Description

What’s the story? In a nutshell, we think PRGO is coming out of a multi-year period of pain, with 90% of its past issues resolved and the rest likely addressed in the coming months. By 2025, we expect the company's underlying earning power to emerge, likely leading to a re-rating in estimates and multiple. We see PRGO potentially generating about $3.5 in EPS in 2025, which at a low-mid teens multiple implies about $45 PT within the next 12 months. The downside seems limited to about 0-10% at most. As a side note, in June 2023, we visited the story and decided it was a pass due to the CEO transition (it had just been announced that the previous CEO, who joined in 2018, was leaving, and a search for a new CEO had started). We didn't want to get in front of the risks associated with a new CEO (resetting expectations, uncertainty about the new CEO's plan, etc). However, since we last looked at it, a new CEO was announced, and since then, he has delivered his first 2024 guidance, and as expected, tackled several issues head-on, reset expectations, and announced much-needed cost-cutting measures. Further details below.

Background:

• PRGO has gone through a lengthy transition over the last 6 years under the previous CEO Kessler (left June 2023). During this period, PRGO spun off their Gx business and some smaller divisions like Animal Health and LATAM operations in an attempt to become a pure-play OTC healthcare products manufacturer. The initial thought was that as a pure-play OTC business, PRGO would become a more stable, predictable business and would command a higher multiple due to the high-quality perception these businesses usually get (stable, defensive growth, while also being highly cash generative). In the process, PRGO also acquired several OTC businesses to strengthen its OTC portfolio.
• While this strategy made sense in theory, in reality the company faced many issues that led to stagnation in the stock and no value creation for shareholders since the previous CEO joined in 2018. So what went wrong?

1. What went wrong #1: Although transitioning to a "high-quality OTC healthcare business" seemed like a sensible strategy given the continued deterioration of the Gx business fundamentals over the last decade, most of PRGO's OTC business actually comes from white label OTC sales in the US (60% of EBITDA). In white label, you can't increase prices as freely as multinational brands can because a) you're expected to only raise prices after all branded players do, forcing you to absorb inflation for a while until you can compensate for it, and b) you're mandated to stay about 20-30% cheaper than brands, while your large customers (WMAT, TGT, AMZN, COST) always try to push back and widen this discount, putting pressure on margins. These dynamics make PRGO’s business pretty vulnerable to inflation cycles, so obviously the inflationary past several years were rough for them. This point was further validated when we recently spoke to a former executive at PRGO who was in charge during the Covid days. During our convo, he mentioned that back in 2020-2022, many believed inflation would be transitory, making it difficult to pitch significant price increases to the Walmarts of the world. As a result, they chose to not adjust their pricing much in 2020-2022. Ultimately, while some inflation proved to be transitory, a significant portion wasn’t. This situation led PRGO to lose about 300bps of OPM between 2019-2022. They have only recently started to take pricing actions to recoup this lost margin.
2. What went wrong #2: Financial leverage - At the start of 2022, as part of its move towards a pure-play OTC position, PRGO made a significant all-cash acquisition of an OTC company in the EU, increasing its net leverage from <3x to almost 7x. Although increasing leverage so much seemed (sort of) sensible at the time, because EBITDA was perceived to be just temporarily depressed (a result of COVID’s “temporary” inflationary period), it soon became clear that recovering EBITDA/FCF to normalized levels and reducing leverage would take much longer than expected. The reasons for the slower EBITDA correction and therefore the slower deleveraging were a) the prolonged time it took for the company to push pricing (still an ongoing effort) and recover margins and b) the unexpected turmoil in the infant formula industry in the US (in which PRGO is a major player) in 2022, which negatively affected and is still affecting PRGO’s results. -------The bottom line is that PRGO’s sustained depressed results have significantly slowed the deleveraging efforts, and left the balance sheet impaired at about 5x leverage until this day-------

What's different now?

1. Margins: PRGO started to push pricing/GM/OPM upwards in 2023 with a 120bps y/y improvement in OPM. While this is a positive development, OPM is still about 200bps below pre-covid levels and as a long way to go. From discussions with former employees and mgmt’s public comments it appears that PRGO is now able to intensify its pricing efforts because a) all brands have already implemented major price increases, allowing PRGO to commence pricing actions as well; b) the discount to brands now exceeds the usual 20-30% mandate, giving PRGO stronger negotiation leverage in raising prices; and c) the widespread acceptance among their customers of persistent inflation facilitates higher pricing. As margins and EBITDA normalize, financial leverage should naturally decrease which in turn would lower the cost of equity/push upwards equity multiples.
2. New mgmt ripped the band-aid off Infant Formula issues, which ignited 4Q23 selloff, but prob puts to rest issues around this side of the business LT. As PRGO puts infant formula issues behind them and returns to generate more normalized earnings from this business, we expect sentiment to improve significantly. Some background:
   1. After Abbott’s recall in 2022, the FDA tightened manufacturing standards for infant formula across the industry, and in the beginning of 2023, issued strict new manufacturing measures that exceeded existing standards.
   2. PRGO attempted to meet the stricter standards in 2023, but their efforts fell short, resulting in two FDA warning letters in August and November 2023. Former employees revealed that the infant formula plants are outdated and significantly below FDA's new requirements. Significant investments were needed for upgrades, which the company previously avoided due to the essentially zero ROI that could have negatively impacted the stock price when disclosed to shareholders. So basically, unlike Abbott, a much larger company that could easily absorb these zero-ROI investments into their overall budgets (and effectively hide them from shareholders), PRGO faced substantial and challenging investments that were difficult to conceal.
   3. However, receiving a second warning letter from the FDA in November '23 served as a wake-up call for new mgmt, highlighting the need for significant changes in the facilities. PRGO announced a major overhaul of the infant formula facilities in Q4 2023, involving downtime for several months, increased OpEx & CapEx for sanitation and new equipment, alongside hiring outside consultants for the revamp. This overhaul is expected to impact FCF by approximately $190mn this year, with costs allocated to CapEx, one-off CFFO effects, and lost operating income from idle plants in the first half.
   4. As of now (end of Q2 2024) PRGO has finished fixing the three facilities and they’re up and running and ramping up production. Mgmt has been pretty vocal about getting back to normalized run rate in infant formula by 4Q24.  
3. New mgmt announced a significant and well needed cost-cutting plan: this plan should contribute about annualized $100mn to the EBIT by YE2024. As part of this plan, they’re going to lay off about 6% of the headcount, which should alone contribute $40mn in savings. From discussions we had with former employees, there is a lot of fat to cut in PRGO, and the blueprint for this cost-cutting plan was ready for several yrs now, but was never executed upon given the consistent disruptions that kept mgmt busy (COVID, infant formula issues, sale of Gx business, acquisition of OTC businesses, Ireland tax issue). This plan should be a relatively low-hanging fruit to grab and should help PRGO possibly reach an all-time-high EBITDA margin in 2025.
4. PRGO is a dog, with perception/sentiment at all times low: Historically one of the biggest problems of PRGO was delivering consistent results, with every year a new problem emerging, the latest one being infant formula issues. This ongoing problem has pushed the company to trade at a steep discount to the market while fundamentally it should trade in line/premium to the market multiple, as it has a higher quality business vs the S&P500 avg company (more defensive/stable, higher ROIC). As they put to rest financial leverage/infant formula issues, a change in perception could finally emerge which should help the multiple to see a re-rating.  

Bottom line – we see PRGO as a dog that is trading at a trough multiple on trough earnings. This could be a classic case of a company emerging from a very long period of turmoil/bad performance and slowly changing the market perception. Usually, cases like this are characterized with a very asymmetric risk/reward profile given the bear case has essentially become the consensus base case.  

EPS bridge this year/next year:

I/we have a position in the issuer’s securities. I/we wrote this article which expresses my/our own opinion. I/we are not receiving compensation for the article and have no business relationship with the company whose stock is mentioned in the article. The contents of the article are based on subjective viewpoints and may be incorrect and/or inaccurate, and actual results may differ substantially from those set forth, projected, forecast or estimated in the article. The article is for informational purposes only and should not be construed as investment, financial or any other advice.

Catalyst

Catalyst

1. Ramping up production volume quotas, EBIT ramping up.
2. Mgmt giving an above consensus 2025 guidance at the end of 2024.
3. Fin leverage moving down towards 3x.