Concordia Guilty By Association

Concordia: Guilty By Association?
|Must Read Mar. 17, 2016 10:15 AM ET55 comments
by: Lester Goh
Summary
• Since the recent public outcry regarding pharmaceutical companies, sector
roll-ups have sold off on fears of increased regulation, amongst other
reasons. For some, the sell-off was quite unwarranted.
• Concordia is one such candidate. Bears cite fears of U.S. regulation,
business model viability, competitive fears, and accounting add-backs, all of
which culminate in concerns of the inability to de-leverage.
• Some of these fears are largely unwarranted and it appears the market is
not pricing in the benefits of the recent AMCo acquisition.
• Concordia has a well-supported, low-risk, multi-year growth story that should
result in high single-digit top line growth and double-digit growth in levered
free cash flow, supplemented by debt-paydown.
Concordia: Guilty By Association? - Concordia Healthcare Corp (NASDAQ:CXRX) | S… Page 1 of 13
http://seekingalpha.com/article/3959040-concordia-guilty-association 1/8/2016

• Based on an undemanding 15x levered free cash flow yield, shares see
~100% upside from current levels.
Thesis
By now, many of us would be familiar with the recent debacle over drug pricing in
the U.S. The two most significant events was probably the Citron report on Valeant
and a tweet by Hillary Clinton on drug pricing. Once news of these hit the wires,
many well-known healthcare companies sold off sharply, with roll-ups being hit the
hardest.
While some of these firms do have particularly questionable practices, there are
some candidates that have been unfortunately caught in the cross-fire for being
guilty by association. In my view, Concordia Healthcare (NASDAQ:CXRX)
("Concordia", "CXRX", or the "Company"), is a perfect example. Concordia was
introduced to me by an investor whose portfolio had meaningful overlap with mine,
and thus I was naturally interested.
Reasons for the opportunity: fears of increased price regulation, business model
viability, competitive fears, accounting add-backs, high leverage.
In my view, considering the share price action of Concordia, it appears that market
participants are overlooking the vast organic growth benefits of the recent AMCo
deal, preferring to focus on the above concerns, evident by the fact that shares
continued falling post-deal. This is unsurprising given the lack of public financials (at
least on regulatory portals) for AMCo due to its private equity ownership pre-deal

and the numerous headlines condemning the sector - which continues to this day -
undoubtedly deterring investors from assigning appropriate multiples that
commensurate with economic reality.
The Company has a well-supported, low-risk, multi-year growth story that should
result in top line growth rates in the high single digits and levered free cash flow
growth rates in the double digits going forward, largely thanks to the AMCo
acquisition. Overall, the roll-up story remains intact, although acquisitions will likely
be put on the back-burner as the Company focuses on deleveraging, in my view.
On my estimates, shares should see ~100% upside from current levels - based
on an undemanding 15x levered free cash flow yield. Due to the durability and
diversity of its products (see infra), as well as its ability to de-leverage, the likelihood
of permanent capital loss seems minimal. While headline risk would likely continue
to act as an anchor on shares, this particular risk should dissipate with time.
Quick Background
Concordia has a stated strategy of rolling up the industry through making accretive
deals using a combination of high leverage and low taxes with a focus on acquiring
durable products. The Company has since made nearly a dozen acquisitions, with
the largest being the AMCo transaction which closed in October last year.
Observers of the industry would recognize that this is very similar to Valeant's
playbook, which has unsurprisingly resulted in the Company's shares following a
similar price trajectory. The fact that Concordia dropped ~9% after the March 15
Valeant call reinforces my belief that the market is seeing Concordia as a
'mini-Valeant', which could not be further from the truth, in my view.
The bear case hinges on the theory that scrutiny of drug pricing practices and
impending U.S. regulation could significantly impair Concordia. Further, with the
recent Valeant saga, nearly all roll-ups in the sector has faced skepticism regarding
the sustainability of their business model and in turn, whether the significant
accounting add-backs that these firms partake in to arrive at their measure of
earnings is warranted. Moreover, competitive fears abound.

All of the above leads investors to question whether Concordia would have the
ability to support its sheer debt load and have led to the pronounced sell-off in
shares since late September last year.
Fears of drug pricing regulation is overblown
Ever since the tweet by Hillary Clinton announcing her intentions to clamp down on
drug pricing, there has been increased concern that this would eventually become a
reality. Notwithstanding the time it would take to implement such legislation, these
fears are overblown in the context of Concordia, in my view.
Post-acquisition of AMCo, Concordia has diversified its geographic exposure away
from the U.S., the area where said legislation would most likely impact. Currently,
the Company's largest geographic exposure (source: AMCo acquisition
presentation, slide 9) is to the U.K. and Europe, at ~66% and ~19% of estimated
2015 revenues respectively. The remaining ~15% exposure is allocated to rest of
the world ("RotW"), likely with a material percentage of this exposure being
allocated to the U.S. (it is hard to tell given the absence of a detailed breakdown). In
short, any drug pricing regulation is likely to occur in the U.S., which Concordia has
a limited exposure to.
Even if pricing regulation were to materialize in areas outside of the U.S. (quite
unlikely, pricing pressure is more common but targeted at drugs sold at high price-
points), its effects on the Company would be fairly benign given that the Company's
products are mostly sold at drastically lower price-points vis-a-vis competitors. A
good example is Donnatal, the Company's largest drug (~10% of sales). A 30-day
supply of Donnatal costs ~$800, while similar drugs cost as high as ~$5,500
(Librax), ~$3,300 (Lotronex), and ~$2,600 (Xifaxan). The story is similar for
Concordia's next largest drugs Plaquenil and Lanoxin. Price data is sourced from
Goodrx.com.
It appears to me that one would be hard-pressed to imagine Concordia's drugs
being targeted for lower pricing given their already-low prices compared to other
similar drugs; price pressure would likely manifest on the more expensive drugs
first. Moreover, its products are for relatively small patient populations and with
lower overall pricing, the cost is marginal to the government, further decreasing the
likelihood of regulatory pressure. Therefore, fears of pricing regulation and/or
pressure is overblown, in my view.

Skepticism regarding business model viability and competitive fears is
unfounded
As with the Valeant story, market participants are broadly skeptical regarding the
viability of Concordia's business model. This is understandable given that casual
observers who allow the media to shape their opinions would come to the
conclusion that the business model is flawed due to either a) sharp price hikes
(false, see supra), b) non-durable drugs and c) lack of R&D, which when coupled
with b) requires constant replenishment on the Company's product line. This could
not be further from the truth, in my view.
Management claims that the drugs it acquires are durable, but the market does not
seem to believe it. In this case, management is correct. Donnatal, their largest drug
has consistently grown throughout recent years and have been on the market for
nearly seven decades and has been prescribed for over four.
Not only did the AMCo acquisition drastically diversify the Company's product
exposure (Donnatal was ~40% of 2014 revenue, now ~10%), it also brought
onboard a broad portfolio (~190) of niche legacy products which face limited
competition and have great growth profiles. ~88% of AMCo products face no more
than 2 competitors in the market, with ~43% being sole-source (no competition,
source: AMCo investor presentation slide 9). AMCo's 2013A-2015E CAGR in
therapeutic areas such as Endocrinology, Ophthalmology, and Urology has been
anywhere from 15%-32% (source: AMCo investor presentation, slide 10).
Moreover, given the relatively higher drug prices sold by the competition, there is a
tailwind driving volume increases to the Company's lower-priced drugs, especially in
the U.K. The U.K. is special in that pharmacists play a role in driving down generic
pricing as they are compensated on a per-prescription basis, incentivizing them to
seek out low-cost providers such as AMCo. Further competition driving down pricing
past AMCo's levels is unlikely in the future given the already small market size and
significant barriers to entry.
For example, levothyroxine sodium - AMCo largest drug, an indication for
hypothyroidism is a <$50m revenue product (too small for large drug companies)
and requires 95%-105% potency (previously 90%-110%) which is technically difficult
to achieve. This is due to worries on shelf life reducing potency levels and thus

raises clinically-material concerns. The FDA letter (linked in this paragraph) also
mentions the sole-source nature of the drug, recognizing its medical necessity and
that there is no other credible alternative.
The apparent lack of R&D is also a concern of investors - AMCo itself spent <$10m
in R&D in recent years and the combined company should do somewhere in the
$10m-$20m ballpark for 2016. However, there is a nuance that needs to be
highlighted - although the Company appears to have a lack of R&D input
(expenses), there is no lack of R&D output (product launches). AMCo had targeted
10 product launches in 2014, but launched 19 instead - indicating extraordinary
R&D efficiency - with its top-line growing ~22% that year (source: 2014 annual
review).
Note that the annual report is sourced from the private equity firm (Cinven) that
owned the Company, suggesting that one would not be able to find it if they used
traditional searches (as AMCo was not public, its filings are not available on
regulatory portals).
Accounting add-backs is mostly warranted, high leverage sustainable
Market participants have recently treated firms which add back numerous charges
to arrive at a definition of earnings with disdain, presumably due to their skepticism
as to whether they are warranted. In Concordia's case, they are largely warranted,
in my view.
To arrive at adjusted EPS, the largest charges that Concordia adds back are share-
based comp, acquisition/restructuring-related expenses, amortization, gains/losses
on realized/unrealized foreign currency hedge contracts, and accelerated accretion
expenses (source: 3Q report). In totality, these add-backs represented ~90% of the
delta between EPS and adjusted EPS on a 9-month basis ending in 3Q '15.
Share-based comp is the only add-back that I disagree with. While non-cash, it is a
real economic cost as it shows up on the diluted shares number. This add-back
represented ~10% of the total add-backs. The rest of the add-backs I agree with.
Acquisition/restructuring-related expenses appear fair given that it has historically
increased post-deals and came down significantly a few quarters after, suggesting
that there are no cookie-jar shenanigans going on (if there were, the expenses

would remain high every quarter, which it has not). Amortization would be a real
expense if the Company was acquiring non-durable patent cliff products, but it
clearly is not (see supra). Gain/losses on realized/unrealized foreign currency hedge
contracts and definitely one-time given that they were entered to hedge the
purchase price of the Company's acquisitions. Accelerated accretion expenses were
associated with the early repayment of debt - also a product of acquisitions as the
Company had refinanced the acquiree debt post-acquisition.
In my view, the skepticism regarding accounting add-backs has resulted in market
participants becoming wary of the ability of the Company to sustain its debt levels.
However, as discussed above, these add-backs are mostly warranted (with the
exception of share-based comp, though other analysts might argue otherwise).
The Company is guiding $625m in mid-point EBITDA for 2016, which if achieved
(see infra), implies somewhere around ~$240m in levered free cash flow (~$242m in
interest expense - assuming 1% LIBOR floors for term loans, 11% tax rate, in-line
with historicals and sustainable due to Canadian tax domicile, ~$100m in working
capital investment, which reconciles with pre-deal historicals, capex is negligible),
which suggests that the Company could de-lever rather quickly going forward.
While levered free cash flow numbers might imply that interest coverage is a little on
the low side, the situation is not that dire if one considers EBITDA numbers
(EBITDA/interest coverage is ~2.6). Furthermore, with rapidly expanding EBITDA
(see infra) and debt paydown, interest coverage ratios would likely improve
substantially going forward. Moreover, given the stability of the business, it is hard to
imagine EBITDA numbers falling off a cliff.
Concordia has a well-supported, low-risk, multi-year growth story
Management is guiding for high single-digit top line growth through 2018, driven by
low single-digit growth in U.S. revenues and mid-teens growth in non-U.S., clearly
implying that the focal point here is on non-U.S. revenues. The Company intends to
get to these rates with its pipeline of ~60 product launches. In my view, these
targets are quite achievable.
Notably, given the level of R&D spending, none of these are bet-the-company
product launches; they are low-risk initiatives such as reformulations and line
extensions, a far cry from high-stakes blockbuster drugs.

With drug companies, it is always difficult to determine the level of sales ramp for
new products. However, the Company's history does offer some perspective as to
the soundness of management's execution and the plausibility of the growth story.
AMCo released 4 new products in 2013 and grew revenues by ~12% (source: 2013
annual review) pro forma for acquisitions and had a banner 2014 with 19 product
launches and ~22% top line growth. Given the sheer size of upcoming product
launches (~60 over the next three years vs. 23 in the prior two), mid-teens growth in
non-U.S. revenue appears very achievable.
Furthermore, there are numerous examples of recent product launches that do give
an investor greater confidence. The Company has targeted the development of
niche formulations in the U.K. given that the NHS rewards new formulations of old
medicines through drastically higher reimbursement (see infra). Levothyroxine
(AMCo's largest drug) oral solutions is one such example. The oral solution was
developed to serve patients who have difficulty swallowing pills and thus could not
be served with levothyroxine tablets. Reimbursement rates are as much as 20-85x
higher for the oral solution compared to the tablets, as seen below.
Levothyroxine February 2014 January 2016
25 µg/5ml oral solution 5,168 9,183
25 µg tablet 283 269
50 µg tablet 196 184
100 µg tablet 195 185
Source: NHS Drug Tariffs February 2014 (page 138), January 2016 (page 155)

Developing new dosage strengths is also a focus. These developments are driven
by changes in the patient demographic such as age (older people tend to require
higher dosages). One example is Pevanti which AMCo launched early last year at
five dosage strengths - 2.5mg, 5mg, 10mg, 20mg, and 25mg. The 2.5mg and 5mg
compete against other generics produced by many different companies and the
25mg competes only against one high-priced product while the remaining 10mg and
20mg face no competition. AMCo has priced the products that face competition at
lower price-points to drive volume through patient compliance (taking a single high-
dose tablet is less prone to error than multiple low-dose tablets) and cost savings -
25mg is priced at ~$57 vs. the competition at nearly 2x-4x the price.
Another growth avenue that is hard to quantify is the internationalization of existing
products. With the AMCo acquisition, the Company obtained a global reach with
distribution in over 100 countries. Management sees the possibility of selling many
of its drugs in other markets, but have yet to give any guidance.
Considering the low-risk nature of the Company's product launches and the success
it has had with recent launches does suggest that the growth story is highly
believable. It is also interesting to note that the Company places a high degree of
emphasis on improving patient care and lowering costs (for examples, see supra),
two factors which tend to drive success in the industry. While a few of the ~60
product launches through 2018 would flop, it appears to me that it is difficult to
envision that a majority of them would fail, given the Company's track record.
Notably, Concordia is not straying from its core competence of developing
reformulations and line extensions, which materially lowers its risk profile, in my
view.
Financials at AMCo also suggest that its existing corporate infrastructure is sufficient
to support its growth going forward, which significantly reduces the risk of adding
materially incremental SG&A as the top-line expands. This is evident from the
margin differential between incremental operating margins at AMCo which number
in the ~54% range, compared to overall operating margins of ~31% (note that my
calculation is adjusted for non-recurring costs in '13 and '14) in 2014. In my view,
the Company can leverage this infrastructure in the future as it launches more new
products, resulting in significant margin expansion going forward.

These data points also support the thesis where management is able to basically
arbitrage the margin differential between the Company and its acquirees.
Management basically looks to acquire products where they see opportunity to
extend its profitable life by expanding sales and renewing marketing opportunities.
For example, AMCo was the product of the merger between Amdipharm and
Mercury Pharma. Both businesses were highly complementary in terms of
distribution, allowing the parts to leverage on each other's distribution channels and
enabling the top-line to expand with lower per-unit SG&A costs, resulting in the high
incremental margins as detailed in the prior paragraph.
Valuation appears very cheap even using conservative assumptions
Source: Company data, author's own calculations
Key things of note:
• Organic growth rates of 5% are probably ~200-400bps lower than management
estimates of high single-digits
• No credit given for future bolt-on acquisitions
Concordia: Guilty By Association? - Concordia Healthcare Corp (NASDAQ:CXRX) |… Page 10 of 13

• EBITDA margin assumptions are ~300bps lower than management guidance of
~60% - partly to account for share-based comp and partly for conservatism
• Zero operating leverage baked into the model - an extremely conservative
assumption given prior discussion on incremental op margins
• 11% tax rate in-line with historicals
• Zero capital expenditures given negligible capital investment in prior years and
no plans for increase in future years
• Steady de-levering to ~4.4x debt-to-EBITDA - assuming all cash flow directed to
debt paydown; management had indicated its intention to right-size its balance
sheet
• No assumption of share buybacks
• Target FCFE multiple of 15x - conservative given high-single digit top-line and
double-digit levered free cash flow growth profiles
• ~100% upside with the aforementioned conservative assumptions
Catalysts
• New product launches driving organic growth
• Cleaner financials as acquisition accounting/expenses fall off in subsequent
years which should increase confidence in the Company's operating model
• Debt paydown
• Margin expansion suggesting operating leverage ramp
Risks

• Integration risk. Mitigant: Both Concordia and AMCo are highly-acquisitive,
suggesting extensive experience in integration. Former CEO/Chairman of
Actavis, Claudio Albrecht, joined AMCo in 2014 (source: annual review 2014
page 8) as Global Strategic Adviser. Actavis has historically been very
acquisitive as well, and Claudio's experience running a significantly larger drug
company should bode well for the Company.
• Higher interest rates. Mitigant: Concordia is not subject to maintenance
covenants until more than 30% of its revolver is drawn (currently undrawn).
Given the cash-generative nature of the business, it is unlikely that the Company
would draw on the revolver barring another sizable acquisition.
• Headline risk
Conclusion
Concordia has many of the characteristics that I look for in a potential long: 1) a
misunderstood company resulting in a cheap valuation, 2) a well-supported, low-
risk, multi-year growth story and 3) a clear path to free cash flow growth (driven by
debt paydown and top-line growth). While headline risk will likely persist throughout
2016 as the election year continues, the business remains significantly unimpaired
in my view, thus allowing investors to build up a position at bargain prices.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate
any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business relationship
with any company whose stock is mentioned in this article.
Additional disclosure: The author's reports contain factual statements and
opinions. He derives factual statements from sources which he believes are
accurate, but neither they nor the author represent that the facts presented are
accurate or complete. Opinions are those of the the author and are subject to
change without notice. His reports are for informational purposes only and do not
offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester")
accepts no liability whatsoever for any direct or consequential loss or damage
arising from any use of his reports or their content. Lester advises readers to

conduct their own due diligence before investing in any companies covered by him.
He does not know of each individual's investment objectives, risk appetite, and time
horizon. His reports do not constitute as investment advice and are meant for
general public consumption. Past performance is not indicative of future
performance.

Concordia Guilty By Association

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