UDG Healthcare — Update 10 December 2015

UDG posted strong FY15 results with adjusted diluted EPS of 34.9c (+21% y-o-y) exceeding our forecast by 2%, helped by a lower tax charge than forecast. Continuing business adjusted diluted EPS of 27.5c rose by 42% y-o-y. Moreover, we believe the operating performance trend was also highly favourable. In particular, the continuing businesses performed more strongly than forecast with higher margins across the Sharp, Aquilant and Ashfield divisions and, in addition, stronger revenue growth (20% FX-adjusted) in the Sharp division. The main drivers were Ashfield’s UK business (+€12.7m EBITA increase y-o-y) boosted by the healthcare communication activities and Sharp’s US packaging business (+€10.9m). Conversely, the drug wholesaling business, which is due to be sold and represents the bulk of Supply Chain Services, was subject to more severe margin compression than we expected; divestments and regulatory pressures caused its EBITA to drop by €11.4m y-o-y.

Furthermore, UDG generated a remarkable €137m in operating cash flow after financing and tax expenses. The strong cash generation was spurred by a €31m release of working capital resulting in 90% of operating profit converted to cash after capex, up from 71% the previous year. This was despite unusually high capex of €65m, largely investments in packaging/serialisation capacity in Sharp, some €22m higher than depreciation and amortisation. Accordingly, year-end net debt of €196m and net debt/EBITDA of 1.42x turned out better than forecast. We expect a return to a normal pattern of modest working capital build in the coming years, particularly taking into account the light capital structure required to run the ongoing businesses, Ashfield, Sharp and Aquilant.

As forecast, UDG’s reported numbers benefited from a strong FX tailwind, boosting the FY15 group revenue growth of 10% by 6pp, its EBITA growth of 19% by 12pp and its diluted adjusted EPS growth of 21% by 12pp. We have updated our forecast for FY16e using the £/€ rate of 1.38 (previously 1.39) and $/€ rate of 0.92 (previously 0.88). Based on the prevailing rates, we expect FX to have a 3% favourable effect on FY16 revenues and profits compared to FY15.

In our 12 November report, we illustrated the financial implications of UDG Healthcare’s planned divestment of its drug wholesaling and MASTA travel clinics business, expected to yield €408m in gross proceeds and €378m in net proceeds after €25m tax/transaction costs and €5m separation costs. The closure of the deal is depends on competition authorities’ approval. At its full-year results analyst meeting in London on 24 November, UDG indicated that the closure may be deferred by a few months compared with the original expected date of March 2016, on which our prior forecasts were based. For the purpose of our model we now base our forecast on a 30 June closure. That said, we envisage a delay by a few months would have an insignificant impact on the company’s financial performance and strategic development, as UDG already has considerable financial resources at hand for acquisitions. Indeed, while UDG aims not to exceed leverage of more than 2.5x net debt/EBITA in the long term, it could temporarily mobilise more than €300m funding up to its 3.5x net debt to EBITDA covenants, even before receiving the disposal proceeds or, indeed, including the borrowing capacity of acquired businesses.

In the unlikely event of a protracted competition authority review, UDG has secured a final deadline for payment of the disposal proceeds by 31 December 2016.

Once the disposal proceeds have been secured, we estimate that UDG should be able to raise €700m funding for acquisitions and investments on the basis of forecast €175m net cash by end of FY16e, forecast €128m EBITDA in the remaining businesses (excluding drug distribution profits of €16m in FY16e) and that it can borrow against EBITDA in new businesses (up to €82m), assumed to be bought at 8.5x EBITDA or 11x EBIT.

On the basis of the results, we make the following main changes to our financial forecasts.

The higher than expected 9% operating margin in the Aquilant division (10% of group profits) is expected to be sustained medium term (6% operating margin forecast previously).

The higher FY15 base of revenues in Sharp is expected to carry through in FY16, now also augmented by a 4% divisional FX tailwind. We retain our forecasts for underlying revenue growth of 11% but increase our forecast of y-o-y margin compression from 20bp to 80bp in FY16e, reflecting initial underabsorption of the 30% increased capacity due to come on stream in H216e. The divisional margin variance in FY16e over FY15 is mainly dictated by the time new customers take to validate Sharp’s new packaging lines. We have adopted a conservative view.

In Ashfield, our largely unchanged forecasts mask the cross-current of a 3% positive FX effect in FY16e and the absorption of the lion’s share of the £5m overhead costs associated with the divested businesses. In addition, the business mix was more favourable, with healthcare communication representing 54% vs forecast 50% of divisional profits. We believe this bodes well for the medium-term margin progression, as healthcare communications generates 5pp superior operating margin than the contract sales business.

Our main valuation method is DCF, which suggests a fair value range of 521p (divestment with no acquisitions) to 649p per share (€700m acquisitions at 11x EBIT FY16-17e in Ashfield). Our valuation is based on financial forecasts to FY22e, borrowing costs of 3.9%, a WACC of 7.4% and long-term growth rate of 2%. In terms of the valuation per share, the upgraded financial forecasts discussed above are compounded by the translation of the euro-based cash flow to the sterling-denominated share price (0.7% strengthening of the £/€ rate from 1.39 to 1.38).

To illustrate the financial impact of potential acquisitions, we have performed a scenario analysis, with varying total investment levels and acquisition multiples. Another likely and at least as profitable investment outlet is increased capex in Sharp. Our sensitivity analysis suggests that by reinvesting €300m in acquisitions at 11x EBIT FY16-17e, UDG should be able to exceed the EPS CAGR of 8.4% FY15-20e forecast before the disposal of the drug distribution activities. Our chosen multiple exceeds UDG’s previous acquisitions at 6-10x EV/EBIT, reflecting higher market valuations, more intense M&A activity in the healthcare sector and UDG’s aim for more sizeable transactions that tend to carry higher valuations. Also, we believe a conservative approach makes sense, as we have not taken into account restructuring costs, revenue dissynergies and unforeseen circumstances (competitive action, legal issues) that more likely than not have negative implications. Conversely, cost synergies have been omitted and would lead to greater earnings accretion on a given deal multiple. Likewise, there would be a likely reduction in average borrowing cost with current market rates of just over 2% for 7-8 year maturities, compared to a current average borrowing cost of 3.9%. We estimate that UDG can spend €700m on acquisitions and additional capex, which would boost EPS CAGR FY15-20e to 14.6%, and still be within its self-imposed gearing limit of 2.5x net debt/EBITDA.

Due to the EPS dilution as a result of the expected disposal, the stock’s 2016e P/E multiple of 21.7x now trades at a 21% premium to its global peers on 17.9x and compares to its five- and 10-year trading ranges of 9.6-16.5x and 8.0-22.5x, respectively. Based on its history of making accretive deals at reasonable valuations, we envisage that UDG is well-placed to make further potentially earnings-accretive acquisitions in the coming 12-18 months. Accordingly, we believe a multiple comparison using current earnings forecasts may be less relevant than previously. The prospect for external growth and improving return on capital should underpin a higher valuation. We note that stocks in the drug wholesaling sector offer comparatively lower valuations than those in healthcare product distribution and healthcare outsourcing (except Catalent).