Value Investors Club / AVID BIOSERVICES INC (CDMO)

Description

An Unproven Outsourced Contract Drug Manufacturer with almost 70% of its

revenue coming from a single Customer with 37% negative manufacturing growth

Y/Y and backlog down 50% Y/Y trades at 4x Sales and is likely to need to raise

more cash.

• Negative Cash flow

• 37% negative manufacturing growth Y/Y

• Backlog down almost 50% Y/Y

• Massive customer concentration risk

• Going Concern

We are recommending shorting Avid Bioservices above $4 after the company’s

recent 50% plus price increase following its recent $2.25 secondary offering in

February, which required a 35% discount to meet institutional demand. Recently,

sell side coverage from Wells Fargo and First Analysis and an overly enthusiastic

write up with little support on Seeking Alpha sent Avid shares soaring. This isn’t

the first time the company’s stock soared without fundamentals to support it. The

first time occurred when the company did a 1 for 7 reverse stock split last year. In

addition, the stock went up 100% when a successful activist campaign resulted in

a change in management and the decision to shutdown the biotech R&D

business. However, when Avid reported negative revenue growth and

accelerating losses, the stock quickly dropped from $5.40 to under $3. Again, the

company is getting promoted due to the recent secondary offering before we see

the fundamentals improving in the business and we would be cautious buying

into a company that is still not growing and continues to generate losses. Until we

see the turn in the business and backlog accelerating substantially, we don’t think

the company or the sell side has any visibility into revenue beyond the 39m in

backlog that is down almost 50% Y/Y. The company will finish its FY18 at the end

of April and management has no incentive to offer strong guidance beginning

2019. In fact, their incentive is the opposite.

When a Company with trailing revenue of $57m has 1 customer that accounts for

approximately 70% (FY18) of revenue we have tremendous concern. "During the

three and nine months ended January 31, 2018, approximately, 53% and 78%,

respectively, of our contract manufacturing revenue was derived from our two

largest customers. Based on our current commitments for manufacturing

services from our two largest customers, we expect our future results of

operations to be adversely affected until we are able to further expand and

diversify our customer base.” Page 6 Avid Bioservices recent 10-Q

When that same customer is not under a long-term contract or minimal revenue

obligations, it quickly becomes apparent that Avid is rapidly drawing down on its

backlog with no visibility into new customers to replace the loss business with

Halozyme. Our concern only grows when we realize that management guided for

FY18 revenue ending in July 2018 to be down 8.8% at the midpoint to

$52m. When we look into the 10-Q for Q3 2018 more closely what we see is that

deferred revenue on a Q/Q and Y/Y basis for was down (52.9%) and (37.6%).

Additionally, backlog as of January 31, 2018 was $39 million, the majority of

which, the company expects to recognize over the next 12 months, compared to

approximately $70 million at January 31, 2017. Furthermore deferred revenue +

Customer deposits are down (39%) Q/Q and (35.8%) Y/Y. What this tells us is that

Avid’s lifeblood and largest customer is not re-ordering. As management stated

on the previous earnings call, the absolute earliest Halozyme would need product

is in the 2Q of FY2019, but it is unlikely that they will actually place orders until

FY20 because it will take time before the FDA completes its review of Myford for

Roche, which is the Halozyme end customer that Avid is working with. All Roche's

product has historically been manufactured at Avid’s original Franklin plant. We

also know that when Halozyme does place a new order, it will be smaller than in

years past given that it is cheaper for Halozyme to manufacture its rHuPH20

(recombinant human hyaluronidase) enzyme at Cook Manufacturing than it is at

Avid. The one saving grace will be that Roche, one of Halozyme’s customers

prefers Avid over Cook, so Avid will be able to retain some of their existing

position with Halozyme and hopefully grow it several years down the road as

Roche brings new subcutaneous products to market. In the interim, Avid has

almost 70m of idle capacity and very limited visibility on orders until then. What’s

even worse is that Avid is not growing its customer deposits other than two very

small orders with non-commercial customers, Roivant Sciences and Acumen

Pharmaceuticals. These deals are in the range of $3m-$5m and only $1m plus per

customer can be recognized upfront with the rest of the revenue not being

recognized for 9-12 months.

The paragraph below is from page 5 of Avid’s most recent 10-Q:

Going Concern:

The accompanying condensed consolidated financial statements have been

prepared on a going concern basis, which contemplates the realization of assets

and the satisfaction of liabilities in the normal course of business. The financial

statements do not include any adjustments relating to the recoverability of the

recorded assets or the classification of liabilities that may be necessary should it

be determined that we are unable to continue as a going concern.

We have expended substantial funds on our contract manufacturing business and,

historically, on the research and development of pharmaceutical product

candidates. As a result, we have historically experienced losses and negative cash

flows from operations since our inception and, although we have discontinued

our research and development segment (Note 1), we expect negative cash flows

from operations to continue for the foreseeable future until we can generate

sufficient revenue to achieve profitability. Therefore, unless and until we are able

to generate sufficient revenue, we expect such losses to continue during the

remainder of fiscal year 2018 and in the foreseeable future.

Our ability to fund our operations is dependent on the amount of cash on hand

and our ability to generate sufficient revenue to cover our operations. At January

31, 2018, we had $17,938,000 in cash and cash equivalents and during February

2018, we raised $23,163,000 in gross proceeds from the sale of our common

stock pursuant to an underwritten public offering (Note 13). In addition, we

expect to receive an aggregate of $8,000,000 in upfront payments over the next

six (6) months from the recent sale of certain of our research and development

assets (Note 10).

In the event we are unable to secure sufficient business to support our operations

beyond the next twelve months, we may need to raise additional capital in the

future. Our ability to raise additional capital in the equity markets to fund our

obligations in future periods is dependent on a number of factors, including, but

not limited to, the market demand for our common stock. The market demand or

liquidity of our common stock is subject to a number of risks and uncertainties,

including but not limited to, negative economic conditions, adverse market

conditions, and adverse financial results. If we are unable to either raise sufficient

capital in the equity markets or generate additional revenue, we may need to

further restructure, or cease, our operations. In addition, even if we are able to

raise additional capital, it may not be at a price or on terms that are favorable to

us. As a result, we have concluded that there is substantial doubt about our ability

to continue as a going concern within one year after the date that our

accompanying unaudited condensed consolidated financial statements are

issued.

What this means is that Avid is not getting new customers in the door. Customers

make deposits before manufacturing begins so if you see that deposits aren’t

accelerating that means new orders are non-existent.

To further support our thesis, one just needs to look at the income statement

where you can see that gross margins on existing revenue are a dismal 26% and

continue to decline from over 40% two years ago. The implications of low gross

margins are lower capacity utilization. Avid has had over 80m of capacity at its

two manufacturing facilities for almost 2 years and yet they can only run at 40

percent. The company booked 57m of revenue in FY2015, but they actually

manufactured another $10m that they couldn’t ship until this fiscal year. So, if

you were to make an apples to apples comparison, Avid actually manufactured

$67m of revenue in FY2015 (shipped $57m) and given their guidance is only $42m

of actual manufacturing revenue this year the Y/Y revenue decline is not (8.8%) at

the midpoint but a much worse (37%) decline.

To make matters worse, Avid is using both its smaller Franklin and larger Myford

manufacturing facilities. As a result, utilization is down and therefore efficiencies

are also down. If they have moved some of their customers manufacturing from

one facility to another and have switched reactor sizes, it is also likely that the

customers may not need to manufacture as much product in a different facility,

which could further put pressure on their ability to grow revenue.

So why can’t Avid generate any new business?

In our conversations with other industry players as part of our due diligence, we

consistently heard that Avid lacks a track record in working with commercial

customers. Outside of their 70% Halozyme customer, to our knowledge, they

have not provided full scale commercial orders beyond test runs. We also heard

that if you come to Avid you must be prepared to pay higher prices. Since Avid

was the red headed step child that received no love until recently with the

spinoff, the company underinvested in technology and equipment. For example,

we were told that Avid does not have a WFI system at its Myford facility. As a

result, the company has to purchase filtered water and charges a pass through

cost to customers. If you look around the industry at some of the large

manufacturers such as CMC Biologics, Cook Pharma, Cytovance and Lonza each of

them has a WFI system. Other industry consultants we spoke with told us Avid’s

process development labs were also in major need of an upgrade and hadn’t been

upgraded in over 10 years. The equipment was outdated and the cell lab needed

to be modernized. So, yes, if the entire industry is capacity constrained Avid will

win some clinical business, but Avid won’t be anyone’s first choice for

manufacturing for atleast 24 months, which is the minimum it will take to get its

facilities up to industry standard. We were at the Interphex this past week and

again in our discussions with competitors and potential customers, it was clear

that the industry dynamics are strong, but that Avid’s facilities were not state of

the art and needed some capital investment to attract commercial business. The

fact that they have a strong FDA track record is good for attracting new early

stage business for their Franklin facility, but it will be more challenging to get new

business into Myford given the limited FDA record and limited customer history.

Last but not least, Avid has over 1.5m preferred shares outstanding, which are

valued at $41m and pay a 10.5% coupon. The company would likely wish to call

the preferred (callable at $25 CDMOP), but Avid doesn’t have the free cash flow

(negative) or the balance sheet strength to call the shares.

On the bright side, Avid was able to raise $23,163,000 in gross proceeds in

February from the issuance of over 10m shares of equity that was over 20%

dilutive to the company at a valuation of roughly 2x sales. The problem now is

that Avid is burning through its backlog and per the 10-Q only has sufficient cash

to fund the company through March of 2019. However, we are not even

convinced that the company can make it past December given that the backlog

will be approximately $33m in July and it takes 9-12 months to actually book

revenue (beyond the small customer deposits) once a new customer engages Avid

or any other CDMO. Avid has 55.5m shares outstanding today and $41.5m in

preferred stock, which we treat as debt. Current valuation is 3.4x EV/Sales for

forward 2019 revenues. We expect the company to need to raise another $25m

in CY19 or issue another 8m shares.

Additionally, the Street is between 80m and 90m in revenue in FY20, implying 35-

45% growth and a quarterly ramp of over 100% beginning in Q419 Y/Y. We don’t

see how that is possible in such a short period of time given that Avid has

underinvested in its facilities and it takes almost a year for new customers to

ramp revenue. Unless, the company has a huge order up its sleeve, we don’t

know about, investors are likely to be disappointed over the next year. When we

pressed the company on this question, their response was that those are the analysts numbers, not ours.

Longer-term, we like the industry and the growth dynamics. We like the

management team at Avid and we believe that a couple of years from now that

the risk reward will be far more compelling for the company. Yes, other industry

companies have been acquired for 15-20x EBITDA, but they actually have EBITDA

and 20 percent plus EBITDA margins! Avid won’t be cash flow positive for atleast

3 more quarters and the company has 55.5m shares outstanding excluding the

preferred and the 4m options at $8. Short-term, the company has negative

growth, low margins, negative free cash flow and no visibility on order growth so

we think there is more downside risk to 2019 and 2020 numbers than there is

upside and if Avid misses revenues in the next year and has to raise more money,

we could see the stock back at $2.50 or lower.

Additionally, Avid still is operating as a going concern and needs to invest atleast

$5m now to improve its Myford facility so it can attempt to attract a second

commercial customer. The preferred shares also have restrictive covenants so

the company has little choice but to issues more shares.

So, our takeaway here is that you have an unprofitable company with Y/Y

manufacturing revenue down 37% at the midpoint of guidance with a massive

customer concentration risk that is going to get worse (see deferred revenue and

deposits) before it gets better trading at 4x EV/sales with limited visibility into

growth and an aggressively declining backlog. At a share price of $2.50, the risk

reward is more compelling given 2020 estimates are too high, cash flow is still

negative, need for additional equity raise is high and revenue ramp is slow.

*We assume the preferred shares and cash (from secondary) cancel each other

out in the EV.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Expectations are too high and stock has moved too far too soon without showing the market any revenue or cash flow growth.

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			2018	2019
Price:	3.95	EPS	0	0
Shares Out. (in M):	56	P/E	0	0
Market Cap (in $M):	220	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0
Borrow Cost:	Available 0-15% cost