A small-cap reverse listing with plenty of upside

Paragon Care (ASX: PGC) has been a troubled business post making numerous acquisitions, with poor returns on capital and multiple leadership changes. It is an average company, at best. 

Recently, however, they announced a merger with CH2. This is essentially a back-door listing, making it look like a much better business. The new business will have a market cap of around $460 million and will become a more relevant-sized company popping up on fund managers' radars.

What is CH2?

CH2 is a wholesale distributor of healthcare products, similar to the larger listed competitors of Ebos (ASX: EBO) and Sigma (ASX: SIG) (and formerly listed API, prior to being bought by Wesfarmers (ASX: WES)). These businesses operate on thin margins and they benefit significantly from scale, which is somewhat of a deterrent to new entrants. CH2 run a "Costco model" whereby they try to operate as the lowest cost player in their industry and then pass that cost benefit on to their customers. This has seen them grow market share in a competitive environment.

CH2 is run by David Collins who started as CFO of the business in 2005, before orchestrating a management buyout in partnership with Peter Lacaze in late 2015. They financed this purchase with the assistance of a division 7A loan, which they have since paid back through the profit generated from the business. 

The two of them each owned 50% of CH2 before the merger. The business will be run by David from now on. They are not selling any of their shares into the deal and combined they will own 57% of the new PGC post-completion. Whilst little is known about CH2 at this stage given it is unlisted, a quick look at their financials suggests that these guys know how to run a business.

In FY15, when David and Peter took over, CH2 was doing top line revenue of around $900 million and lost almost $22 million. Two years later they had organically grown the top line by almost 40% to $1.25 billion and generated net profit after tax of around $600,000. At that time, CH2 was mainly distributing healthcare products into the hospital and aged care market.

A step change in the business happened in 2017 when CH2 was awarded a CSO (Community Service Obligation) licence, which opened up a $15 billion market for them in pharmacy distribution. That turned CH2 into the fourth-biggest player in the pharmacy wholesaling market and it was the first approval given to a company in 10 years. From a standing start, the team have grown this part of the business to an expected $1.3 billion of revenue in FY24, making up approximately 44% of their total.

Whilst their growth has been impressive, the return on capital has been even more so. Their expected Return on Equity (ROE) for FY24 is a whopping ~76% - compared to Sigma at sub 2% and Ebos at 11.5%. 

That has obviously been assisted by their use of the original debt to buy the business, however, the company stated that their rolling Return on Capital Employed (ROCE) is close to 24%, which compares to Ebos at 15% (SIG doesn’t rate a mention here..).

CH2 also run a lean cost base as evidenced by their distribution costs which are lower than those competitors and, on a metric we believe is a good indicator for the efficiency of a distribution company, their inventory turns run at an industry-leading 12 times.

Competing with Chemist Warehouse

One of the key questions we need to ask ourselves here is how the business will compete with Chemist Warehouse now that the latter will be merging with CH2 competitor, Sigma. Chemist Warehouse isn't a company I would like to compete with. There is, however, a structural benefit to the CH2 business which may help them - their independence. 

The other large competitors of CH2 are not only wholesalers, but they also have a retail pharmacy banner which essentially competes with their own clients. Ebos has Terry White Chemmart, API has Priceline and Sigma has Amcal and now Chemist Warehouse. 

Anecdotal evidence from industry players we have spoken to suggests that the independents, who represent around 43% of a now $18 billion market, will be less likely to deal with Sigma, now that Chemist Warehouse can see their numbers. In any event, CH2 is winning market share outside of that anyway.

“Di-worsification?”

Di-worsification is a term coined by famed investor Peter Lynch when a company with a good business buys another company with a poor business. This certainly looks to be a key risk in CH2 merging with Paragon and the CH2 management will admit that as well, however, they also note they have been following Paragon for a number of years now. 

Whilst this risk can’t be ruled out, we think that the valuation compensates for this, with the combined CH2/Paragon business valued at around ~12.5 times PE, versus EBO at 21 times, whilst Wesfarmers took over API at ~20 times, so there is some margin of safety here.

The second argument we would highlight is that the PGC team have successfully shown their ability to cut costs and improve profitability in the past. Remember, CH2 was losing $22 million when the current management team took over. It wouldn’t surprise us to see a new Paragon with better margins and fewer businesses.

Summary

There is always risk when a new management team comes to the ASX, as their operating history has not been for us to see in the public domain. From the early research we have conducted on CH2, we think this is a management team that has a laser focus on their return on capital. 

CH2 management has share ownership, a long runway for growth through increased penetration into pharmacy, low costs, high returns on capital and the potential to improve an existing ASX-listed business. The deal still needs to go through shareholder approval in May, however, after that time, we think we are looking at a much higher-quality business at a fair valuation.