SIF Portfolio: Alliance Pharma could be the defensive prescription I need

Two weeks ago, I decided to hold back from adding more cyclical stocks into the SIF Portfolio.

My hope was that a defensive stock would become available in my screen results. This would allow me to reduce the portfolio’s long-running imbalance between cyclical and defensive stocks. I’m pleased to say that’s what has happened this week.

AIM-listed Alliance Pharma has been propelled into the Stock in Focus Screen following a strong set of interim results last week. This isn’t a company I’m very familiar with, so despite Stockopedia’s focus on the numbers, I’ve taken a little time to get up to speed with the firm’s story.

No R&D, just sales

Alliance Pharma is a pharmaceutical firm which specialises in buying products from other manufacturers and then marketing them. It doesn’t develop its own products. The company started trading in 1998, when it acquired a portfolio of 16 specialty brands from Novartis. It now has annualised revenues of more than £100m.

The group’s focus is on maximising the commercial returns from the products it acquires. Activities such as manufacturing and logistics are outsourced. Company founder John Dawson remains in charge of the business, which has grown through a series of 28 acquisitions.

One of the most significant deals was the £127.5m acquisition of a portfolio of products from Sinclair Pharma at the end of 2015. This added 27 products to the Alliance portfolio and contributed more than £40m of annual revenue.

Alliance now has a portfolio of 90 products, with sales in more than 100 countries. The bulk of these are “established niche prescription products”, which presumably have little in the way of competition.

Margins are high and the company appears to generate plenty of cash. Last week’s interim results showed that revenue rose by 8% to £50.3m, while underlying pre-tax profit edged higher to £11.9m. Net debt fell by 17% to £63.4m, and shareholders were rewarded with a 10% hike to the interim dividend.

The share price has doubled over the last five years and risen by 10% so far this year.

Stockopedia likes the shares too. At the time of writing, Alliance is the second-highest ranked firm in the Pharmaceuticals sector, with a StockRank of 80 and a style of Super Stock.

Improving value

Alliance Pharma’s StockRanks aren’t actually that outstanding, but the trend is upwards:

Last week’s interim results have clearly had a positive effect. The ValueRank of 71 is reassuring. When broken down it contains some attractive ratios, in my opinion:

The highlights for me are the price/free cash flow ratio of 10.4 and the earnings yield of 9.8%. Let’s take a quick look at each.

Free cash flow: Trailing free cash flow shows up as 5.1p per share in Stockopedia, which is slightly above my own estimate of 4.5p per share. It’s worth noting that if you calculate values such as FCF yourself from companies’ published accounts, you’ll usually get a figure that’s slightly different to the Thomson Reuters data used by Stockopedia. The reason for this is simply that the Stockopedia financial data is processed and normalised by Thomson Reuters, so that it’s consistent across companies. Actual errors are fairly rare.

In this case, I’d be more comfortable assigning the stock a P/FCF of about 12, which is still attractive in my view.

Earnings yield (EBIT/EV): I like this metric because it combines valuation and profitability. So companies with differing levels of profitability and valuation can be meaningfully compared.

Alliance Pharma’s earnings yield of 9.8% implies that the company is only valued at around 10 times operating profit, including debt. That’s attractive, in my opinion.

Although the dividend yield of 2.4% is fairly low, the payout has grown by an average of 10% per year since 2011. At present, I’m happy to see free cash flow focused on debt reduction as well as dividends.

Acquisitions have hit quality

When Graham Neary reviewed this stock back in March, he raised a potential concern about debt levels. I agreed with his view that net debt of 2.8x EBITDA didn’t seem to leave much headroom below the group’s banking covenant of 3.0x.

However, the company’s confidence in its future cash flow seems to have been validated. Net debt to EBITDA has fallen to 2.4x during the first half of the year. In real numbers, this equates to a reduction of £12.7m in net debt to £63.4m.

That’s roughly 3.9 times forecast net profit for 2017. Although this is close to my screening limit of four times net profit, it is still acceptable, especially as management guidance is for net debt to fall “to around 2.0 times [EBITDA] by the end of the year”.

Looking elsewhere at the quality factors, there are no obvious problems. A Piotroski fundamental health score (F-Score) of 8/9 highlights profit growth and strong cash generation. The only fail is that the group’s profitability has fallen when measured using return on assets.

I suspect this is a glitch in the TTM calculations, resulting from the firm’s acquisition activity. Looking at the last eighteen months, the StockReport data shows an improvement in ROA following the interim results:

This table also provides a useful illustration of how a company’s margins can diverge from its return on capital employed (ROCE). Although Alliance’s operating margin has been stable at an average of 28% since 2011, ROCE has performed much more poorly.

This can be a characteristic of acquisitive groups. The price paid in an acquisition of this kind is meant to reflect the present value of future earnings. So balance sheet assets often increase much more quickly than profits following acquisitions.

Alliance Pharma’s total assets increased from £107.9m in 2014 to £282.6m in 2015 after the Sinclair acquisition. The ROCE generated by these assets should improve as profits rise and the assets are depreciated. ROCE has already returned to its pre-acquisition level of 11.5%, from a 2015 low of 6.5%.

Strong technical momentum

I’m comfortable with the value and quality offered by Alliance Pharma shares. But without a dose of momentum, the opportunity cost of tying up the portfolio’s cash might not be worthwhile.

Fortunately, the momentum picture looks broadly positive. Although the firm’s last results were apparently slightly below expectations, price momentum looks strong. A number of technical factors appear to support the case for further gains:

Overall, I’m comfortable with the outlook here. The group’s short-term profits may continue to fluctuate slightly due to acquisitions and other one-off costs. However, I think the firm’s focus on niche prescription medicines should mean that underlying revenue is very stable.

Financial quality is visibly improving as the Sinclair acquisition beds in, and the shares looks reasonable value to me, on a blended forecast P/E of 12.

I will be adding the stock to the SIF portfolio this week, but as always please let me know what you think.