I bought shares in Paragon Care Ltd. (ASX: PGC) on 12 June 2014 for 23.5 cents and sold them on 17 July 2014 for 30 cents. Today the stock is trading at 71 cents and so I sold far too early which may make me a biased observer and is important to bear in mind when reading this article.
Paragon provides equipment to the health industry and has grown primarily through acquiring other businesses. The healthcare industry is thriving thanks to favourable demographic trends that are expected to last for decades. Private hospital operator Ramsay Health Care Limited (ASX: RHC) is one company that is riding this wave, its share price is up a massive 342% in the past five years. Not bad for a $12 billion juggernaut.
Growth by acquisition is difficult to execute well for the following reasons and generally I am not a fan of the strategy.
- You don't know what you're buying until the deal is done, at which point there is no going back. In contrast, the vendors know exactly what they are selling giving them a major advantage in negotiations. Furthermore, it is always in the interests of bankers, lawyers and other advisors to get the deal completed regardless of who they represent.
- You don't know if the culture of the business you are buying will be a good fit with your existing business. A cultural clash can lead to employees leaving and taking key customer and supplier relationships with them.
- Aside from the acquisition price, there are various other significant costs such as the cost of raising capital, advisory and legal fees, debt interest and restructuring. This means that in a year when an acquisition is completed, it is difficult to assess business performance. If many acquisitions are done every year then these costs become ongoing and it is almost impossible to judge how things are tracking.
- When a small company first begins acquiring it can lead to rapid profit growth which the market then rewards with a high earnings multiple. At the outset, the company is usually conservatively geared but as it continues to acquire, debt can quickly balloon out of control. Incentivised by options, management makes larger and larger acquisitions to maintain percentage growth and market multiples to keep the share price rising. This is unsustainable and one way or another the share price eventually falls back to reality.
In 2015, Paragon's revenue was up 66% to $32.2 million and net profit after tax (NPAT) rose 90% to $2.1 million. Earnings per share (EPS) were up 60% to 3.2 cents, a lower growth rate than NPAT because of new shares issued as part consideration for acquisitions during the year. Revenue and NPAT growth are not very relevant measures for this type of company because they take no account of the cost of acquisitions.
The company has elected to increase its dividend by 12% to 1.4 cents per share for 2015, a move that is likely to be popular. I am not so keen because I think the company would be better off reinvesting this money into its aggressive growth strategy.
Debt less cash grew from $1.5 million to $8.5 million during the year and operating cash flows were just $0.8 million. Debt increased mainly to fund acquisitions and cash from operations was less than NPAT largely due to rising inventory and receivable levels through the year. When you also factor in $1.3 million spent on non-current assets, the business didn't generate any cash at all in 2015 which is why I do not approve of the decision to increase dividends.
After the end of the reporting period, Paragon announced the acquisition of three further businesses for $66.1 million, more than two thirds funded with new equity and the remainder with debt. Paragon's revenues are expected to more than triple and EPS is predicted to increase by 50% as a result of these deals. As with any forecast, these figures should be treated with caution.
At the current share price of 71 cents, Paragon is trading at a price to earnings ratio of 22x based on 2015 actuals and 15x based on forecast earnings per share. These are not expensive multiples but they are not cheap either, especially when debt is mounting and cash generation is currently so weak.
Personally I prefer Lifehealthcare Group Ltd (ASX: LHC) which is also a medical device distributor and is growing both through acquisitions and organically. A key difference for me is that Lifehealthcare has so far acquired much more slowly than Paragon without raising equity and has strong free cash flows.
