Description

Procaps Group: Leading LatAm Pharma Company at an Inflection Point with 80%-100%+ Potential Upside

Procaps Group (Procaps, or the company) is a leading, innovative, high-growth pharma company headquartered in LatAm. It has been in existence for 45 years, producing and marketing pharmaceutical and consumer healthcare products with customers in 50 countries across 6 continents. The company had ~$410mm in revenues and ~$70mm of EBITDA in 2022. After a strong 3-year run, Procaps experienced a perfect storm of adverse events in 2022/2023. It appears to be close to an upward inflection, and we see 80-100% potential upside. (Please see Disclaimer below)

 Summary Investment Thesis:

·        Beneficiary of Three Secular Growth Tailwinds: 1) Latin America & Caribbean region, its primary market, is the least penetrated and fastest growing pharma market globally, at 8% CAGR (’18-’22) 2) Long-term trends towards outsourcing of drug manufacturing, as CDMOs (Contract Development and Manufacturing Organizations) are increasingly taking production share, and 3) LatAm’s population is aging and is increasingly getting healthcare coverage.

·        Industry Leader: Procaps is the largest integral CDMO in Latin America. It is one of the top 5 firms globally in terms of softgel production capacity offering a deep portfolio of patented, differentiated oral pharma products.

·        Innovative, Diverse Portfolio of Products and Strong IP: The company has hundreds of products in its markets, having received 200+ drug registration approvals as of December 2022, with another 170+ pending. Its diverse portfolio is protected with 40+ patents and 5,000+ trademarks. It employs 300+ research scientists and technicians, spending 4-5% of sales on R&D annually. The company’s growth plans are focused on treating chronic conditions which provide a certain level of revenue recurrence.

·        Superior Quality, Yet Lower Cost of Operations: Procaps has state-of-the art facilities, well-integrated with its customers in terms of software and logistics. Quality of manufacturing is key in this industry, and Procaps is one of the few LatAm CDMOs that has received FDA approvals. In fact, it owns the first FDA-approved manufacturing facility in LatAm and has received multiple approvals from other healthcare regulatory agencies. Its LatAm location affords it a low cost of operations vs. other global peers.

·        Founder/Owner/Operator company: the founding Minski Family owns ~60% of the shares and has been involved in management of the company since its inception in 1977.

·        Experienced, Well Incentivized Board: Members of the board and their representatives own another ~16% of the shares and have one of the best operational and monetization track records in the LatAm pharma industry. Insiders in total own ~85% of the shares.

·        Solid M&A Growth Opportunity: The LatAm pharma and global CDMO industries are quite fragmented. Valuations have reset, allowing for attractive accretive inorganic growth opportunities.

·        Strong Historical Growth Record and Cost Cutting Efforts: During 2019-2021, the company registered strong top line growth (13%) and adj. EBITDA margins in the mid-20s%. During 2022/2023 it got hit with multiple adverse events, which appear to be normalizing. The management has several organic and inorganic levers to pull to return to historical trends, including a recently announced cost-cutting program and new pricing strategies.

·        Close to a potential Inflection Point: Recently restruck debt covenant agreements, point to an inflection in EBITDA. The 2022/2023 headwinds appear to be normalizing and insiders have vowed not to sell any shares through 2023, unless they appreciate another 150%+ from current levels (i.e., $10). The management has established 2026 / 2027 goals of reaching $1bn in revenues and $250mm of EBITDA, a significant increase from current levels.

·        Heavily Discounted Valuation. Despite attractive prospects, the company is trading at a substantial discount to CDMOs and Pharma Companies despite lesser growth. We see 80-100% upside at peers’ valuation metrics.

·        Catalysts: 1) Recovery of Revenue Growth and Margins, post recent inventory build-up, cost cutting efforts and price adjustments/supply chain disruptions (likely by Q4/end of 2023), 2) Production launch at Florida Factories and new product offerings (likely in early 2024), 3) FCF generation and debt paydown (2024-2025), 4) increase of stock liquidity via greater investor marketing or potentially conducting a warrant exchange or an equity financing to de-lever balance sheet (likely in 2024), 5) Accretive M&A (likely in 2024), 6) Stock rally in the “Forgotten Corners of the Market”, i.e., Emerging Markets and Small Cap Stocks should provide a boost to beaten down shares like Procaps, 7) normalization of the US Dollar strength vs. LatAm currencies as we approach the end of FED rate hikes.

 Business Description:

Procaps is a leading global pharmaceutical company focused on the development, manufacturing, and commercialization of innovative and differentiated pharmaceutical and nutraceutical solutions, medicines and hospitals supplies. Founded in 1977, by the Minski Family, the company is headquartered in Barranquilla, Colombia, and has direct presence in 13 countries – Colombia, Brazil, El Salvador, USA, Peru, Costa Rica, Guatemala, Honduras, Equador, Bolivia, Panama, Nicaragua, and Dominican Republic. Procaps exports its products to customers in over 50 countries worldwide across 6 continents.

 Products and Services:

The four categories of products that Procaps offers are: 1) NextGel: Contract manufacturing of healthcare products for third-party pharma companies, e.g., CDMO 2) Farma / Clinical Specialty: Branded Prescription (Rx) drugs and hospital supplies 3) VitalCare: OTC consumer healthcare products, and 4) Diabetrics: diabetics products and services. The company reports its segments with an emphasis on geographical regions and not by product category as presented below.

1.      NextGel (iCDMO Division): Procaps produces softgels, gelatin coated tablets and gummies for third party pharma companies, i.e., it acts as a CDMO for other healthcare businesses. Its key product here are softgel capsules, which encapsulate liquid, paste, or oil-based formulations within an outer soluble shell. They are used in a broad range of consumer products including Rx drugs, OTC medications, dietary supplements, unit-dose cosmetics, and animal health products.

Ø  Procaps is the top producer of softgel capsules in South and Central America and a top 5 in the world. It competes with companies like Catalent, Aenova, and Patheon.

Ø  The NextGel Division generated $125mm of sales in 2022 (31% of total sales) with a ~41% contribution margin.

Ø  This division launched more than 50 new products in 2022, 49 in 2021 and 45 in 2020 targeting analgesics, skin care, hormonal, feminine care and food/supplements.

Ø  The client roster of this division is populated with leading global and regional pharma / consumer healthcare companies with c. 10-20 years’ long average relationships (see table below).

2.      Farma Procaps and Clinical Specialties (Branded Rx Drugs): Farma Procaps formulates, manufacturers and markets branded prescription drugs. It represents a high growth proprietary portfolio that focuses on nine therapeutic areas (feminine care, pain relief, skin care, digestive health, growth and development, cardiology, vision care, central nervous systems, and respiratory).  Clinical Specialties is a leading provider of high-complexity care treatments, making and marketing personal protective equipment and hospital drugs like antibiotic, blood clot, immunosuppressants, oncology and analgesic products.

Ø  The Farma Procaps and Clinical Specialties division derived 18% of its sales from new products in 2022. In 2021 the same metric was 21% - indicating a relatively high level of new product innovation.

Ø  Over the last three years, the company has received approvals for 65-75 new Rx Drug applications per year across its 13 direct presence markets in Central and South America.

Ø  The key competitors for this segment are Abbot, Bayer, GSK, Sanofi, Genfar, Lafrancol, and La Sante Pharma.

3.      VitalCare (OTC Consumer Healthcare Products): VitalCare develops, manufactures, and markets OTC consumer health products including antibiotics, anti-inflammatory, anti-parasitic, cardiovascular, feminine care, pain relief, gastrointestinal, hormonal, metabolic, CNS, endocrine, ophthalmic and diet/vitamin supplements.

Ø  The Rx and OTC divisions are lumped together in the reporting. Together, they generated ~64% of the total sales ($264mm) at a contribution margin of ~35%. 

Ø  The OTC VitalCare division derived 15% of its sales from new products in 2022. In 2021 the same metric was 12% - indicating a somewhat high level of new product innovation.

Ø  Over the last three years, the company has received approvals for 20-25 new OTC Drug applications per year across its 13 direct presence markets in Central and South America

Ø  The key competitors for this segment are major Pharma companies like GSK, Bayer, Pfizer, Sanofi, Genoma, and McKesson.

 4.      Diabetrics (Diabetes products): The Diabetrics Division develops, manufactures, and markets products and services targeting diabetics patients including blood glucose meters, telemonitoring, Rx oral anti-diabetics, insulin delivery systems, insulin, and supplements. 

Ø  The Diabetrics division accounted for $21mm of sales (5% of total) with a contribution margin of `15%

Ø  Approximately 7% of the global population has diabetes and 11.5% of global health expenditure is spent on fighting this disease.

Ø  Procaps is the leader in its home Columbian market (60% market share in glucose monitors and 50% market share in insulin delivery systems, e.g., pens)

Ø  About 15% of its sales are derived from new products in this division (less so in 2022) and the company has received approval for 37 new products across its markets

Ø  The key competitors are Hoffman LaRoche, Abbot, Johnson & Johnson, Merck, Novo Nordisk, Becton Dickinson, McKesson.

 Investment Highlights

 Positive Secular Industry Trends: Procaps benefits from three secular industry trends. 1) Long-term trends towards Outsourcing of drug manufacturing (CDMOs), 2) LatAm & Caribbean is one of the fastest-growing, global pharma markets with low current penetration 3) Aging of population and greater healthcare coverage (source: company 20F/Presentation).

Ø  STRONG SECULAR CDMO TAILWINDS: Currently only 26% of pharmaceutical production is outsourced. Larger companies are increasingly focused on growing their pipeline either through R&D or M&A. They are looking to outsource capital intensive manufacturing to third parties. Smaller companies similarly are focused on innovation rather than production. As a result, the CDMO market has been growing at mid-single digits and is expected to continue to expand at ~6.5% p.a. in the coming years.

Ø  FAST-GROWING LATAM HEALTHCARE MARKET: LatAm’s pharma market size is $58bn (660mm people) and has grown at 8% CAGR ’18-’22. In comparison Africa/Asia/Australia have grown at 6%, combined, while USA, Europe and Japan have grown at 5%, 4% and 2%, respectively. Given the relatively low penetration of the market, measured by $/person spend, these trends should continue.

Ø  AGING POPULATION: Over the last 50 years, the 65-years+ population in LatAm has increased ~2.5x (from 4% to ~10%). The expectation is that this percentage will double again by 2050. Furthermore, healthcare service coverage in LatAm is improving (77% insured in 2019 vs. 65% in 2000).  This bodes well for healthcare stocks in the region.

Innovative, Diversified Portfolio Targeting High Growth Areas: Procaps has hundreds of products in its portfolio.

Ø  As of the end of 2022, Procaps had 202 new drug registrations approved during the year, with another 179 pending approval.  In 2022, about 27% of total sales came from new products. In the last quarter (Q2’23), that percentage increased to 34%.

Ø  The company spends about 4-5% of its sales on R&D annually and has over 300 research scientists and technicians on staff.

Ø  The company’s portfolio is protected through 42 patents (34 more pending approvals) and 5,415 trademarks globally, with another 302 pending approval.

Ø  The company’s growth plans are focused on treating chronic conditions, which provides a certain level of revenue recurrence.

High Quality yet Low Costs of Operations:  Procaps has a strong operational track record.

Ø  The Pharma / CDMO industries are highly regulated. The quality of drug production facilities is a very important aspect of competitive differentiation and is closely monitored by regulatory agencies.  There have been multiple issues with other CDMO/pharma companies that have gotten in trouble because of compromised operational standards.

Ø  Procaps manufactures its products across its eight plants located in Colombia, Brazil, El Salvador, and USA. The Company maintains a cost competitive advantage due to operating in regions with lower labor costs and real estate prices, as well as favorable access to raw materials.

Ø  The company has some of the best facilities in the business, with state-of-the-art technologies enabling it to manufacture- highly complex products. Its manufacturing facilities include the first FDA-approved Rx pharmaceutical plant in South and Central America and one of only five hormonal softgel plants in the world. Additionally, its manufacturing facilities are certified, where required, by several regulatory entities including the FDA, Health Canada, the MHRA, the TGA, Cofepris, and ISO.

Ø  Procaps recently published a white paper highlighting its innovative production technology for extreme temperature-resistant gummies. This is an important differentiated feature for its clients, Pharma companies, as temperature changes during the export process can damage products in transit.

Ø  The facilities are built to allow for flexibility and adaptability to accommodate the production of a wide range of products. Furthermore, the operations are well-integrated within its customers’ value chains (e.g., software/logistics) leading to greater stickiness of its business.

Ø  As an indication of the quality of the operations, Procaps has virtually no outstanding litigations ($0.1mm of total legal contingencies), which is commendable for an industry known for legal issues.

 Strong Historical Growth and Margins + Cost Cutting Efforts: Between 2019-2021, Procaps revenues grew at a CAGR of ~13% (US$ basis) with EBITDA margins in the mid-20s% range. Some of this growth was a potential Covid-19 pull-forward as revenues in 2022/2023 did suffer somewhat from higher channel inventories in parts of its business (Clinical Specialties, primarily).  Economic factors (i.e., macro slowdowns) adversely impacted demand as well. A strong dollar is another reason for the 2022/2023 growth slowdown, as ~50% of the revenues are denominated in non-US$. 

Ø  The management has set lofty goals in terms of financial performance. They aim to achieve $1bn in sales and $250mm of EBITDA by 2026-2027.  This deadline has already been pushed out by 12-18 months, due to some growth hiccups, as highlighted above, and FX headwinds.

Ø  The company is going through a cost-cutting program to reduce at least $10-15mm of costs (20%+ of run rate EBITDA) to improve margins and has already achieved at least half of such reductions.

Ø  The company has also announced proactive steps to adjust pricing and balance out inflationary costs to protect profitability. Gross margins in 2020-22 did reach 60% but have fallen to mid-50s% in 2023. The company is looking to rectify that.

Owner / Operator: The Minski family owns the majority of Procaps shares (~60%). Ruben Minski, is the founder and CEO/Chairman of the company since its launch in 1977. However, he has indicated that he will step down by the end of this year (at the age of 72) with a succession plan being currently implemented. He will remain and Executive Chairman. The new CEO will be appointed at the start of 2024. Ruben Minksi is a well-regarded entrepreneur in the world of LatAm pharma having grown the company to be one of the leading softgel makers in the world.

Ø  The Minski family has indicated that they won’t be selling any of their shares through 2023 unless they reach at least $10 (vs. current prices of ~$4.00)

Accomplished Board Members with Aligned Incentives: Procaps board members own a large portion of the shares and have significant experience in operations and assets’ monetization.

Ø  Mr. Alejandro Weinstein owns 14+% of the company and although he recently stepped down from the Board, he has appointed a representative. Mr. Weinstein has more than 30 years of experience in the healthcare and wellness industries, both operational and investing. Previously, he was the CEO of CFR Pharmaceuticals S.A. for ten years, where he was responsible for transforming that company from a local Chilean pharmaceutical company into a major global pharmaceutical company with a presence in 26 countries and three continents, via 15 acquisition transactions. Under Mr. Weinstein’s leadership, in May 2011 CFR completed an initial public offering, one of the largest IPOs in Chile. In September 2014, Mr. Weinstein led the sale of CFR to Abbott Laboratories for approximately $2.9 billion at a very attractive valuation (c. 14-15x EV/EBITDA).

Ø  Mr. Kyle Bransfield, a board member, owns and represents another 2% of the company’s equity and has substantial M&A, Private Equity, and investment banking experience with multiple successful transactions in his track record. He is also leading the M&A board committee. Other insiders own another 10% of the shares, i.e. insider ownership is ~85%.

Ø  The Board and the Management team is focused on M&A opportunities, although this is likely a 2024 event. The CFR pathway marked by Mr. Weinstein should be a reasonable guidepost for Procap’s management team to follow and emulate.

Substantial M&A Opportunities: The CDMO industry is highly fragmented, with the top 10 manufacturers holding less than a 20% market share in terms of revenue, creating opportunities for inorganic growth through consolidation and entry into adjacent markets. The company’s goal to get to $1bn of revenues by 2026-2027 does include M&A. As highlighted above its Management / Board has a proven track record in this regard.  

The Perfect Storm of 2022/2023:

Last year, Procaps was hit hard on multiple fronts, which led to deteriorating financial performance and a sagging stock price.

Ø  FX Headwinds: Approximately 50% of the company’s operations are denominated in non-US$, with Colombian Peso and Brazilian Real being the most important ones. These two currencies devalued substantially, affecting operations. The company’s sales’ and profits’ growth screens better in constant currency. The strength of the US$ is to a great extent due to aggressive FED hikes, which should be reaching a peak and a potential reversal, thus likely normalizing FX pressures.

Ø  Inflation and Supply Chain Disruptions: Inflation and supply disruptions hit many businesses in 2021-2022 and Procaps wasn’t spared. Its gross margins dipped 5-10% as a result. However, the management has adapted its pricing strategies to balance out this effect and protect profitability.

Ø  Geopolitical / Economic headwinds: Global economic slowdown and political upheavals in LatAm and Colombia caused some additional waning of demand orders and slowdown in the region.

Ø  Inventory De-Stocking: It appears that Covid-19 might have pulled forward some demand with hospitals ordering more supplies than needed, leading to inflated inventories. Those had to be worked out in 2022 / 2023 with most of that headwind already behind. The management called out in the latest earning report that inventories in the channel are low and anticipated recovery of demand orders by 2023’s year-end.

Ø  Failed Acquisition: Procaps announced an acquisition of Grupo Somar, a Mexican Pharma company with similar operations and complementary markets (it would have allowed an entry into the lucrative Mexican market). However, the acquisition failed to close due to some issues with its seller, PE Firm Advent, not related to Somar, i.e. overarching liabilities related to other holdings in Advent’s portfolio, which delayed and ultimately blocked the sale. The company is looking to for some compensatory payments what is owed to it contractually as a result of the failed sale.

Ø  High Interest Costs / Fees: The company had procured financing for the Somar deal from a consortium of banks. However, as the transaction failed to close, Procaps owed the bank some fees as well as had to renegotiate its existing debt with its lenders leading to higher borrowing costs. 

Ø  Rising Leverage and Working Capital Needs: As a result of the revenue and margin reductions, EBITDA declined, leading to higher Debt/Leverage ratios and FCF generation. Working capital utilization has also been poor, especially the monetization of Trade Receivable and Inventories, straining the balance sheet.

Ø  Florida Facilities Pre-Operations Launch Costs: Procaps acquired two large production facilities in Florida (Miramar / West Palm Beach) to produce gummies / softgels. The acquisition and set-up launch costs hit the company financial statement upfront without any offsetting revenues at this point. These two facilities are expected to start production in early 2024.

Ø  Management Disagreements: The failed transaction caused some disagreements between the Board and Management team. Mr. Weinstein resigned from the board in February of 2022 but then rejoined again a month later, and six months later stepped down again, appointing his own representative. Different objective / expectations deadlines seemed to be behind the dispute.

Ø  No Demand for Small Cap/EM/Less Liquid Stocks: As 85% of the shares are owned by insiders, the float is quite small and hence trading volumes have been minimal, at best. Buyside / Sellside coverage is virtually absent as well. On a macro level, the rapid rate hikes and subsequent economic slowdown pushed investors away from the more speculative areas of the market and into high quality bonds and mega cap stocks.  

 Procaps Appears to be Close to an Inflection Point

Despite the 2022-2023 headwinds, it appears we might be close to an inflection point in the company’s operations. The company recently renegotiated its bank loans with its key lenders and the Leverage Covenant contained some interesting clues: It was set at 4.3x Debt / EBITDA for the period ending September 30, 2023 (i.e., we are near the trough) and 3.0x for any period after that. The agreement was reached recently, August 16, 2023, and indicates that management sees EBITDA improvement of over 43% in the coming year (as indicated by the tighter leverage ratios post September 30, 2023).  This optimism is understandable as a lot of the headwinds that hit the company in 2022/2023 are starting to normalize, namely, the currency impact and the inventory destocking cycle. The management stated in the last earnings release that they are seeing recovery of the demand orders by year end, alongside its new pricing strategies aimed at recovering profitability. The tone of its latest press release exudes somewhat greater confidence compared to other recent ones. Further, the Florida facilities (Miramar/West Palm Beach) are close to starting production in 2024, with 1.8bn annual capsule production capacity in the WPB Facility alone. The company has also announced several new products’ launches for 2H’2023 as well as new CDMO orders that were postponed earlier. Lastly, valuations for potential M&A targets have reset and with a renegotiated capital stack, the company should have greater flexibility to pursue accretive M&A opportunities in 2024 once it restores its profitability and cash levels.

 Valuation: The company is currently trading at ~7x EV/2023 EBITDA, whereas other CDMOs are trading at 10x-12x with Catalent (leading global CDMO) as high as 18x. Pharma / Branded Drugs Companies are also trading at similar ranges, i.e., 10-12x, despite lower growth rates. At the peers’ valuation range (10x-12x) and based on current EBITDA guidance for 2023 ($90mm-$100mm), we see 80-100% upside from current levels. If the company successfully completes its cost cutting program and pricing strategies,  returning to its historical margins return, we could see potentially 150% upside i.e. close to $10 from current levels.

 Attractive Warrants: The Procaps Warrants represent great value (ticker PROCW). The company has warrants (legacy from its SPAC roots) that are trading at particularly cheap levels, even in comparison to its already beaten down stock price (based on implied vol). The warrants have a 3-year remaining life and provide a levered way to play for the embedded upside. They contain the usual anti-dilutive and merger protections. Furthermore, they could be called out to clean up the capital stack and increase common stock liquidity.

 Risks

Leverage / High Borrowing Costs / Cash Usage – the company is currently levered at close to 4.5x (coming down to 3x next year). It faces high interest costs due to having debt outstanding in countries with elevated interest rates. Is working capital use has been inefficient with rising A/Rs and inventories. FCF generation has been absent in the last 3 quarters.

FX headwinds – despite the recent normalization of the Colombian Peso vs. USD, geopolitical risks in LatAm may lead to another decline in local currencies.

EM Geopolitical Risks – operations in LatAm and associated geopolitical / economic risks.

Operational/Execution/Management/Regulatory Risks – things could always go wrong as they did in 2022/2023.

Competition – the CDMO/pharma industries are highly competitive.

Illiquidity of the shares – the liquidity of the shares is minimal as there is no float. Insiders own ~85% (~75% is CEO/Board Members) of the shares and have agreed not to sell shares in 2023 unless the price is at least $10 (e.g. Minski / Weinstein). The company came public via a SPAC and as such has been orphaned in terms of sell-side and buy-side coverage. The management is looking for ways to increase the visibility and liquidity of the shares. A redemption of the warrants might be one of the more plausible ways of achieving that.  

Delayed Reporting / Limited News-flow– the company is quite slow in reporting its financials, a problem the management has said will be rectified by mid-2024 with the installment of new financial reporting systems. Further, there is limited news-flow / investor outreach from the company, which has contributed to its orphaned status.

 Catalysts: 1) Recovery of Revenue Growth and Margins, post recent inventory build-up, cost cutting efforts and price adjustments/supply chain disruptions (likely by Q4/end of 2023), 2) Production launch at Florida Factories and new product offerings (likely in early 2024), 3) FCF generation and debt paydown (2024-2025), 4) increase of stock liquidity via greater investor marketing or potentially conducting a warrant exchange or an equity financing to de-lever balance sheet (likely in 2024), 5) Accretive M&A (likely in 2024), 6) Stock rally in the “Forgotten Corners of the Market”, i.e., Emerging Markets and Small Cap Stocks should provide a boost to beaten down shares like Procaps, 7) normalization of the US Dollar strength vs. LatAm currencies as we approach the end of FED rate hikes.

DISCLAIMER:  This is not Financial Advice. Do NOT rely on this analysis for investment decisions. Please do your own work as I may have made errors and omissions in this write-up. I own securities in the company and may trade them at any time without additional notice. 

Catalyst

Catalysts: 1) Recovery of Revenue Growth and Margins, post recent inventory build-up, cost cutting efforts and price adjustments/supply chain disruptions (likely by Q4/end of 2023), 2) Production launch at Florida Factories and new product offerings (likely in early 2024), 3) FCF generation and debt paydown (2024-2025), 4) increase of stock liquidity via greater investor marketing or potentially conducting a warrant exchange or an equity financing to de-lever balance sheet (likely in 2024), 5) Accretive M&A (likely in 2024), 6) Stock rally in the “Forgotten Corners of the Market”, i.e., Emerging Markets and Small Cap Stocks should provide a boost to beaten down shares like Procaps, 7) normalization of the US Dollar strength vs. LatAm currencies as we approach the end of FED rate hikes.