A thorough examination
Ascendis Health fell 77% in 2018, one of the worst-performing shares on the JSE. Were there signs of impending trouble? If so, what were they?
Ascendis Health is an SAbased international health and wellness company. Founded in 2008 and listed on the JSE in November 2013, the group has supplemented its organic growth by buying complementary businesses.
Since 2015 it has acquired four businesses in Europe: Farmalider in Spain (pharmaceuticals and over-the-counter medicine); Remedica in Cyprus (generic pharmaceuticals); Scitec in Hungary (sports nutrition); and Sun Wave Pharma in Romania (nutraceuticals).
The largest European acquisitions were Remedica and Scitec, costing about €500m.
This analysis of Ascendis relies on return on assets managed (Roam), the capital structure of the group and the returns generated thereon.
Roam is derived from two ratios: Earnings before interest and tax (Ebit) margin; and asset turnover (ATO).
Roam has almost halved, to 6% from 11% at its peak in 2015 (Figure 1). Ebit margin has been constant around 12%-13%, 2016 being the exception (Figure 2). ATO has almost halved from its 2015 peak. Given the limited compression in margin, the conclusion is that the increase in the balance sheet has not been matched by an increase in earnings (Figure 3).
Many investors fixate on earnings and earnings growth (income statement), ignoring the health of the balance sheet, in essence the engine of the business. Roam is a simple ratio that addresses that.
Return on equity (ROE) and return on invested capital (ROIC) paint a picture of a business struggling to earn an acceptable return, be it on shareholder funds or the total capital invested in the business: 4% and 2% respectively (Figure 4). This affirms what the deteriorating ATO shows: the group overpaid for acquisitions. The falls in the two ratios also flag a group whose capital structure has deteriorated at both the debt and issued share capital level.
The debt/equity ratio, sharp increase in shares issued and poor returns confirm a group with a deteriorating capital structure, with a concomitant increase in risk. The debt/equity ratio is close to 100%, while the number of shares in issue has increased by 150% since 2013. The group borrowed heavily to fund acquisitions, partially supplemented by two rights issues: R1.2bn in 2016 at 2,200c per share, which was heavily oversubscribed; and R750m in 2017 at 2,000c per share, which was not fully subscribed for, some investors having doubts then (Figure 5).
Ascendis highlights the dangers of fixating on Ebit, or the more commonly used earnings before interest, tax, depreciation and amortisation. Interest paid and depreciation/amortisation are costs incurred in operating a business. Depreciation and amortisation are not a cash charge, but need to be accounted for, so provision is made in the accounts to replace assets at the end of their useful lives.
Comparing Ebit with the earnings before tax margin shows a different picture: the interest charge of R395m reduces the return to 7% (12%) (Figure 6).
Figure 7 highlights the real problem — despite a significant increase in the asset base, revenue and earnings have failed to keep pace. The group has not extracted the synergies hoped for, be they improved efficiencies and/or costs saved, and overpaid for assets.
A review of the financials
flagged enough issues: the deteriorating trends in ATO, ROE and ROIC; the very low ROE and ROIC; a debt/equity ratio close to 100%; a sharp increase in shares in issue via two rights issues; and the large increase in the asset base not matched by a concomitant increase in earnings. All these were warning signs that the group had overstretched itself in its expansion strategy.
But there’s more. Interest cover has more than halved in three years to below 2.5, goodwill (R5.5bn) and intangibles (R4.3bn) now exceed shareholder funds of R6.6bn, and vendor loans of R422m are payable this year at a time when cash and the ability to raise further debt to make the payment are constrained, a further rights issue at the current rating not being an option.
Remedica was bought for about €335m on after-tax earnings of €16.5m for 2015, implying the business was bought on a p:e of 20.3 times after-tax earnings, or an earnings yield of 4.9% vs borrowing costs of about 6%. Before some purist accuses me of comparing pre- and post-tax rates, the tax rate for 2018 was only 12%; it will not make a meaningful difference. Consistently buying assets on yields approximating your cost of capital leaves little scope for error.
Apart from the quantitative warnings, there were qualitative ones as well — the group appointed a new CEO and a major review of the business was undertaken.
The CEO who had overseen the expansion was replaced a year ago. Was he solely responsible for the ambitious global expansion, or is there a more deep-rooted problem? The major shareholder has acted as the group’s financial adviser. Given that over R8bn has been spent on acquisitions since 2015, what fee income was generated (if any)? If fee income was generated, what was the basis of calculation and how much flowed to the major shareholder? What were the checks and balances to resolve potential conflicts of interest and ensure other shareholders were not prejudiced?
Compounding the problem in recent months have been Sens announcements stating: “Involuntary sale, on market, as a result of forced sales actioned by financial institutions due to the shares being linked to equity finance transactions resulting in margin calls.”
In plain speak, shares were pledged by the major shareholder to financial institutions for funds to follow the last rights issue at 2,000c per share. The fall in the share price has required margin to be topped up to avert the pledged shares being sold; as margin was not forthcoming, the shares were sold to remedy the shortfall. Wise buyers have refrained from paying up, hence the fall in price — rolling headline EPS are 78c, placing the share on a p:e of 6.4.
The group has received an unsolicited offer for Remedica — an asset that is doing well. But it still requires a further payment to the vendors of several hundred million rand this year. It has announced the sale of its SA sports nutrition business for R54m and its direct selling and network marketing business for R40m; it has also concluded a sale agreement of its pharmaceutical manufacturing facility in Isando for R130m. Further disposals may be needed to raise the funds necessary to keep the jewel.
At some point Ascendis may well be a buy. But given the uncertainty around the group’s assets, those that are to be disposed of (and the price), the impact on profitability and capital structure, and the continued distressed selling by the major shareholder, the prudent may elect to bide their time.