We have meaningfully increased the Forager Australian Shares Fund’s investment in Paragon Care (PGC) during March. Cobbled together through acquisitions over the past decade, Paragon is one of Australia’s largest health care suppliers. Most acquisitions didn’t live up to expectations and the share price was languishing at a level that suggested the whole was worth substantially less than the shareholder capital spent putting it together.
The inevitable fix-it job was already underway. In early 2022, John Walstab merged his business, Quantum Health, with Paragon and ended up owning 19% of the combined company. Since the merger Paragon has been a small investment in the Fund. By the end of 2023, frustrated with its performance, Walstab had taken over management of the whole business. His efforts over the past six months were showing signs of progress in Paragon’s half-year result.
That was completely overshadowed by an announcement that Paragon would be merging with another distribution company, CH2. This is a deal that we like. A lot. CH2 is a privately owned company that has become one of Australia’s largest distributors of medicine and medical consumables. You might be familiar with the big players in this market: Sigma Healthcare (SIG), Wesfarmers’s (WES) API and Symbion, owned by New Zealand’s EBOS (EBO). They deliver everything from drugs to bandages and vitamin pills to the country’s pharmacies and hospitals every day.
These companies, including CH2, have been around a long time — replicating their distribution networks is almost impossible. CH2 was owned by Spotless in the early 2000s and part of a private equity/API joint venture until 2015, when it was sold to prior management.
That’s when everything changed for the company. API’s ownership of CH2 meant CH2 was unable to compete with API in retail pharmacy distribution — a market several times larger than the hospital market. Freed from those shackles, CH2 was granted a license to distribute drugs to pharmacies from 2017. From a standing start, it has picked up 7% of Australia’s $18 billion pharmacy wholesaling market and, in total, is expected to generate almost $3 billion in revenue this financial year.
CH2 Revenue and Earnings Before Tax
This is a low-margin business with relatively fixed overhead costs. As it has grown, CH2 has become increasingly profitable. It made $12.8 million of net profit in the 2023 financial year and is on track to make $16.8 million this year. We are confident that trajectory can continue.
Its three giant competitors all own or are aligned with retail brands. Sigma owns Amcal and intends to merge with Chemist Warehouse. API owns Priceline and Symbion owns TerryWhite Chemmart. CH2 is the only independent distributor and wants to stay that way, leaving it ideally placed to service a significant number of “non-aligned” pharmacies. Management estimates those non-aligned pharmacies represent some 44% of Australia’s total retail pharmacy sales.
That share probably falls over time — Chemist Warehouse looks like a genuine category killer. But we think CH2 can keep growing its share of a growing market for many years to come.
Profitability in its hospital distribution business should be helped by its acquisition of Sigma’s hospital business in mid 2023, leaving CH2 as one of only two players in that market. And, perhaps most importantly, the opportunities within Paragon’s existing business look significant. If the deal is approved by Paragon shareholders, CH2’s two shareholders will end up owning 57% of the combined entity. David Collins, CH2’s managing director, will take over management of the company and he and his co-owner will both take seats on the board. Walstab will keep his board seat and two independent directors will be appointed.
The ParagonCare Board, including Walstab, is supportive of the deal. Unless something significant changes, we are too, making it highly likely to proceed. At the stroke of a pen, Paragon will be transformed from a sub-scale distribution business with a patchy record of capital allocation to a profitable owner-manager company taking market share in a growing industry. And there should be significant synergies between the two companies.
Healthcare distribution is not an easy sector in which to operate. Sigma’s return on capital has been sub-par for a long time and API hasn’t been much better, even under the stewardship of Wesfarmers. There are risks associated with being a minority shareholder in a company controlled by management, including the inability to replace them if necessary. It might take several years for the benefits to become obvious and, given the insider ownership, the stock will remain illiquid for a long time to come.
On balance, though, this is a significant change for the better for Paragon shareholders. Collins is not taking a cent in cash as part of the transaction and will have his life’s work tied up in Paragon, making him heavily incentivised to make a lot of wealth for all shareholders.
We think we have finally found the right jockey for a horse that has been particularly difficult to ride, and have added meaningfully to the investment over the past month.
This is an excerpt from the Forager Chief Investment Office Letter March Quarterly Report