Description

We look for leading assets and brands globally that are undergoing dislocations and have operating potential that the market is missing. In these situations, investor fatigue and complexity tend to keep people away. We believe PRGO equity is worth over $92 versus its current price of $48.80. The following is an overview of the idea. 

Perrigo (“PRGO” or “the Company”) is one of the world’s largest manufacturers of store brand over the counter healthcare products. The scope and dominance of Perrigo’s manufacturing is misunderstood – it is an underappreciated fact that the Company sells more Ibuprofen than Advil and more Acetaminophen than Tylenol. Retail partners view their OTC store brands as a real source of profit margin and customers benefit from being able to purchase identical products at 30%+ discounts versus branded peers. The Company is undergoing a dislocation as a result of several factors discussed below. Most notably, Perrigo’s historical emphasis on rapid expansion, distracted from the core business. We’ve identified one business unit in particular that has been causing the most trouble operationally (Infant Nutritionals). Given investor fatigue in the name, this is something that the market is neglecting and will start to show a dramatic inflection in the near term and furthermore has continued growing through Covid and the core capabilities of the business have strengthened. 

Under the leadership of Perrigo’s newly appointed CEO, Murray Kessler, PRGO equity has +100% upside looking out 2 years. The market views Perrigo as a “healthcare” company today – this misconception results from the fact that the Company owns a generic pharmaceuticals business which will be sold in the next 12 months (remainder of the business will be “consumer selfcare”. Given that the market is negative on all things related to generic pharma today, this has weighed on the stock’s multiple and skeptics question why the segment wasn’t sold in 2019 (as per prior management’s target). I view this as a positive. There are signs that generic valuations are actually going to start rising (Teva’s recent comments indicate improvement) and MK’s decision to be patient with the sale, while a disappointment to the market, is a sign of discipline and will result in greater deleveraging. Management will take the business through a rebranding at the end of which Perrigo will both improve operationally and trade at a more appropriate consumer valuation.

Looking forward, the capacity to deleverage is enormous. Perrigo will sell or spin the RX business for $1.5-2B (current total debt is $4.1B and the remaining consumer health business will generate $880+ in EBIT). Perrigo is also highly cash generative and over the next 3 years will conservatively generate $900MM in cumulative free cash from non RX segments + already currently sitting with $1.45B of cash on balance sheet. Net of deleveraging, we are creating the equity at only 6x EBIT / <10x earnings. This is too cheap for the world’s most dominant manufacturer of store branded self-care products and reflective of overhang from generic pharma. The Company will start to trade more in line with consumer healthcare peers which trade closer to 22x earnings. Even if we look at this on a consolidated basis, PRGO equity is trading at 10.5x consensus 2022 earnings and is indicative of the fact that the market is underwriting zero margin growth in North Americas and no credit for deleveraging. In a highly conservative scenario, PRGO equity is worth $97 (100%+ upside from today). Looking out longer term, the return profile improves even more as the Company will use its cash flow to take advantage of a landscape of poorly capitalized/distressed OTC consumer companies (ie. PRGO recently bought oral care assets from High Ridge Brands out of bankruptcy).

Sources of Mispricing and Catalysts:

1.  Perrigo looks like a declining business on paper

The market’s inability to disaggregate recently divested divisions within PRGO’s segments has created the misperception of declines. As the Company started divesting less profitable divisions (animal health, VMS, etc..), consolidated sales have declined, but on a unit level, the Company is actually showing volume growth across all major verticals. In North America, cumulative sales have fallen 5% from $2.5B in 2016 to $2.39B in 2019. Investors mistakenly view this as a symptom of competitive pricing dynamics that the broader industry is facing. However, the following breakdown illustrates the extent to which core Perrigo categories have been growing (despite negative pricing, discussed further below), and growing overall top line. Once we disaggregate the Animal Health and VMS businesses that were divested, the business grew top line +4.5% through a period of deflated pricing and mismanagement that neglected to focus on product development and innovation. I believe that Perrigo’s problem area in North America lies in Infant Nutritionals. In this segment there are operating levers that can dramatically boost sales over the next two years. 

2. Operating declines at “Infant Nutritionals” are fixable

There are only four companies that are allowed to manufacture infant formula in the US. The domestic market generates roughly $6B in sales and has a unique barrier to entry. The market thinks that nutritional supplement products are commoditized, but a startup would have to invest $300-$500MM to build their facilities as well as make investments in required clinical studies for all their formulas for both routine and specialty products (a $1B+ endeavor). As a result, the market has steadily remained dominated by four large participants. In recent years Perrigo saw a dramatic drop in sales for Infant Nutritionals ($423MM in 2018 revenue to $373MM in 2019). Over the years, as Perrigo was growing, it neglected to continue investing in the segment and ran out of manufacturing capacity. MK plans to invest $200M in capacity over the next three years. Furthermore, there are two temporary factors that resulted in the near term decline: a contract packaging inventory issue and retail disruption from a product recall. Both of these have already subsided and as indicated, will show strong growth in the upcoming quarters with continued wins from retail partnerships.

3.  Problems at Perrigo are misunderstood and create opportunities for growth

Perrigo is facing a number of challenges today which create significant opportunity. These challenges are a result of distraction, shifts in leadership and direction and a rapidly changing external environment that was not addressed. The market looks at the following challenges as reasons not to invest, BUT each of the following will actually create the greatest opportunities for Murray Kessler to exploit. For an overview, please refer to the following appendices.

• Less RX to OTC Switches in today’s environment
• Innovation
• Adjacencie
• Ecommerce

Appendix A: Diagnosing the Problems in Perrigo’s North America Business

Perrigo spent the past decade making acquisitions. Since the 2000s, the Company went from generating $750MM in revenue to nearly $5B today. However, over the past 5 years, Perrigo’s growth has come to a halt.

CSCA (North America):

In North America, from 2009 to 2015, there were three major categories of growth (RX to OTC switches, innovation and bolt on acquisitions). These three categories contributed most of the top line growth during the period.

Sales were compounding at a 9% CAGR from 2009 to 2015. Then 2015 came along and things started to turn the other way. Over the three year period following, the Company compounded sales at a negative rate. Sales from innovation fell from $395MM to $55MM and bolt on acquisitions completely vanished as the Company was left with years of undigested growth. In the absence of innovation, in negotiations with Perrigo, retail customers began demanding concessions given the lack of new product offerings. However, during this period, unit volume grew faster than revenue due to price contraction. Perrigo was losing its ability to price in consumer store branded products. This is not a symptom of competitive dynamics (PRGO retail customers are actually leaning into the manufacturer more heavily than in the past), but was a result of no new products or adjacent offerings (discussed below).

The key of it is ramping innovation back up and starting bolt on acquisitions again. Because I can’t emphasize enough, when I go into companies that turn around, I believe that the best way to make that happen is not try to take tired brands and rejuvenate them, but to take companies that have had structural problems with great brands and get rid of or simplify around them and get them going. And Perrigo today remains a great company with growing categories. With all of those factors that I said that existed for growth, with the exception that we’ve let the innovation engine bleed out on us over the past few years as we focused on other places. But the categories we compete in are all still growing. Murray Kessler, 2019 Investor Call

Appendix B: How MK is repositioning Perrigo for growth

There are a number of discrete actions that management will execute on in the near term to reposition the business. Since joining the Company in 2019, Kessler is already proving to be aggressive about each.

“I came on board with the belief that by focusing on the initiatives that matter most, namely a reallocation of Perrigo’s vast resources, the sale/ spin of RX, and the upgrade of certain skill sets and investments in technologies, we will be able to return Perrigo to its rich history of strong performance and creating shareholder value. Having reinvigorated companies before, I know it will take some time to put in place a clear, consumer-based, strategic plan that will generate long-term, sustainable, and reliable growth. While we are doing so, we will remain cognizant of the near term and pursue actionable initiatives to drive meaningful progress” 2019 Investor Presentation

1. RX to OTC Switches

Perrigo benefited from a robust number of RX to OTC switches / patent expirations over the past decade. In recent years, the pace of switches is slowing down. Management is now moving in a new direction to use cash flow to acquire rights to OTC brands before they come off patent and for the first time, Perrigo is no longer waiting around for these sorts of opportunities to come to them. This represents a strong shift in focus.

As evidence of this new strategy, Perrigo acquired exclusive rights via a licensing agreement with Merck for Nasonex which is currently available as prescription only. Annual prescription branded and generic market sales for the 12 months ending June 2018, were approximately $214MM. Perrigo paid $50MM for the rights to manufacture the OTC version. The product will come to market in 2022 and gives Perrigo a first mover advantage with an innovative store brand product equivalent to Nasonex. On a recent call Murray said: “We’ve already been approached by 6 or 7 other companies to do the same thing, because there’s a lot of pharma companies out there that have sold off their consumer divisions.” Since then, Perrigo has kept up the momentum and moved to acquire rights to Prevacid OTC from GSK (see Appendix C).

2.  Innovation to drive pricing

Perrigo’s lost focus on innovation has come at the expense of new product introductions and ultimately a decline in pricing power. From 2010 to 2012, 5% of volume each year in North America was from new product launches and organic innovation. The following two years, new product sales dropped to 2% and rebounded slightly the following two years. Perrigo’s innovation is not a function of absolute R&D spend, but driven by productivity. The Company’s total spend on R&D is roughly consistent (but was getting spread across more initiatives) despite the fact that new product revenue continued to decline.

Perrigo’s old way of innovation was driven by ANDAs and subsequent national brand equivalents (NBE) from brand name drugs that rolled off patents and went into OTC. In today’s environment of fewer switches, Perrigo management will focus less on national brand equivalents and instead on NBBs which won’t require an NDA or ANDAs.

3. Adjacent profit pools (new areas: CBD, oral care, etc…)

Perrigo has the opportunity to participate in adjacent profit pools through organic entry and bolt on acquisitions to accelerate growth. Adjacencies have been a growth accelerator for Perrigo in the past, but the company lost focus on this and invested elsewhere. The best example of this is Nicotine. In 2005, Perrigo entered a partnership agreement to market OTC nicotine and today has 90% share of the store brand market and 55% of the total market. The product currently generates $490MM in sales and has grown at a 8.5% CAGR and is bigger than the Nicorette brand.

Infant formula does $350MM in revenue and grew at a CAGR of 6% and then Perrigo ran out of capacity. Over the next three years, the plan is to invest $200MM in capacity to upgrade infant formula to unlock latent consumer demand and exert pricing power through new offerings.

Vaping technologies have grown dramatically in the last 5 years. The FDA is asking now for a product that could be used for cessation management purposes in reducing the amount of nicotine consumed. This is an opportunity for Perrigo to participate and take advantage of pre-existing relationships and ANDAs in the space. CBD is another product in the space which is just starting to break into the OTC self care market. Perrigo recently signed a letter of intent on a joint development agreement with a vapor dosing technology company.

4.  Investment in Technology

Perrigo today suffers from a lack of investment in technology. Lack of data analytics and typical retailer brand dynamics (retailer hoards data) are holding back the Company. Perrigo has to go through IRI to get data on the store brand products it manufactures. This is a problem that management is focused on addressing and will change over time with investments that the business is making. 

Appendix C: Actions taken by MK since joining Perrigo in 2019

1.  Obtained rights to Prevacid OTC

As discussed above, PRGO is being aggressive in maneuvering a light RX-OTC switch environment and going out to create their own deals. Nasonex was one example of this. Similarly, in a recent transaction from September 2019, PRGO entered into a definitive agreement to acquire the branded OTC rights to Prevacid from GSK. Under the terms of the arrangement, Perrigo will have exclusive rights to market, sell and distribute Prevacid in the US OTC market.

2. Divested Animal Health

Animal Health did not fit in the consumer oriented vision for Perrigo. Was divested for $185MM in cash which was used in funding of Ranir acquisition

3.  Acquired Ranir

In 2019, Perrigo completed the acquisition of Ranir for $750MM. Ranir is the leading producer of store branded oral care products. The business had grown 11% annually for the past 10 years, but still suffers from a lack of distribution and store penetration is low. With Perrigo’s retail relationships, this business has the potential to monopolize the market with two strategic acquisitions that were made earlier (see below).

4.  Steripod / Oral Care assets of High Ridge Brands

In January 2020, PRGO acquired Steripod, a leading toothbrush accessory brand and innovator in the toothbrush protector market. In February 2020, PRGO then acquired oral care assets from High Ridge Brands in bankruptcy for $113MM in cash. Both of these acquisitions will further strengthen PRGO’s position in the oral care market.

Appendix D: Tax related special situation

In addition to the factors discussed above, the market is negative on Perrigo as a result of two tax related disputes.  This includes transfer pricing related to Athena Neurosciences, a subsidiary of Elan acquired in 1996. None of this is as relevant as the market thinks. The Company is in the process of disputing these issues and the impact will be negligible. Perrigo disagrees with both the basis on which Elan has been assessed and the methodology used to calculate the amount set out in the NoA. The 8k states that “Perrigo firmly believes that the NoA is without merit and that Irish Revenue’s position is incorrect as a matter of law. Perrigo also believes that, based on applicable case law, Irish Revenue’s published guidance on what constitutes a trade for Irish tax purposes, and related published precedents, Elan Pharma’s tax returns were filed correctly. For approximately 20 years, Elan Pharma has consistently filed its Irish corporation tax returns on the basis that it was carrying on a trade of acquiring, developing, holding, exploiting, dealing in and disposing of intellectual property rights and licenses for use in the pharmaceutical industry. Perrigo can point to numerous examples of prior disposals of such rights where such treatment for tax purposes has not been disputed by Irish Revenue. Accordingly, Perrigo will appeal the NoA and will pursue all available administrative and judicial avenues as may be necessary or appropriate.”

Catalyst

-  Divestiture of generic pharma and transformation into pure play consumer business

-  PRGO will generate $900MM+ of cumulative lfcf over the next three years. No one is talking about capital allocation

-  Excess cash will be used to acquire distressed operators in the consumer pharma space

-  Operational improvements will drive growth and margin improvement at CSCA