Description

If names like Valeant, Acatvis and Endo hadn’t proven so contentions in recent months, we would have labeled Albany Molecular (AMRI) “Valeant v3.0” (Endo being v2.0).  Instead, we will frame the investment case in a manner that contrasts favorably with that group.  AMRI is a US-based contract manufacturing (“CMO”) and research (“CRO”) organization whose customers range from big pharma to small biotech.  AMRI’s end markets (and company) grow double digits organically. If the new CEO successfully employs his roll-up strategy in a heavily fragmented market, AMRI trades at just 5x 2018 cash earnings on publicly disclosed targets.  We believe that the market fails to appreciate the investment opportunity because: (a) AMRI was generating most, and in several years more than 100%, of its earnings from royalties connected to the blockbuster drug Allegra, (b) these now declining royalties obscured the early and rapidly successful efforts to transform the company, (c) AMRI is small and covered by just 3 analysts (third picked up coverage yesterday) and (d) sales and earnings were temporarily, but materially depressed at AMRI’s important Burlington, MA facility due to FDA sanctions in August 2010, which were lifted in November 2013.  We will describe the business and its growth drivers, the new CEO’s surprisingly strong background (given that the company had a market cap of <$350 million when he joined), address the aforementioned market dislocations and lastly, dive into the stated acquisition strategy and why we believe it’s feasible. 

Business Description

In 2014, AMRI will generate ~$300 million and $60 in EBITDA from four key market areas that are moving to three: Discovery and Development (“DDS” - 26% of 2014E sales), API (51% of 2014E sales), Drug Product (14% of 2014E sales) and Royalty revenue (8% of 2014E sales and rapidly declining).  The over-arching theme is that from discovery to delivery, the pharmaceutical industry is increasingly moving towards outsourcing to lower costs, improve efficiency and mitigate regulatory/manufacturing induced tail risk.  Many pharma companies want to streamline their operations and their number of suppliers. AMRI offers them a full outsourcing toolkit focused for complex drugs.  From one large academic CRO: “Back when everything was in house, pharma companies would characterize materials, formulate it, test it on animals, go into the clinic, do it. Offshoring or outsourcing BIG chunks of all that, moving to working more with CMOs and CROs always, even back when [pharma companies] had their own organizations. Often you need specialized equipment hugely expensive, compliance with FDA is hard...so we’ve gone, since I started this up [2.5 years ago] from $30k in revenue to a quarter of a billion and I don’t see any slow-down.” 

DDS serves as the outsourced R&D arm for dozens of pharma companies. AMRI is particularly suited to provide discovery and preclinical stage drug development to both large pharma and small biotech because the company has amassed a large library of cost-effective molecules, natural products and synthetic compounds to use for screening within FDA cleared manufacturing facilities. Their particularly strong development franchise and large scale manufacturing capabilities enable faster than industry growth as the Company has a semi-captive source of clients for commercial production.  From speaking with several customers and competitors, most clients like to stay with a single CMO for as long as possible with horrific service serving as the relationship killer as opposed to price.  The newly found cost and return focus of pharma have led to increasing DD&S outsourcing and Kalorama/McKinsey expect 9-15% industry growth for this $13 billion market (outsourced DD&S) over the next several years.    AMRI currently generates $80 million (2014 company estimate) with a $200-300 million target for 2018 and a 25% EBITDA margin.

API, or active pharmaceutical ingredient, is exactly that: outsourced manufacturing of the key ingredients of the $825 billion global pharma market.  There is a significant trend towards outsourcing as branded companies move toward their core competencies (sales and marketing) and generic companies struggle with the complex manufacturing of certain formulations.  AMRI focuses on controlled substances (must be manufactured domestically with a lot or red tape, which limits foreign competition as well as new entrants), custom/complex chemistry, steroids/hormones (heavily regulated providing entry barriers) and peptides/proteins/biologics (often complex requiring specialized manufacturing).  These are not commoditized white powders.  AMRI focuses on smaller niche markets that do not interest bigger players, so the pricing environment is strong and the growth rates are superior.   Additionally, prior to the 2014 acquisitions, 11 customers generated 52% of sales.  Of those 11 customers, 3 are in DDS and 8 in API.  Of those 8 in API, 7 came from DDS.  This affirms (a) the synergies between DDS and API, (b) the stickiness (and price inelasticity) of customers and (c) the lack of competitiveness due to high industry barriers in AMRI’s niches.  Competitors think of AMRI as a “specialty” of CMO where TEVA, Dr. Reddys and Mylan are more mainstream white tablets.  Catalent is trying to be the specialty of the “fill finish” side of CMO (not yet API).   API costs are typically <10% of the price of a typically branded product with reliability playing a more important role than cost.  AMRI is currently ~90% weighted towards branded with generics becoming an increasing focus for the new CEO.  The estimated outsourced API market is $14 billion, growing 8% per year through 2016 (both #’s from Frost & Sullivan) and AMRI generates $156 million in sales (2014 company estimate) with a $700 million target for 2018 and a 30% EBITDA margin.

Drug Product is the final leg of the CMO business, which focuses on sterile drug fill/finish capabilities and other complex formulations.  The business is increasingly focused on growing in specialized delivery systems including inhalation (oral manufacturing) and patches.  The Oso Bio acquisition put meat on this leg, adding ~$60 million of standalone revenue (but closed mid-2014).  The quasi-closed Burlington facility is also part of this division, which should generate ~$16 million of sales in 2015 (from ~$7 million in 2013).  For 2014, this business will generate $42 million of sales (Company estimate) with a $200-300 million target for 2018 and 30% EBITDA margin.  Frost & Sullivan estimates the outsourced Drug Product market to be $15 billion with a 12% CAGR through 2016.  Catalent, the largest player in the space (with an arguably commoditized packaging services offering), estimates 6-10% annual growth for the advanced delivery technology market (from their S-1).  Similar to API, AMRI grows faster because they are more exposed to “growthier” niches (more discovery exposure than Catalent). 

The final business, which is rapidly becoming minor, but still profitable, is the Royalty business.  Like many companies in the Healthcare space, AMRI hit one homerun and the entrepreneur scientist CEO squandered most of the proceeds.  New CEO Bill Marth is actively reallocating the capital to areas of visible growth and high returns.  This business will generate $25 million of sales in 2014 with $15 million coming from Allegra (down from $35 million in 2011) and $9 million from Actavis.  Allegra went off-patent in 2012 with the agreement concluding in mid-2015.  The Actavis royalty will expire in November 2017 at which point the supply agreement could be renewed.  These royalty agreements may add additional profit on top of management’s targets, but they will not be core focuses of the new team.

Management Track Record

Before we discuss the track record, incentive and vision of new CEO Bill Marth, it is worth a quick analysis of his predecessor.  AMRI collected Allegra royalties of $270 million from 2004-2012 under former CEO Thomas D’Ambra.  He spent nearly $90 million in R&D, directly collected 10% of the royalties ($27 million) and the company generated cumulative losses of $68 million and generated a TSR of NEGATIVE 57% during this period.  Beyond low-return R&D spend, former management also attempted a complex build strategy, including its former Bothell and Hungary facilities, which were both closed in 2012 due to a lack of profitability.  Enter Bill Marth. 

Mr. Marth began on January 1, 2014.  He was previously head of Teva America where he grew the business from $400 million in sales in 1999 to $12 billion in 2012 while improving margins.  He oversaw and integrated more than 10 significant acquisitions, including Cephalon ($7.4bn) in 2011, BARR Laboratories in 2008 ($6.8bn) and Ivax ($8.5bn) in 2005.  All major deals were accretive in year 1.  The BARR synergy target was raised from $300 million to $400 million and Ivax from $200 million to $300 million.  After six conversations with former Teva employees, we are confident in Mr. Marth’s ability to set and meet/exceed targets, acquire businesses at reasonable prices, integrate them rapidly and drive both sales and cost synergies.  Multiple references admitted to buying AMRI stock following Mr. Marth’s appointment and all thought he was dramatically over-qualified to join such a small business.  Thus, the question is, why did Mr. Marth join AMRI?

We think money and autonomy are the most likely answers.  Mr. Marth currently owns 1% of the company with RSUs on another 0.33%. He will likely get another slug of options in 2015 beyond the 30-90% of salary.  We think there will likely be a more aggressive and clear LTIP plan beginning in 2015.  As of now, we think without major changes to the compensation plan, Mr. Marth will still be worth ~$40 million in stock if the company targets are met in 2018.  This is significantly more than any he could have earned in any role at Teva, excluding the CEO role.  Additionally, given his successful acquisitive track record on a much larger and complex scale, we believe that Mr. Marth chose this opportunity, because of his confidence in creating substantial value rapidly in his first CEO role.

Mr. Marth’s biggest accomplishment since joining AMRI in January 2014 has been transitioning the business away from its dependence on Allegra royalties, which accounted for 11% of revenues, 51% of EBITDA and 75% of EPS in 2013.  Through cost-cutting, organic CMO growth and two acquisitions (with most of the benefit accruing in 2015), 2014 EBITDA is set to grow 23% and EPS by 28% (Company guidance).  As a result, the Allegra patent cliff has already been more than bridged.

Market Dislocation

With just three sell-side analysts covering the stock (one bear from Sterne, Agee and Leach, one bull from Morgan Stanley and a new bull from JPM – as of yesterday), it is no surprise that the stock trades in-line with its peer group despite offering significantly more upside potential.  To give you a sense for the quality of coverage at Sterne, Agee and Leach on AMRI, the analyst’s 2015 earnings estimate went up from $0.48 in June 2013 (when he initiated) to $1.07 in July 2014 yet his target price remained unchanged (and yes, he also had correspondingly higher cash flow estimates).  The original source of the dislocation is among the most common in the healthcare space.  AMRI was receiving a royalty from Allegra sales that contributed >100% of EBITDA every year from 2009 through 2012.  It is understandable that the market would be skeptical (or ignorant of) a rapidly growing underlying CMO business.  The decline in Allegra temporarily masked the significant transformation that the business underwent partially in 2013 and then dramatically in the first half of 2014.  That being said, the comps have gotten easier and will continue to do so (from flat sales and -25% EBITDA growth yoy in Q1 2014 to +15% sales and +47% EBITDA yoy in Q2).  Next, both contract revenues and EBITDA were temporarily depressed due to FDA sanctions at AMRI’s Burlington, MA, in August 2010, which were lifted in November 2013.  This facility went from generating roughly $16mm in sales and ~$4mm in EBITDA pre-FDA sanctions to being forced to operate at just 30-35% of capacity, resulting in a $7 million sales run-rate and $5 million of annual losses in 2013.  In 2014, this facility should generate roughly $12 million of sales and break-even at the EBITDA level.  With no additional capex, we expect this facility to generate $16mm sales in 2015 and get back to $4mm of EBITDA ($9mm EBITDA swing from 2013 and roughly 8% incremental EBITDA in 2015 vs. 2014).  Lastly, as is typical in roll-up stories, no analyst forecasts significant growth from acquisitions.  This is the biggest, if not only reason, to buy this stock. 

The Acquisition Story (READ: Key Value Driver)

This is undoubtedly the most relevant pressure point requiring the greatest diligence.  Fortunately, there is some decent data available (much of which the Company and its peers have republished from third parties).  Underlying results by AMRI and its competitors largely substantiate the industry reports.  Through CapitalIQ, Bloomberg, PharmSource, Morgan Stanley’s initiation report and calls with several industry experts, it is pretty easy to gain conviction in the fragmentation of the industry.  Lastly, our VAR calls with competitors and reference checks on Bill Marth have enabled additional conviction in the feasibility of AMRI successfully employing its acquisition strategy (these notes are not for available for public consumption).   

Let’s start with the total addressable market for each vertical.  See page 11 in the following AMRI presentation:

http://www.amriglobal.com/img/uploads/file/Investor_Presentation_August_2014.pdf

If AMRI achieves the midpoint of its 2018 sales targets, they will garner <2% market share in DDS and Drug Product and 5% for API (from just over 1%).  None of these numbers appear outlandish.  The sources for the denominator appear credible and the numbers do not conflict with reports from Catalent and Patheon (PE owned peers – both with public filings/documents).

The next question is how much capital do they need to deploy to get there? With underlying organic revenue growth of ~12% per annum, we think they need to deploy roughly $1.4bn of capital between now and December 31, 2017 to achieve these targets.  We assume an 8.5x pre-synergy EBITDA multiple (weighted down by API acquisitions) with EBITDA margins starting at 20% and moving to 26% by year 3.  We get a bit under 500 basis points of EBITDA margin improvement from 2014 to 2018 (~19% to 24%).

So how will they finance this and do they have sufficient balance sheet capacity?  We think they can keep net debt/EBITDA at or below 4.0x throughout the period in question (see model).  The Company has said they are comfortable going to 4.5-5.0x net debt/EBITDA for the right deals.  If there is a large acquisition at the right price sooner than our forecast, we would not rule out a mix of stock and debt.

Is the universe big and fragmented enough to achieve this?  Are there other competitors employing the same strategy?  Will that result in higher acquisition prices and lower returns? 

From a Patheon company presentation republished in the Morgan Stanley initiation report:

CMO Est. 2013 Revenues Est. Market Share

Catalent $1,340 12%

Patheon $530 5%

Vetter $405 4%

Baxter $400 4%

Famar $368 3%

Aenova $294 3%

Fareva $294 3%

Haupt $265 2%

DPT $250 2%

Recipharm $219 2%

Nextpharma $213 2%

Hospira $200 2%

Asian CMOs $600 5%

AMRI $133 1%

Others $5,402 50%

Total $10,913 100%

While we believe that this reflects just a fraction of AMRI’s core business (Drug Product and large portions of DDS are largely absent from the chart above), it does provide a sense for the level of industry fragmentation. Most targets are private, generate $10-200 million in sales and there appear to be a few hundred of them (at least according to senior executives at Catalent, Patheon and PharmSource).  Catalent, recently IPO’d by Blackstone (and largely in slower growth verticals), stated in their S-1 that they “operate in highly fragmented markets in both our advanced delivery technologies and development solutions businesses. Within those markets, the five top players represent only 30% and 10% of the total market share, respectively, by revenue.”

There are a few public players that focus almost purely on DDS/CRO (Charles River Labs, WuXi Pharma, Evotec).  There are a few that focus on large-scale manufacturing (Lonza, Cambrex and Aceto) and there are a couple large clinical CROs that share adjacencies with AMRI (Quintiles and Covance – Mr. Marth aspires to replicate Quintiles transformation over time in AMRI’s niches).  Conversations with industry experts further validate the size and fragmentation of the industry.  From speaking with management, most deals are negotiated versus run through competitive auction.    Every competitor and customer that we asked expressed the view that the industry is plenty big and fragmented for multiple acquirers to pursue acquisitive strategies without impacting the other.

So what will they pay?  We think that on average they will pay around 8.5x pre-synergy EBITDA.  This multiple is weighed down by more acquisition dollars spent on API purchases (highest revenue target) and pulled up by the DDS business.  Public peers trade in this range and it is reasonable to assume a fairly significant discount for smaller private players.

Can they extract costs?  Thus far that appears to be the case.  Contract margins grew from 16% in Q2 2013 to 27% in Q2 2014, largely as a result of synergies from the Cedarburg acquisition.  This API acquisition closed at the end of Q1, was purchased for 8x EBITDA ($41mm and $5mm EBITDA) and should generate $1.5mm of synergies within 12 months (on a standalone sales base of ~$18mm and growing).  Pro forma for synergies, the deal price goes down to 6.3x and the EBITDA margin to 36%.  Oso Biopharma was at the other end of the spectrum.  This Drug Product business was purchased for $110mm on 7/1/14 for 11.5x EBITDA (8.8x post-synergies) and accretive year 1.  These synergy targets do not include revenue synergies from the additional spare capacity of the new assets.   Lastly, Catalent is probably the best public comp and we do expect slightly higher margins (24% vs. 20% for Catalent today) for AMRI over the medium-term, because they have more niche exposure (see above).

There are several risks inherent with owning AMRI even outside the obvious inherent acquisition risks.  First, non-compliant manufacturing facilities provide significant idiosyncratic tail-risk, especially given the concentration of the company’s operations.  Burlington went from a highly profitable facility to a major loss-maker.  An FDA problem at multiple plants or just the Rensselaer plant could significantly impair the value of the equity.  Additionally, the Aurangabad facility is currently underutilized and awaiting FDA approval with an inspection, which should take place by the end of 2014.  If approved, this site will be used for API manufacturing that will be sold into regulated markets (the US) at higher margins.

Location Square Feet Primary Purpose (from 10K)

Rensselaer, New York 276,000 Contract Manufacturing

Albany, New York 198,000 Contract Manufacturing, Contract Research and Administration

Aurangabad, India 208,000 Contract Manufacturing

Holywell, United Kingdom 68,000 Contract Manufacturing & Contract Research

East Greenbush, New York 64,000 Contract Research

Hyderabad, India 62,000 Contract Research

Burlington, Massachusetts 46,000 Contract Manufacturing

Singapore 37,000 Contract Research

Syracuse, New York 28,000 Contract Research

Pricing power could also be an issue.  GE Healthcare accounts for ~12% of contract revenue.  The next largest is also above 5%.  While there are undoubtedly some relationships where AMRI can push pricing, they also have major multi-national customers (Sanofi, Actavis, etc.) that can push back.  Realistically, we see this more as an opportunity than a threat.  As mentioned, we have just gone from a science-focused CEO to a commercially minded one.  While we don’t see a replication of Taro or Questcor past pricing trajectory, we do think Mr. Marth will probably generate an incremental 100-200bps of gross margin upside from pricing (mapping their limited DMFs reveals very limited competition at the end market level versus CMO peers).

Lastly, there is an outstanding convertible.  It can be settled in cash and is <10% dilutive if the stock doubles.  We assume this is debt for modeling purposes and will be rolled into bank debt in 2015.

Catalyst