Description

* Please note above valuation metrics are for the Class B shares

Thesis

Grifols S.A. (GRFS) is one of three major blood plasma derivative producers that is benefitting from both company-specific improvements and recent horizontal and vertical consolidation in the industry.  The simple case is that following GRFS’ 2011 acquisition of Talecris, the company is now a top player in an industry that should continue to grow in the high single digits, with an ability to expand margins to match industry peers (over 1,000 bps of potential improvement over the next few years), benefit from reasonable financial leverage, and generate strong free cash flow.  The combination of these elements should allow the equity value to compound at 30+% in the near term and 20+% in the long term.  In addition, the non-voting Class B/ADR shares trade at a 25% discount to the voting Class A shares despite identical economic rights, and the narrowing of this discount should produce additional stock upside.

The Market

Plasma is derived from human blood and is fractionated then purified into a series of components including immunoblobulin, albumin and a series of proteins.  These are used to treat a variety of medical conditions including bleeding and neurological disorders that are often treated chronically. The global plasma industry has grown approximately 7.5% annually over the past twenty years.  The main product is immunoglobulin (IG) which accounts for almost half of industry sales, followed by a series of other proteins which are also purified; GRFS sells significant amounts of Alpha-1, Albumin, Factor VIII and several smaller ones.  To be profitable, manufacturers need to sell multiple proteins from each liter of plasma they collect and fractionate(i.e. you cannot simply make IG and ignore the rest).  The industry is underpenetrated in many of the indications, implying the historic growth rate is at least sustainable.  Increasing emerging market penetration and new indications for these proteins will provide additional growth opportunities.  For example, there would be upside if plasma is proven to work in Alzheimer’s disease.  While we believe this is a low probability event (<20%) it would potentially triple the market size if it worked (Baxter will have Phase 3 data in 1H 2013).  GRFS and Talecris have historically grown at above-industry rates for the past five years, which we expect to continue and potentially accelerate.  

Currently there are three similarly sized players (GRFS, Baxter, and CSL).  They dominate the global blood plasma market, which had  thirteen suppliers 20 years ago.  These suppliers control 60% of the global market, over 80% of the more attractive North American market and have a significant cost structure advantage over smaller competitors.  The total market size was €10.2 billion in 2010.  Generally the industry view is that the market will grow 6%-8% in line with the historical rates noted above, excluding any major new indications – but notably Baxter has stated they believe the market is currently trending higher than this level. 

Over the last decade, the major participants also vertically integrated into the blood collection process reducing the risk of input supply/demand imbalances.  We view the vertical integration of the industry as critical to better industry structure; excess collections are no longer a risk in driving overproduction.  Furthermore this increases barriers to entry since only US collected plasma can be used in the US and many developed countries due to safety issues. 

The barriers to entry in the industry are quite substantial due to onerous regulatory requirements, a costly approval process for new facilities and customers’ preference to work with established suppliers.  To build an efficient de novo fractionation and purification facility would cost hundreds of millions of dollars. It would also take approximately 7 years from planning to actually having an operating plant able to sell product due to construction, FDA approval and then production startup timelines.  There is no significant excess or brownfield capacity that could easily be rehabilitated.  Beyond manufacturing hurdles, there are additional regulatory hurdles; a new producer would have to run trials and get the final products approved by the FDA. To make plasma profitable, several proteins need to be sold from every liter produced; this  requires coordinating the simultaneous sale of multiple proteins and makes the commercial aspect more difficult.  The existing incumbents have decades of safety and efficacy data on their products -- even though they are similar, they are not identical.  A new producer would have to sell at a discount and convince loyal doctors to switch, a significant additional hurdle.  The manufacturer would also have to get access to collections of FDA-approved blood plasma for their inputs – the supply of which, as noted above, is now controlled primarily by the top 3 producers and there is very limited additional supply.  Collections could be setup at additional cost, but this would take time to ramp up.  In summary, it would be a very long, difficult, capital intensive and risky path for any prospective new entrant to this business. The combination of vertical integration, industry consolidation and these high barriers to entry should lead to better pricing and returns for the remaining industry players in the coming years

Revenues

GRFS and Talecris both grew at above industry rates for the last several years and we expect these gains to continue and potentially accelerate. Combined, GRFS and Talecris sales grew at a 14% CAGR from 2005-2010.  This was due to a combination of industry growth, market share gains and recent disruptions in the supply chain.  We believe that GFRS can grow at or above the high end of the industry (8+%) with the possibility of even faster growth if pricing strengthens or new indications are proven successful.  There should also be substantial revenue synergies resulting from combining the two portfolios of products with their different geographic footprints.  This business should also prove to be resilient in weak economic times as it is driven by medical necessity.  While GRFS does have 9% of their sales in Spain (much reduced since the acquisition), Spain is an even lesser percentage of profitability, making this a manageable risk in our view.

Margins

The Talecris acquisition dramatically improved GRFS’ scale and creates the opportunity for substantial revenue and cost synergies.  GRFS’ operating margins were in the mid-20%s prior to the acquisition of Talecris, whereas CSL’s and Baxter’s plasma businesses reported margins in the mid-30%s.  Combining with Talecris should help GRFS eventually reach margins similar to those of CSL and Baxter.  GRFS has outpaced initial cost synergy guidance, and our analysis would suggest they may report cost synergies almost double management’s original guidance of $230 million, which would represent over 1,000 basis points of incremental margin.  Our work suggests that some low-hanging fruit was easily captured (IT leverage, SG&A reduction), and other benefits are just starting to kick in – with collection efficiencies improving (Talecris had a much higher collection cost per liter) and improving scale efficiencies in testing etc.  The larger opportunities will really hit in 2014 as the manufacturing is better integrated to optimize production efficiency and maximize sales of proteins.  Our analysis of the synergies on the cost side alone could be over $400 million. We note management recently increased guidance to over $300 milllion from $230 million previously.  Additional revenue synergies were not included in management estimates and could be significant.

We estimate that between revenue growth and margin expansion from synergies and operational leverage, EBIT should grow 20+% for the next few years.  Reasonable financial leverage (28% of TEV is debt) and sensible redeployment of capital should further enhance returns leading to substantially higher EPS growth.

Balance Sheet

Currently the capital structure is 28% debt to TEV and management has committed to reducing debt/EBITDA to a target of 2-2.5x from about 3.5x currently.  The company also has a stated desire to reinstate their dividend and we believe they are likely to pay a cash dividend in 2013.  Furthermore, the FCF generation should dramatically increase as earnings growth accelerates and the capex is reduced (they are currently finishing a major capacity expansion in Clayton that will give them sufficient capacity through 2020). 

Share Classes

The ADR represents a single Class B share.  This was established as part of the Talecris acquisition in order to provide dollar-denominated shares.  The Class B has the identical economic rights as the Class A but does not have voting rights (although can prevent any dilutive actions).  The Grifols family still controls approximately 40% of the Class A shares, suggesting limited additional value to the vote at this point as it would be difficult to override the family anyway.  The Class B shares trade at a >25% discount vs. the Class A that we don’t believe is merited.  We believe this discount is driven by three factors – overhang from Cerberus exiting ADRs, lower liquidity vs. class A shares and more limited voting rights.  We believe the first two factors will improve over time as Cerberus exits and liquidity improves.  As for the voting rights- we evaluated other Class B shares – and we found that this Class B share has better rights, and yet still has bigger discount than most other dual class structures. The company intends to issue a cash dividend as soon as the debt is reduced (possibly as soon as 2013) which will create a yield difference in the two classes of shares and probably cause a reduction in the spread.

Valuation

Based on our 2013 estimates the Class B shares trade at 13.5x EPS and 9.5x EBITDA – which we believe is very attractive for a company that should grow its bottom line almost 40% next yr and 30% the following year – with attractive long-term prospects (20+% EPS growth) due to the recent re-shaping of the industry.

Risks

Product recall risk: this is a low probability, but high impact risk.  This would be due to an issue in collection or manufacturing - and has happened to a smaller competitor recently (Octapharm).  GRFS has never had a major recall and has put in substantial safeguards including specific tracking of each liter of collected plasma through their entire process.  Importantly they can isolate any risk pretty quickly and limit the breadth of any issue.  We also think the FDA would work closely with the company due to their large market share and tight supply conditions in the industry.

New virus risk: the emergence of a new blood-borne virus could create an industry-wide issue, but the screening processes now are much more sophisticated than they were then years ago, and GRFS now inventories the plasma for a much longer period of time prior to sale to safeguard against this.  We note they were able to manage the West Nile virus with no issue at all.

Spain risk: as noted above, they have 9% of their sales in Spain and are incorporated there.  We have gotten comfortable that they would be able to manage a Spanish exit from the Eurozone in the worst case scenario.

Pricing risk: in Europe, pricing has been under pressure due to fiscal austerity.  They have diversified away from Europe, and pricing is now reaching a level where smaller local players can’t make money, suggesting that we are close to a bottom.  Supply constraints and industry consolidation should prevent significant pricing pressure in the US.

Technological obsolescence risk: there is always a risk that new alternative therapies could emerge.  However, GRFS’ key products (IVIG, Alpha 1 and albumin) cannot be made synthetically.  They also tend to be used for a wide variety of indications, so any given indication does not drive a disproportionate share of their revenues.

Conclusion

We believe the combination of potentially accelerating industry growth, market share gains, material merger synergies, operating leverage, financial leverage and increasing free cash flow should drive equity value compounding of over 30% annually for the next few years and over 20% longer term after synergies are fully realized.  Furthermore, exposure to the non-voting Class B ADRs creates an additional discount of over 25% to the Class A shares despite having the same economic rights.  This discount should narrow over time providing additional returns to the position.  GRFS is a very good and improving business currently selling at a highly attractive price.

Disclaimer: Alan579 had long exposure to GRFS at the time of publication 8/7/12.  Alan579 has no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation.  Alan579 makes no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation.  Alan579 expressly disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation.

Catalyst

• Realization of greater than expected synergies over next several quarters
• Higher than industry growth rates from share gains, pricing strength
• Cerberus share liquidation to reduce Class B share discount
• Re-institution of cash dividend