margins will contract so long as IG demand grows faster than inframarginal proteins and expand when inframarginal protein demand outstrips that of IG. To maximize long term profits, Grifols makes substantial capital investments to optimize long term capacity planning across its value chain to increasing the amount, proportion, and quality (yield) of the proteins extracted from plasma to align with market demand.

Both higher returns on capital are generated when many proteins are produced from each liter of plasma collected and rapid capital destruction can occur when the raw supply of plasma decouples from end plasma-derived protein therapy demand, so the industry tends toward vertical integration and monopoly / oligopoly. Hence the industry’s existing oligopolistic market structure wherein Grifols, CSL, and Takeda (formerly Shire and Baxter / Baxalta) generate ~70% of U.S. industry revenue (and ~85%+ of U.S. industry EBIT), because they have the manufacturing efficiency, formulation sophistication, regulatory / safety record, and sales reach to safely extract and sell 6 – 20 proteins from each liter of plasma versus smaller players who can only yield 1 – 3 proteins from the same liter. Consequently, this structural advantage leads to the “Big 3” generating higher returns on capital than competitors and acts as a self-reinforcing competitive advantage wherein Grifols / CSL / Takeda generate higher profits, which can be reinvested to widen the moat through (i) organic capacity / yields improvements, developing new proteins / product formulations or (ii) accretive bolt-on acquisitions and joint ventures.

Industry

In addition to an attractive market structure, the industry exhibits tremendous secular growth tailwinds. The plasma market as a whole grows at about 8% - 9% p.a., depending on the specific protein / product / application. Growth is broadly driven by demographic tailwinds (aging population), approval for new indications / administrations, higher diagnosis rates (autoimmune diseases as a group are under-diagnosed; most immunodeficiencies remain undetected for 10+ years), and increasing IG use per capita in European and developing markets (these markets’ IG use per capita lags that of the U.S. / Canada / Australia generally by about 2x – 12x).

The U.S. is the “OPEC” of the global plasma derived product industry with about 45% market share; China is number two with about 15% of the global market. Europe currently runs a structural plasma deficit with the U.S, because ~8 million liters of plasma are collected in Europe, but ~13 million liters are required to meet clinical demand p.a. (the 37% deficit is covered by imports from the U.S.). Canada also runs a large plasma deficit with the U.S. – Canada only supplies ~17% of the 1.2 million liters of plasma needed to fulfill its own domestic demand p.a.

However, the U.S. is consuming more of its plasma collections and this trend is expected to accelerate due to its aging population, by 2025 the U.S. / European plasma deficit is estimated to reach 44% of Europe’s demand. Therefore, Europe will likely be forced to become more self-reliant with respect to its plasma procurement going forward. Many European countries currently (i) outlaw private sector plasma collection and compensation to donors and (ii) all European countries allow less frequent plasma donations, in mostly lower volumes per donation than the U.S. Changes to these regulations are likely and if they occur, will be favorable to Grifols, because ~15% of the Company’s collection centers are located in Europe and higher plasma collection productivity generates very high incremental returns on capital due to the Company’s heavy fixed cost structure.

Regulations, proven regulatory / safety record, capital intensity, vertical integration, complex manufacturing / formulation know-how (including the availability and cost of human capital), strong payor / provider relationships, and the long-tailed nature of plasma-derived therapies all create high barriers to entry. Grifols management estimates it would take 2.0 – 3.5 years and 5.0 – 7.0 years to obtain FDA / EMA approval and construct each new collection center and fractionation / purification facility, respectively. About ~€113mm of “soft costs” alone are required to simply complete the required test runs to get a fractionation or purification facility approved to run for commercial operations after construction. Several recent market exits by sub-scale operators in North America are shining examples of the barriers to enter and effectively compete in the industry (Grifols recently acquired both of them, Biotest’s U.S. plasma collection assets and Green Cross’ U.S. collection and Canadian fractionation / purification facilities).

Grifols Overview

Grifols owns ~252 and ~43 plasma collection centers in the U.S. and Europe, respectively. The Company’s fractionation capacity is located in Clayton, NC (~54%), Barcelona, Spain (31%), and Los Angeles, CA (15%). The Diagnostics division is headquartered in Emeryville, CA with the main manufacturing facility in San Diego, CA.

Company Segments

• Biosciences (~78% of revenue / ~80% of EBITDA) – Grifols core, vertically-integrated plasma collection, fractionation, purification, and plasma-derived medicine production business
• Diagnostics (~14% of revenue / ~17% of EBITDA) – Blood and plasma testing instruments and systems that screen donations at owned and third-party collection centers and blood banks for infections / viruses, provide blood type / compatibility tests before transfusions, reagents, workflow software, etc.
  • 55% market share in donor screening (effectively a duopoly with Roche)
  • 15^th largest diagnostics company / segment in the world
    • Grows 2% - 3% p.a.
    • Margins will be lower than 2017 – 2019 (average ~38% EBITDA margin), but should be stable for several years due to a large cohort of recent multi-year renewals
• Hospital (~3% of revenue / ~0% of EBITDA) – Provide consumables (blood bags, saline, etc.) to hospital / compounding pharmacies and Grifols collection centers. Includes fast-growing safety / regulatory focused hospital pharmacy workflow software platform (grew over 100% in 2018)
  • Growing HDD p.a. but EBITDA is currently breakeven (was negative 2016 – 2019)
• Biosupplies (~5% of revenue / ~4% of EBITDA) – Supplies plasma-derived proteins to other biotech / pharma and diagnostics companies for research, clinical trials, and as a raw material for biotech / pharma products
  • High growth (in-line with biologicals market ~15% p.a.) and margins

Grifols undertook an extensive capital investment program following 2014, increasing their collection centers from 150 to 297 from 2014 – 2019 (14.6% CAGR) and increasing fractionation capacity from 8.6mm liters to 15.3mm liters (12.2% CAGR). For reference, 2019 maintenance capital expenditures were ~$130mm and Grifols’ 2015 – 2019 capital expenditures totaled ~$1.57bn. However, Grifols has signaled the normalization of this heavy investment cycle via management’s expectation to only increase collection centers to 370 at the end of 2024 (4.5% CAGR).

Given that collection costs and a substantial amount of manufacturing overhead is included in COGS, this capital investment program is the proverbial “pig through the python”, which has hampered margins in the short run. I actually don’t think the street is unaware of this, but I do think there is a disconnect between the market’s investment horizon and that of the Grifols family (the market also generally dislikes the Company’s lack of margin / financial guidance). If you can take the long view, I believe there is a substantial behavioral edge and alpha available through re-orienting your investment horizon with the Grifols’ family and waiting for the Company’s gross margins to normalize back toward ~50%.

Biosciences Revenue by Product / Protein:

• IG (~59% of Sales) – Used to treat many non-curable autoimmune diseases, that on average take 10+ years to diagnose, because symptoms are broad and often suggestive of less serious conditions for which either OTC medication or antibiotics can be used. IG is far and away the best treatment for most autoimmune diseases and continues to grow both from (i) taking share from steroids and (ii) higher diagnosis rates. The main diseases that IG is used to treat are listed herein. Primary immunodeficiencies (PI) – a group of 350+ rare, mostly-genetic, chronic disorders where the body’s immune system doesn’t function properly. Secondary immune deficiency diseases (SID) – acquired immunodeficiencies from environmental factors (chemotherapy, burns, malnutrition, etc.). Chronic Inflammatory Demyelinating Polyneuropathy (CIDP) – a neurological disorder where the body’s immune system attacks and swells nerve roots leading to progressively weakening muscles, deteriorating reflexes, and numbness (without treatment, 30% of patients become wheelchair bound). PI, SID, and CIDP collectively comprise 2 / 3 of total IG demand and CIDP is the largest single source of IG demand (20% - 30%)
  • U.S.: Growing 8% – 10% p.a. primarily due to closing gap of underdosing, underdiagnosed autoimmune and genetic diseases, and share growth by subcuteaneous
    • Intravenous IG (“IVIG”): IV drip of IG given through veins
      • ~90% of IG market; growing ~6% p.a.
    • Subcutaneous IG (“SCIG”): IG that is self-administered via under-the-skin injection at home, gradually enters the system (less “spike”, more prolonged drug absorption), is more tolerable for patients (less side effects), and a better administration route for patients with poor veins. Sells at 20% - 30% higher price per gram and requires more plasma per dose than IVIG
      • ~10% of IG market; growing ~20% p.a. with higher margins but unlikely to become a large percent of the market in totality
  • Rest of World: Driven by China, should grow in double digits for decades due to increasing IG use per capita
• Albumin (~13% of Sales) – Used as replacement for blood or fluid loss due to surgery, trauma, burns, sepsis / septic shock, respiratory distress, etc.
  • Grifols’ top 20 markets growing ~7% p.a.
• Alpha-1 Antitrypsin Deficiency (“Alpha-1”) (~18% of Sales) – Grifols’ dominant Prolastin franchise has ~2 / 3 global market share for treating this genetic, progressive disease that impairs long term lung and liver function that some refer to as “genetic emphysema,” which is characterized by progressive lung and / or liver disease that results in lung / liver transplants and premature death if untreated
  • Growing LDD p.a. (patient count / volume growing ~8% p.a.)
• Factor VIII (~5% of Sales) – Declining 1% p.a. / stable due to increasing emerging market unit demand, but lower pricing since recombinant and synthetic product launches in 2013 – 2017
• Hyperimmunoglobulins (“H-IG”) and Biosurgery Products (~5% of Sales)
  • H-IG: IG-based product with enriched levels of antibodies to either prevent serious infections / viruses or substantially speed up recovery from an infection
  • BioSurgery: Biologically compatible glues to seal vascular and organ surgery incisions to quickly stop / control bleeding
  • U.S. growing HDD p.a. (est. ~50% market share in the U.S. H-IG market)

RAAS Deal and GCBT

Grifols recently completed two highly accretive JV / partial ownership transactions, resulting in ownership of (i) ~26% of Shanghai RAAS (“RAAS”), a public, fast-growing Chinese blood products company and (ii) ~53% of Green Cross Biotherapeutics (“Canada Assets”), which owns crown jewel Canadian fractionation and purification capacity that will become the de-facto plasma infrastructure monopoly in the country once it begins commercial production in 2023.

In February 2020, Grifols announced that they signed a term sheet (non-binding) with Saudi Arabia’s sovereign wealth fund (PIF) to form a JV that will build, own, and operate a network of plasma collection centers, a fractionation plant, and protein purification plant in Saudi Arabia. No economic terms have been released, except for a statement that “Part of the recognized value that Grifols would contribute to the joint venture includes its knowledge and expertise in the industry, as well as the intellectual property it holds”, which seems to indicate a deal structure that would generate very high returns on capital for Grifols.

In early 2017, Grifols bought out Hologic’s ~2 / 3 economic stake in a Grifols-Hologic blood diagnostics JV that was forged in 1998 for ~€1.75bn, implying an EV of ~€2.65bn (~11.6x 2017 EBITDA). After the transaction Grifols’ owned 100% of the JV, which makes up ~55% of Grifols’ current diagnostics segment. In March 2020, Grifols closed a non-cash deal to receive 26.2% of publicly-traded RAAS (SZSE: 002252) in exchange for 45% ownership of Grifols’s diagnostics segment (really ~33% of Grifols’ diagnostics segment after accounting for Grifols’ look through ownership through the ~26% RAAS stake). Shanghai RAAS has 10% - 16% market share in China, depending on what measure you use and I believe the market misunderstands how accretive the deal is for Grifols.

At current market pricing and FX rates, Grifols’ Shanghai’s RAAS stake is worth ~€2.16bn. Grifols’ diagnostic unit generated ~€270mm of EBITDA in 2019, which implies that Grifols monetized the stake in their diagnostics unit at ~24.0x 2019 EBITDA (versus 11.6x 2017 EBITDA that Grifols purchased most of the division for ~3 years ago). Furthermore, Shanghai RAAS will become the exclusive distributor of Grifols’ plasma and diagnostics products in China. I believe this arrangement will provide for significant revenue and cost synergies for Grifols, making both the Company’s Bioscience and Diagnostics units more valuable.

The Chinese plasma market is expected to grow MDD p.a. (i.e. quadruple) over the next 10 years, in line with RAAS’ ~14% average revenue growth (with ~43% EBITDA margins) over the past five years. Grifols is now the largest shareholder of Shanghai RAAS (26.2%), which also counts Creat Group, a Chinese PE fund (26.18%), and Mr. Hoang (22.78%) as major shareholders. My research points to at least four of six Creat board members being billionaire China-nationals, ex-chairmen of state-owned enterprises, and university professors (it’s especially important for a business to have close government ties when operating in a highly regulated business in China).

Grifols also recently announced what I expect to be a highly accretive acquisition of 11 U.S. collection centers and the Canada Assets for ~€400mm (cash), a cheap price to procure ~1.5mm liters of immediately licensed U.S. / Canadian fractionation capacity and collection centers that gathered 350k liters of plasma in 2019. The Canada Assets are the sole commercial-scale plasma manufacturing facilities in Canada, and will hold a domestic monopoly position for quite some time, given that Canadian fractionation demand is ~1.2mm liters p.a. Grifols expects the facilities to begin producing IG and albumin beginning in 2023. When GC Pharma began construction of the facility in 2015, they expected to generate €320 – €330 million of revenue p.a. once it was up and running. Assuming these assets can generate long run EBITDA margins of 30%, Grifols’ implied purchase price is 7.9x normalized EBITDA.

Why Does This Opportunity Exist?

• Spanish Market Sell-Off – Grifols’ shares have generally sold off in-line with the Spanish market (B Shares down 23% YTD versus IBEX 35 down 29% YTD). For reference, the Fidelity MSCI Health Care Index (FHLC) is up 5% YTD. Admittedly, Grifols has been more (negatively) effected by COVID than many of its pharma peers, but we think the sell-off of shares is overdone
• B Shares Lack Passive Index Demand / Buyer Support – The B Shares are ~6.5x less liquid than Class A shares and are effectively non-voting, participating preferred shares, a unique instrument for the public markets. This may disqualify many index funds from owning the B shares (the Class A common shares are a constituent of Spain’s IBEX 35 Index)
• Orphaned Company / Stock-Listing That is Complex and Underfollowed in the U.S. – Despite the Company’s size, shares have an orphan-like status. Most of the Company’s revenue / profits are generated in the U.S. but the Company’s main listing, headquarters, and controlling family all reside in Spain. The plasma industry is also idiosyncratic, requires interdisciplinary knowledge, and is only covered by two American analysts (neither works at a major desk). Grifols' has only been written up once on VIC - This was eight years ago, as a re-activation idea, by someone who appears to no longer be an active member of the community
• Low Interaction with Investors + Lower than Expected Plasma Collection Volumes and Recent Guidance Spooked the Market – Grifols doesn’t host quarterly earnings or M&A calls and does not provide financial projections / guidance. So the Company spooked the market in June when the Company pre-announced that they would take a $200mm inventory write-down due to lower plasma collection volume from COVID in 1Q20 / 2Q20, which will be partially offset by $100mm of 2H20 operating cost reductions. All in, this $100mm headwind implies a ~7% and ~11% decline to the street’s previous 2020E consensus EBITDA and earnings estimates. Shares have sold off 11% since this announcement and there wasn’t a boogeyman when the company reported 2Q20 results a week ago. A prolonged period of low plasma collections will negatively effect sales on a three-to-four quarter lag, but we think this is more than priced in at these levels
• Sell-Side Short Termism / Misunderstood Competitive Risks – Some sell-side coverage has cooled on Grifols due to a “bad set-up” stemming from the expected release of early stage, Phase II clinical trial data commentary (not Phase II results) in 3Q20 for several recombinant / gene therapy products that could compete with some of Grifols products. These readouts are not likely to come in 2020 and the sell-side misunderstands the staying power and longevity of Grifols’ treatments
  • Vertex’s VX-814: This is the most significant of the announcements / risks, because the drugs would compete with Prolastin, Grifols’ Alpha-1 franchise (est. ~18% of 2019 revenue). Vertex is a market-darling and while I concur that it is an excellent company, Vertex’s management and the market’s expected clinical trial timeline for VX-814 has been unrealistically aggressive. Vertex used biomarkers to speed through Phase II clinical trials and then blazed through Phase III FDA approval for its blockbuster drug for cystic fibrosis, a disease that previously had many patients with no treatment options. The expectation of an imminent data readout and the extrapolation of a one or two-year approval trial after VX-814’s Phase II is misguided for several reasons:
    • Vertex announced last week that (i) VX-814 trial enrollment was delayed due to COVID and (ii) expected date of the Phase II data read out is now 4Q20 / 1Q21
    • 65% of the actively recruiting sites for the VX-814 trial are in COVID “hot spot” states of CA / FL / TX or a recently designated “red zone” state by the White House task force leading me to believe further delays are reasonably likely given that the Alpha-1 population is a high-risk COVID group (https://clinicaltrials.gov/ct2/show/NCT04167345). Furthermore, many of the testing sites are in college towns that could become local “hot spots” if and when students return for the fall semester
    • Alpha-1 patients have well-established, effective, and safe treatment options. Prolastin was FDA-approved in 1987 and is the gold standard of Alpha-1 treatment (67% market share). VX-814 will not only need to prove it is more effective than plasma-therapy, but also prove that it is safe (VX-814 has never been put into an Alpha-1 patients body before). Small molecule therapy for a disease that requires lifelong treatment creates high toxicity and tolerability risks for patients. Several early iterations of Alpha-1 recombinant / gene therapy treatments were shelved due to safety problems (e.g. allergic reactions in the lungs)
    • The nature of Alpha-1 lends itself to long clinical trial testing requirements, because the disease is ultra-rare and progresses slowly, making it a lengthy process to analyze well-defined clinical end-points. Alpha-1 is a chronic, progressive disease that does not kill anyone over night, but if left untreated leads to toxic build-ups in the liver and lungs over years. In order to see a statistically significant survival / mortality rate divergence for Alpha-1 patients using plasma-therapy (versus no treatment), 500 – 1,000 patients have to be studied over about seven years
    • Alpha-1 is an ultra-rare disease with only about 10,000 plasma-therapy patients in the U.S. The FDA held a workshop focusing on Alpha-1 drug / clinical trial development last year and referenced a National Heart, Lung, and Blood Institute study that recommends a four-year trial duration for 400 participants and stated The FDA’s expectation of “substantial evidence of clinical effectiveness” (https://www.fda.gov/media/134986/download) for any new Alpha-1 drug approvals. It would be very difficult to enroll 400 individuals (4% of the Alpha-1 population), especially considering that Alpha-1 patients are geographically disbursed in-line with the U.S.’s broader population density. Even if you had 40 – 50 testing sites, patients would also need to reside close enough to these sites and be willing to regularly drive to them over the course of several years
      • One of the most comprehensive Alpha-1 studies of all time (known as RAPID; available at clinicaltrials.gov) took seven years and 24 sites collaborating internationally to recruit and complete a two-year study for 180 patients
      • The FDA further offered a clue at how long an ultimate Vertex Phase III trial could be when it noted at the workshop that the RAPID study’s two-year length was “now in retrospect, too short to better inform us on the important other clinical endpoints beyond CT lung density.” Furthermore, there have been zero FDA approvals based on CT lung density in emphysema, so it seems that an ultimate Phase III trial will definitely be more than two years
      • VX-814 will need to show it is more effective than Prolastin based on specific clinical endpoints, not “on paper” (surrogate outcomes / biomarkers). Vertex will also have to recruit up to 4x – 8x more people for VX-814’s Phase III trials (versus Phase II) and the last person recruited will likely need to be tested for four years. If you assume that Vertex can recruit all the necessary patients in one year, VX-814 is likely facing at least a five-year timeline to finish Phase III trials (mid-2026 assuming the Phase II trial is completed / accepted in mid-2021). If we assume another 6 months for FDA review / approval, VX-814 won’t reach the market until the end of 2026. In the meantime, you don’t have to use heroic assumptions to project that Grifols doubles to triples its earnings and more than completely de-levers by the end of 2026
    • It will be hard to completely displace Prolastin in any event, because the reality and problem with small studies (even those that are approved) that test patients that are using the existing standard of care (plasma-therapy) is that many unknown will remain. Does the new therapy work / differ at different stages of lung disease (Alpha-1 patients only use plasma-therapy at the onset of emphysema, so is there a false positive from testing Alpha-1 patients that don’t yet have emphysema?), for men versus women, long term function, exacerbation frequency and severity, mortality, etc.
    • VX-814 is statistically unlikely to be approved. Pure statistics point to a 15% - 34% probability of VX-814 approval depending on what methodology you use
  • Momenta Pharmaceuticals’ M254 (FcRn / Hypersialylated Immunugloblin): This would compete with Grifols’ Immunoglobulin (“IG”) franchise in Immune Thrombocytopenia Purpura (ITP) indications. This indication accounts for a very small portion (<5%) of Grifols revenue and is a slow-growing IG indication category (~5% p.a.). Management believes that FcRn treatments are more likely to provide an alternative to weak or non-responding patients under the existing standard of care (IG), not replace IG altogether. Furthermore, IG is an input required to manufacture M254 and therefore Grifols management views M254 approval as an opportunity rather than a risk. Furthermore, Grifols has an in-licensing agreement with Rigel Pharmaceuticals (NASDAQ: RIGL) for Tavlesse, a recombinant drug that is already approved and used as a second / third line treatment in refractory ITP patients.
    • My scuttlebutt discussions with doctors also revealed that recombinant factors can be 2x – 10x more expensive than IG, which is an under-the-radar consideration for resource constrained hospitals and physicians’ offices that don’t want their own money tied up in working capital. The now non-existent Japanese recombinant albumin market serves as just one historical precedent for recombinant factors not gaining traction due to a lack of relative efficacy and higher costs compared to plasma-derived therapies
  • Competition in CIDP: There is a general fear that M254 / FcRn or other recombinant therapies could emerge that compete with plasma-derived therapies in Chronic Inflammatory Demyelinating Polyneuropathy (CIDP), which is a key indication for Grifols (CIDP is responsible for 20% - 30% of the IG market’s sales. Grifols’ Gamunex-C has high market share / had orphan drug status for this indication until 2015)
    • Like the Vertex VX-814 concerns, these too are very early stage and would take a very long time to come to market. M254 expects to start Phase II trials and Argenx expects to deliver a Phase II data update in 2021
    • It is important to note that IG volumes utilized for each treatment of CIDP is double that of PI treatments. Recombinant therapies have a poor track record of regulatory approvals and efficacy as a treatment for diseases that require large amounts of proteins (such CIDP and Alpha-1)
    • I have also had several discussions with doctors, who believe that CIDP is a poor candidate for FcRn and gene therapy treatments. FcRn receptors don’t play a major role in CIDP’s mechanism (which is largely unknown) and it is a very heterogenous disease. Given many potential pathways and a constellation of symptoms, CIDP is a poor gene therapy candidate. This characteristic makes it extremely difficult to even design a sound CIDP clinical trial, demonstrate measurable superiority, and interpret the results. You can segment patients by their clinical state, but this is inherently subjective and physicians are risk-adverse, especially with auto-immune patients who already have an established, safe, and effective treatment protocol

Valuation

I’ve sliced and diced this in different ways (including a SOTP, which I won’t discuss here since the business won’t be broke up and sold) and think it is difficult to get impaired.

• Downside Case: Assume Vertex’s VX-814 is approved at the end of 2023 and Grifols’ Alpha-1 revenue immediately goes to zero in 2022. I assume YOY revenue growth of 5% in 2021, -9% in 2023, and 7% p.a. every other year through 2024. GM ranges from 39.5% - 45%, EBITDA margins 23% - 27%, and I arrive at a 4% - 7% IRR.
  • Returns are primarily driven by net leverage declining to ~2.0xI assume an “exit” multiple of 15x LTM EBITDA and 25x earnings in all scenarios
• Conservative Base Case: 5% YOY revenue growth in 2020 and 7% p.a. through 2024. GM% range from 43% - 47%, EBITDA margins range from 26% - 29%, and track to a 17% - 18% IRR
  • These are lower than consensus projections
  • Even if I project out to 2026 and assume that Grifols’ Alpha-1 business abruptly goes to zero (which as discussed above, I believe is still unlikely), I project a ~10% IRR
• Upside Case: 5% YOY revenue growth in 2020 and 9% p.a. thereafter, GM% ranges from 45% - 51%, EBITDA margins range from 28% - 33%, and I arrive at a 23% - 24% IRR

Free Options

• Alzheimers – Building on Grifols’ deep experience in treating neurological disorders with plasma proteins (Gamunex was the first IVIG therapy approved for a neurological disorder, CIDP) also has a deep background in using Grifols’ early studies using a combination of plasmapheresis, albumin, and IG to slow Alzheimer’s in moderately-severe patients (AMBAR) have been promising. These therapies are obviously already approved for other indications, with a well-established safety record, and a benign side-effect profile. Alzheimer’s currently has no approved treatments and the market for moderately-severe patients under the AMBAR protocol is ~€22 billion and expected to double over the next 10 years (~€16.5 billion annual revenue opportunity for Grifols via its 75% ownership of Araclon, versus total Grifols 2019 revenue of ~€5 billion). Furthermore, given that worldwide supply of albumin and IG is limited and largely keeping pace with existing demand, if AMBAR were to become either approved or widely used off-label, albumin and IG prices are likely to significantly increase, providing a strong tailwind to Grifols (and the rest of the plasma industry)
  • Grifols will likely initiate a phase III AMBAR trial in 2020 with more optimized protocols with likely updated data in 3 – 5 years. However, it is also possible that the American Psychology Association / American Society of Apheresis could approve the AMBAR protocol for off-label use after the AMBAR data is published in a peer-reviewed medical journal (I expect publication in 2020)
  • I think it is reasonably likely that AMBAR will be approved for off-label use for Alzheimer’s (progressive, debilitating, most expensive to treat disease in the country, that doesn’t have a cure). Plasma exchanges such as the one proposed under the AMBAR protocol are widely used as a first-line treatment for several neurological conditions and have benign side effects that have been well-tested and tolerated by patients for several decades
    • https://www.grifols.com/en/view-news/-/news/results-of-grifols-ambar-clinical-trial-published-in-alzheimer-s-dementia-the-journal-of-the-alzheimers-association
    • https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7272580/
    • https://www.alzforum.org/news/conference-coverage/going-indirect-can-therapies-halt-alzheimers-outside-brain

• COVID – Covalescent plasma is currently one of the only off-label and well-tested treatments for COVID (this treatment process dates back to the 1800s) and Grifols is leading production of an anti-COVID H-IG in collaboration with the FDA, NIH, and BARDA. Grifols delivered the first batch of this H-IG for clinical trials in late July
  • Everyone has their own opinion here, but I think it is unlikely that a COVID vaccine will be approved, manufactured, distributed, and accepted / adopted at scale by the public throughout the world by the end of 2021
  • Grifols will benefit from providing H-IGs to healthcare workers, government officials, high-risk patients, and others in order to “bridge” to worldwide vaccination. Grifols is in a better position to benefit from COVID than other plasma producer given its FDA / NIH / BARDA collaboration, safety record, and large amount of spare N. American capacity fractionation capacity from their heavy 2014 – 2019 capital investment program
  • H-IG development is low-risk / probability when compared to vaccine development. Grifols’ H-IG development process is proven and has produced H-IG for public health emergencies in the past (e.g. Ebola) versus vaccine mechanisms and development processes that have never been approved before (e.g. Moderna)
  • 25%+ of Grifols U.S. collection centers location are located in current COVID “hot spots” of California, Texas, and Florida which may be advantageous to procuring COVID antibodies for a COVID H-IG cocktail
  • Grifols is also running trials for using Prolastin to treat COVID patients. Prolastin is known to be safe and has a strong track record as a powerful anti-inflammatory that protects the lungs
•  Additional Margin Expansion
  • Lower Collection Costs – I would not be surprised by COVID leading to a large pool of previously untapped / unwilling donors (e.g. high earners, etc.), especially if this crowd starts boasting about their donation and helping others on social media platforms, which would drive higher revenue and lower collection costs. It seems this has already started (see https://thefightisinus.org/en-us#home, https://www.usatoday.com/story/entertainment/celebrities/2020/07/30/bryan-cranston-had-covid-19-now-donating-plasma-help-others/5551095002/, and https://ec.europa.eu/commission/presscorner/detail/en/STATEMENT_20_1062)
    • Furthermore, if there is a prolonged period of economic / employment weakness or higher inflation, collection costs are also likely to decline (as they did during the financial crisis years when Grifols could pay donors less while still procuring enough plasma to meet demand)
    • The federal, state, and local governments are beginning to promote the importance of plasma donation, it seems reasonable to believe this could become our generation’s “Uncle Sam Wants You” campaign that could drastically lower Grifols’ customer acquisition costs https://www.whitehouse.gov/briefings-statements/president-donald-j-trump-promoting-safe-plasma-donations-protect-americans-defeat-covid-19/ and https://www.fda.gov/emergency-preparedness-and-response/coronavirus-disease-2019-covid-19/donate-covid-19-plasma
  • Operating Leverage – Even where I consider some margin normalization / re-rating, my assumptions pail in comparison to CSL’s 55% - 57% GM%. No matter what scenario you consider, margin expansion will continue to be a source of incremental future value as Grifols grows into its existing collection and fractionation capacity due to secular tailwinds and inframarginal protein demand outpaces IG demand
  • Price Increases – My research points to most of Grifols’ historical growth coming from volume growth rather than price increases; plasma-derived therapy prices have lagged drug price increases historically and a reversion closer to drug price hikes could add meaningful incremental earnings power
• New Product Releases – Xembify is Grifols’ 20% concentrated SCIG product for PI (the SCIG market is growing ~20% p.a., PI uses of IG is growing ~11% p.a., SCIG products command a 20% - 30% pricing premium to IVIG, and SCIG treatments require more IG per dose). Vistaseal is also a unique product with high margins. TAM for both products is likely in excess of €1bn
  • Grifols is also developing a treatment for anti-biotic resistant diseases that can be manufactured at extraordinarily high incremental margins (raw material is a protein fraction from the Gamunex process that is currently discarded)
  • Grifols has a Phase III trial underway for double dosing Prolastin for a large subset of the Alpha-1 patient population, which could lead to a very quick and large ramp in profitability if approved (and margin expansion)
• CSL’s SCIG product for CIDP Indication Loses Orphan Drug Exclusivity in 2025 – Grifols’ Gamunex-C was the first IVIG product for CIDP / nuerological conditions (had Orphan Drug Exclusivity through 2015). Grifols can create a SCIG formulation of Gamunex-C or a new brand to compete in the SCIG market for CIDP beginning in 2025
• Higher European Collection Center Productivity / European Plasma Policy Shift – Europe is may change their regulatory approach to plasma collection through a combination of allowing a higher frequency of annual donations and increasing donor compensation due to the structural plasma deficit that the continent runs with the U.S.
• Other International Growth – I have not assumed a big upstart in growth from Grifols strategic alliance with RAAS. Grifols currently can only sell albumin in China (LDD – MDD growth) and the RAAS alliance opens China’s IG market, which is growing MDD – HDD. I also have not included the potential Saudi Arabia JV or any other potential transactions / alliances
• Bolt-On or Transformational Acquisitions – Grifols could execute additional bolt-on or strategic transactions, especially as leverage declines later in the hold period
  • Creat Group owns Biotest AG and BPL and has shown interest in combining their ownership with RAAS; Grifols may have an inside track increase its stake in RAAS or play another role in a transaction with Creat Group
• New Proteins / Indications – Grifols can test and seek approval for existing proteins / brands to treat new indications and the Company is also exploring several new proteins, although these are likely six to seven years from commercialization (but will exhibit high incremental margins due to last liter economics)

Risks

• I am wrong and one or more key products are displaced by novel treatments or my revenue / margin assumptions prove incorrect
• COVID causes a prolonged period of low collection volumes which hurt future inventory levels / sales starting in 3Q21 – 4Q21
• Manufacturing / quality issues or recalls
• SCIG takes significant share from IVIG – Grifols’ Ganumex-C is the market leading IVIG for CIDP and neurological indications. If these indications demand swiftly shifted to SCIG, it would hurt Grifols’ financial performance
• Decoupling of supply and demand – Degree of consolidation and vertical integration in the industry mitigates the risk of a sharp supply and demand disconnect. Only real risk I see is in China’s albumin market. A potential crackdown on China’s over-prescription of albumin could disrupt current supply / demand, but would be limited to China due to import / export restrictions. Furthermore, CSL is both the global and Chinese market leader in albumin and has the most exposure to this risk in the industry

Catalyst

- Clinical trial data / FDA and professional society clinical trial decisions and recommendations

- COVID treatment progress / announcements

- Better than anticipated plasma collection volumes / costs