As a teenager, I worked at the local Shoppers Drug Mart for a few years, helping the pharmacist prepare prescriptions and stock shelves. I knew the pharmacy industry has fantastic tailwinds as the aging demographics will need more and more medicines and health services. I was actually quite angry when Canadian retail giant Loblaws (L:CA), acquired Shoppers Drug Mart a few years ago and removed a favorite investment vehicle. So when I saw that there was a new public participant, Neighborly Pharmacy Inc. (TSX:NBLY:CA), I was intrigued.
Unfortunately, Neighborly is a name I would stay on the sidelines for for the time being. NBLY has not demonstrated operational synergies typical of roll-up strategies. All I see is a random acquirer of low-margin community pharmacies. I think it will serve the company well if management takes a break from major acquisitions and turns their attention to wringing out some operational inefficiencies.
Neighborly Pharmacy Inc. is a fast-growing national chain of independent community pharmacies in Canada. With the recent acquisition of Rubicon Pharmacies, Neighborly has a coast-to-coast footprint with 275 locations (Figure 1).
By number of stores, Neighborly is the third largest pharmacy operator in Canada, behind leaders Shoppers Drug Mart (owned by Loblaws) and Rexall (owned by McKesson) with 2.5% market share. (Author’s note, Jean Coutu, owned by Metro, has over 400 stores and should rightfully be considered #3)
Neighborly’s main business strategy is a ‘roll-up strategy’. Neighborly aims to be the preferred acquirer, especially for independent pharmacies in smaller, underprivileged communities where competition is less intense (Figure 3). As baby boomers reach retirement age, Neighborly is addressing the need for succession planning among many independent pharmacy owners.
Unlike national retailer Shoppers Drug Mart, where in-store sales account for ~50% of sales, Neighborly generates 70-80% of sales from prescriptions. This was designed as more than two-thirds of Neighborly’s pharmacies operate in communities of less than 100,000 inhabitants. Neighborhood pharmacies often serve as a “community health center” by providing a wide range of health services to patients and thereby benefiting from higher patient loyalty and margins.
Since the company was founded in 2015, Neighborly has acquired and integrated more than 270 pharmacies, developing expertise in sourcing, closing and integrating pharmacies into its network. According to company literature, Neighborly can complete an acquisition within 8 weeks of signing a letter of intent, with minimal disruption to banner, staff, layout and patients. Figure 4 shows the number of pharmacy acquisitions in recent years.
Financial data does not show a good model
Neighborly’s lightning-fast acquisitions make financial reports cluttered and difficult to analyze. Figure 5 shows the company’s condensed financial data for the F2022 (end of March). On a year-over-year basis, F2022 had revenue of $428 million, up 39.5% year-over-year. Same store sales growth was 3.1%. Pro-forma acquisitions (those completed in F2022 and Rubicon, which closed after the end of F2022) would have brought in revenues of $798 million.
What strikes at first glance is the overall lack of profitability. F2022 gross margins were 37%, roughly in line with F2021’s 37.4%. This gross margin is inline, as Shoppers Drug Mart showed gross margins of ~39% before the sale to Loblaws (Figure 6).
However, Neighborly’s operating margin was -2.6% in F2022, compared to 2.8% in F2021. The reversal to an operating loss was the result of an increase in operating expenses (from 26.0% of sales to 27.4%) and higher acquisition costs (2.3% of sales to 6.2%).
What is worrisome from an analyst’s point of view is the lack of operational leverage. The whole point of a roll-up strategy is to leverage economies of scale. However, it is disappointing to see operational and administrative costs increase as a % of revenue. In addition, NBLY’s financial data does not show that higher margins and less competitive work environment that the company trumpets in its investor presentations.
For context, Shoppers Drug Mart had consistently reported operating margins in the 8-9% range, from Figure 6 above. Loblaws, which is not expanding its pharmacy business, reported F2021 retail operating margins of 5.2%. Metro Inc. (MRU:CA), another grocer/pharmacist, reports operating margins in the range of 7-8%.
Neighborly also had a large change in the fair value of losses on financial liabilities in F2022 and F021 as a result of the IPO in May 2021 and the conversion of preferred stock and warrants into common stock. These losses are expected to be non-recurring and non-recurring.
Last quarter was more of the same
For the quarter ended June 18, 2022 (author’s note, what a weird date for the end of the quarter!), Neighborly reported revenue of $114 million, up 34% year-over-year. Gross margins remained stable at 37%, but operating and administrative expenses increased to 28.0% of sales. A notable decrease in acquisition costs resulted in an operating profit of $2.3 million or 2.0% operating margin.
Appreciation is expensive
Since Neighborly has no income, it makes no sense to value Neighborly based on P/E statistics.
Neighborly currently has a market cap of $900 million and $313 million in net debt, for $1.2 billion in enterprise value. Even scaling up the company’s revenues to ~$800 million pro forma the Rubicon acquisition and applying the 11% adjusted EBITDA margin in Q1/F23 translates to a current valuation of 13.6x EV/EBITDA . Note, management believes pro forma EBITDA is $95.5 million, so management’s EBITDA estimate shows NBLY is trading at 12.6x EV/EBITDA (Figure 8).
Loblaw’s, Canada’s largest retailer with much higher operating margins, is trading at a 9.3x Fwd EV/EBITDA. Metro, another leading Canadian grocer with a pharmacy business, is trading at 11.9x. On EV/EBITDA, Neighborly seems overvalued.
Neighborly stormed out of the gates in May 2021, rising from its IPO price of $17 to nearly $40 by the end of the year. However, since early 2022, NBLY has fallen abruptly to a recent low of $19, below its closing price on the first day of trading (Figure 9).
The biggest risk to the Neighborly story is the lack of operational leverage. So far, in its short business history, NBLY has not shown any ability to take advantage of economies of scale and generate superior operating margins. Instead, operating margins were paper thin. A continued roll-up strategy with no apparent operational benefits will ultimately fail, as the acquirer typically takes on debt to make acquisitions and relies on synergies to pay off debt.
Speaking of debt, Neighborly currently has $313 million in net debt outstanding or 3.3x net debt/pro-forma EBITDA. Even if the pro-forma EBITDA figure is correct, that’s still a hefty debt burden. High debt can limit management’s ability to respond to challenging market conditions.
In short, Neighborly is a name where I would stay on the sidelines. While the tailwind for the pharmacy industry is evident in its aging demographics, NBLY has not demonstrated a superior business model. All I see now is an eager purchaser of low-margin community pharmacies.