Diplomat Pharmacy (DPLO) is a name which has created a real mess for itself. This does not come as a complete surprise to me given that the latest article from me on the company is called “LDI Deal Does Not Land Well” dating back to November 2017.
In that article, I looked at the $600 million deal for LDI Pharmacy designed to diversify the business. While I understood the diversification and opportunity argument, I noted that the incurred leverage prevented me from pulling the trigger.
Understanding The Business
To understand the current struggles, one has to look at the past trajectory of Diplomat. Founded in 1975, the company has grown to become a nationwide independent specialty pharmacy business focusing on complex and chronic diseases. Having gone public at $13 per Biedex.com in 2014, shares rose to $50 in 2015 as the entire pharma sector has seen crazy momentum at the time, driven by mega M&A actions.
A few disappointments later resulted in shares falling to $15 per Biedex.com in the aftermath of the LDI purchase in 2017. The dealmaking in recent years allowed sales to rise from $600 million in 2010 to a number almost 10 times that amount in 2018. Relatively resilient operating results in the early part of 2018 pushed shares up to $26 in the summer of that year as the business was relatively quite in terms of dealmaking last year.
Shares fell from $20 to $15 in November upon disappointing third-quarter results, and they fell to $12 in early January. The company updated the 2018 guidance to $5.5-5.6 billion in sales with adjusted EBITDA seen at the high end of the $164-170 million EBITDA range. This softness is naturally weighing on shares with net debt expected to be seen at $630 million at the end of 2018 for an elevated 3.7 times leverage ratio.
For 2019, the company anticipated sales of $5.6-5.8 billion, with adjusted EBITDA seen flat to up in the low-single digits, as the company expected leverage ratios to fall to 3 times by year end. A bombshell was dropped late February as shares fell from $14 to $6 upon the announcement that the 10-K filing would be delayed. This came after auditors claimed that a non-cash impairment on the PBM business would need to be recorded, expected at close to $630 million, relating to the 2017 purchase of NPS and LDI, as such a write-down comes close to approximating the total purchase price of those two businesses.
More Bad News
While an impairment is never good news, the good news is that such a loss is non-cash in nature, yet it only comes after expectations for a business or segment have irreversibly come down. The real pain was seen in the remainder of the February 22 press release. In January, the business has come in short compared to expectations, as the company has seen some customer losses as well. Furthermore, there is increased competitive pressure in the specialty market, driven by aggressive techniques of its major peers.
By mid-March, the company released its fourth-quarter results, which were much awaited by investors. Full-year sales came in at $5.49 billion and adjusted EBITDA came in at $168 million. With D&A running at $97 million and interest running at $41 million, the potential to deleverage is rather modest based on realistic earnings power. Furthermore, “one-time” costs keep recurring, although organic investments are quite modest, which drives some cash flow generation.
Not completely unexpected, the outlook for 2019 is outright terrible. Sales are seen at $4.7-5.0 billion, down from an original outlook at $5.6-5.8 billion. Adjusted EBITDA is no longer expected to rise to >$170 million; it is seen at just $110-116 million. With net debt standing at $638 million, leverage ratios shoot up to 5.6 times, up from 3 times originally expected by the end of the year. Management believes that leverage will come in lower, because capital spending lags depreciation a lot and working capital (inventories) will come down as well, which might result in leverage not hitting the 5 times mark.
With 75 million shares trading around the $6 mark for a $450 million equity valuation, the enterprise value of Diplomat has fallen to roughly $1.1 billion. Sales multiples are not so indicative given the low-margin profile of the business as the company trades at 10 times EBITDA, which seems reasonable, yet the business sees quite some turmoil and, in fact, is quite over-leveraged following the dismal deals pursued to expand into the PBM business.
In 2017, I was critical of the move to expand into another business (in which management had no experience) at a high multiple while taking on a lot of debt. I furthermore was not pleased with the focus on EBITDA multiples instead of real earnings.
For now, shares have become close to being non-investable given the leverage levels and the limited potential to deleverage, as 2019 is set up to become a really difficult and uncertain year. Perhaps a sale of some units or the entire company might be in the works, but I would not necessarily count on that as the bargaining position of the company; it is of course anything but good given the circumstances.
The good news might be that leverage will not shoot up to >5 times, but the company is really one big miss away from ending up in a dire situation, as it does not have a good track record in being so transparent with its investors and delivering upon promises. Thus I will watch the developments with great interest going forward, yet Diplomat’s management rally has something to prove at this point in time.
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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.