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As a teenager, I worked at the local Shoppers Drug Mart for a few years, helping pharmacists prepare prescriptions and stock the shelves. I knew there was a big tailwind in the pharmacy sector as the aging demographic would require more medicines and healthcare services. I was actually pretty pissed off when Canadian retail giant Loblaws (L:CA) acquired Shoppers Drug Mart a few years ago, giving up a favorite investment vehicle. So when I saw this new public participant, Neighborly Pharmacy Inc. (TSX:NBLY:CA), I was curious.
Unfortunately, Neighborly is a name I’m going to stay away from for now. NBLY has not demonstrated operational synergies typical of roll-up strategies. I only see low-margin community pharmacies taking over indiscriminately. I think the company would do well if management took a break from major acquisitions and focused on addressing some operational inefficiencies.
Neighborly Pharmacy Inc. Canada has a rapidly growing national chain of independent community pharmacies. With the recent acquisition of Rubicon Pharmacies, Neighborly has a coast-to-coast footprint of 275 locations (Figure 1).
Based on the number of stores, Neighborly claims to be the third largest operator of pharmacies in Canada, behind Shoppers Drug Mart (owned by Loblaws) and Rexall (owned by McKesson), with a 2.5% market share. . (Author’s note, Metro owned Jean Couteau has over 400 stores and should rightly be considered number 3)
Neighborly’s central corporate strategy is the “roll-up” strategy. Neighborly wants to be the acquirer of choice, particularly for independent pharmacies in smaller, underserved communities where competition is less intense (Figure 3). As baby boomers reach retirement age, Neighborly is capitalizing on the need for succession planning among many independent pharmacy owners.
Unlike the nationwide chain Shoppers Drug Mart, where front-store sales account for about 50% of sales, Neighborly generates 70-80% of sales from prescriptions. This is by design, as more than two-thirds of Neighborly’s pharmacies operate in communities with fewer than 100,000 residents. Neighborhood pharmacies often function as “community health centers” by offering patients a wide range of health services and therefore enjoy high patient retention and margin.
Since the company’s inception in 2015, Neighborly has acquired and integrated over 270 pharmacies, developing expertise in sourcing, closing and integrating pharmacies into its network. According to company literature, Neighborly can complete the acquisition within 8 weeks of signing a Memorandum of Understanding with minimal disruption to banners, staff, layout and patients. Figure 4 shows the number of pharmacy takeovers over the years.
Finances do not show a good model
The breakneck pace of Neighborly’s acquisitions has muddled financial reports and made them difficult to analyze. Figure 5 shows the company’s short financial position for F2022 (year-end March). For the full year, F2022 reported revenue of $428 million, up 39.5% year over year. Same-store sales growth was 3.1%. With the pro forma acquisition (completed in fiscal 2022 and Rubicon closing after the end of fiscal 2022), revenue would have been $798 million.
What is most striking at first glance is the total lack of wins. F2022’s gross margin was 37%, which was roughly the same as F2021’s 37.4%. This gross margin is in-line as Shoppers Drug Mart had ~39% gross margin prior to its sale to Lobla (Figure 6).
However, Neighborly’s operating margin was -2.6% in fiscal 2022, compared to 2.8% in fiscal 2021. The shift to operating loss was due to an increase in operating expenses (from 27.4% to 27.4% of revenue) and higher acquisition costs (2.3% to 6.2% of sales).
What’s worrying from an analyst perspective is the lack of operational leverage. The crux of a roll-up strategy is to leverage economies of scale. However, it’s disappointing to see the increase in operating and administrative expenses as a percentage of sales. In addition, the financial position of NBLY is not reflected Higher margins and less competitive operating environment That the company plays the trumpet in its investor presentations.
For reference, Shoppers Drug Mart has consistently reported operating margins in the 8-9% range from Figure 6 above. Loblaws, which isn’t breaking out of its pharmacy business, reported a 5.2% retail operating margin for 2021. Metro Inc. (MRU: CA), another grocery/dispensary operator, is reporting operating margins in the 7-8% range.
The fair value of the financial liability losses in F2022 and F021 also changed significantly due to Neighborly’s IPO in May 2021 and the conversion of preferred and warrants into common stock. These losses are expected to be non-recurring and non-recurring.
the last quarter was the same
For the quarter ended June 18, 2022 (author’s note, what an odd quarter-ending date!), Neighborly reported revenue of $114 million, up 34% year over year. However, gross margin remained steady at 37%, with operating and administrative expenses rising to 28.0% of sales. A significant reduction in acquisition costs resulted in an operating profit of $2.3 million, or an operating margin of 2.0%.
Appraisals are expensive
Since Neighborly has no income, it makes no sense to weight Neighborly in the P/E metric.
Neighborly currently has a market cap of $900 million and net debt of $313 million with an enterprise value of $1.2 billion. Although we take the company’s revenue for the Rubicon acquisition pro forma to ~$800 million and apply an adjusted EBITDA margin of 11% for Q1/F23, this translates to a current valuation of 13.6x EV/EBITDA. Note that management expects pro forma EBITDA to be $95.5 million, so NBLY is trading at 12.6x EV/EBITDA based on management’s EBITDA estimate (Figure 8) .
Loblaws, the leading Canadian retailer with very high operating margins, is trading at 9.3x Fwd EV/EBITDA. Metro, another major Canadian grocer and pharmacy, is trading at 11.9. For EV/EBITDA, Neighborly looks overvalued.
Neighborly went out of the gate in May 2021, going from its IPO price of $17 to almost $40 by the end of the year. However, since early 2022, NBLY has recently fallen to a low of $19, below the close of its first day of trading (Exhibit 9).
The biggest risk to Neighborly’s story is its lack of operational leverage. To date, in its short operating history, NBLY has not demonstrated an ability to leverage economies of scale and achieve superior operating margins. Instead, the operating margin was very slim. A continued roll-up strategy without clear operational leverage will eventually fail as the acquirer typically takes on debt to complete the acquisition and relies on synergies to service the debt.
Speaking of debt, Neighborly currently has outstanding net debt of $313 million, or 3.3 times net debt/pro forma EBITDA. While the pro forma EBITDA figure is accurate, it still carries a heavy debt load. High levels of debt can limit management’s ability to respond to difficult market conditions.
In the end, Neighborly is a name I would stick with. While the tailwind for the pharmacy sector comes from its aging demographics, NBLY hasn’t demonstrated that it has an improved operating model. What I’m looking at right now is a business-hungry takeover of low-margin community pharmacies.