|Shares Out. (in M):||56||P/E||NM||NM|
|Market Cap (in $M):||139||P/FCF||NM||NM|
|Net Debt (in $M):||-9||EBIT||-30||2|
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• Avid Bioservices has divested its value destructive R&D operations which were masking its biologic contract manufacturing division
• A low price for the company’s divested IP has disappointed the biotech focused shareholder base and a poorly executed equity raise thereafter has crushed the stock price.
• Yet biologic contract development and manufacturing organizations (CDMO) are high quality businesses with high barriers to entry, high margins, long contracts on commercial products, high ROICs, and high growth. Avid’s impressive regulatory track record, an important selling point for customers, is matched by only the largest CDMOs
• The CDMO industry is consolidating rapidly and comparable companies have received buyout multiples ranging from 15-17X EBITDA and 4-5X revenue. I estimate that Avid’s legacy facility alone has a private market value 30% higher than the company’s current enterprise value
• Avid is now the only pure play biologic CDMO in the public market and the divestiture of its IP puts the company in play. 17% of shares outstanding are owned by a value-oriented hedge fund as well as an activist investor
• Avid has grown revenue at a 40% CAGR over the last 6 years despite no focus on sales and marketing. Competitors are achieving similar growth rates
• The fixed cost nature of contract manufacturing and a high proportion of low margin process validation revenue in Q1 have temporarily depressed margins. I estimate that the company is trading for 5X what the company will be earning three years from now, and that the equity should trade at a premium multiple
• Due to large losses on R&D, the company has federal NOLs of $390mm and state NOLs of $260mm- very substantial for a company with an enterprise value of only $130mm. The company should not be a cash tax payer for many years to come
• A newly reconstituted board of directors is unusually qualified, consisting of industry CEOs and entrepreneurs. Three have recently purchased shares
New Shareholders, New Board, New Management
Avid Bioservices (known as Peregrine Pharmaceuticals prior to its name change on 1/8/18) was a biotech drug development company for most of its history. The previous management team wasted hundreds of millions of dollars, funded by shareholders, on the development of a biologic drug. But while shareholders suffered, management and the board of directors paid themselves well. The previous CEO, Steven King, took home over $8 million of cumulative compensation since 2010 while the shares outstanding exploded from 55 million to 315 million. Since 2003, shares outstanding have grown at a 20% CAGR. Non-executive directors of Avid were compensated, on average, more than the non-executive directors of pharmaceutical giants like Merck and Pfizer.
In anticipation of a commercial release of its own drug, Avid management began building out its own biologic manufacturing capacity. Customer demand proved to be so high that Avid had to keep expanding to maintain the capacity for its own drug production expectations.
In February of 2016, Avid announced that its most promising clinical trial was a failure. By mid-year, prior management decided on a plan to focus the company on contract manufacturing with the goal of achieving profitability within 24 months. In March of 2017, Ronin Capital filed its first 13D and began agitating for the replacement of the board.
To placate Ronin, the company hired Dr. Roger Lias, a CDMO consultant, to run the biologic manufacturing division and to serve on the board of directors. The company added two more independent directors with relevant experience, although the four incumbents still retained control of the seven-person board. On November 28th, Ronin entered into a standstill agreement with the company and the remaining four incumbent board members were replaced with three Ronin nominees and one independent director to serve as chairman. Shortly thereafter, the CEO stepped down and Dr. Roger Lias was hired as CEO. The company changed its name to Avid Bioservices and its ticker to CDMO to indicate the focus on contract manufacturing.
The R&D operations are now essentially wound down, and after hundreds of millions of dollars invested in the IP, it was sold in February for only $8mm up front and potential royalty payments in the future. The company then raised $21.5mm in a secondary offering through Wells Fargo at the price of $2.25/share. The CFO from the pre-activist days resigned shortly thereafter.
Biologics and Avid’s Positioning
Avid is a unique company in that there aren’t very many public companies with biologic CDMO operations, and none are US pure plays. I don’t believe public market investors are too well educated about the industry itself. Biologic pharmaceuticals are drugs that are derived from biological sources in contrast to fully synthesized traditional pharmaceuticals. Biologic sales are estimated to grow at high single digits for the next few years, and by the year 2020, 50% of the top 100 drugs will be biologics. CDMO industry growth is accelerating and biologic active pharmaceutical ingredients (API), Avid’s wheelhouse, is the fastest growing subset of the industry. The sweet spot of outsourced demand will be smaller runs that require the sub-5,000L single use bioreactors. Avid’s flexible 1,000L and 2,000L reactor trains are well positioned. The bigger CDMOs have wider service offerings but generally use larger volume stainless steel reactors and wouldn’t compete directly for the same molecules (Catalent and Patheon- now Thermo Fisher- being two notable exceptions).
Unlike ‘small molecule’ pharmaceuticals, biologic molecules are so large and complicated that the active chemicals are unknown. The biologic is therefore defined by its manufacturing process rather than its chemical structure. To ensure continuity of product along the development timeline, there is close attention paid to the consistency of the manufacturing process. Each molecule requires its own unique process that needs to be validated any time there is a change.
The regulatory process, while onerous, creates a high barrier to entry for any new competitor. The regulatory track record of a company is of high importance to customers because mistakes mean time and money, and assistance on navigating regulatory processes is valuable. Any company that has shown an ability to satisfy regulators has a leg up. Avid has a pristine record that can only be matched by a handful of the largest competitors.
The manufacturing facilities have been successfully audited several times by the FDA, the EU, ANVISA, the Canadian Health Authority, the Australian Department of Health, and Turkey’s Ministry of Health. Private big pharma audits are known to be even more rigorous than government audits and the company has passed several including Shire audits and a recent audit by Roche where they received their satisfactory rating, the highest rating Roche gives out. The difficulty of changing manufacturing facilities and the long life of drugs means that customers of commercial product are generally operating on 10-15 year time frames. The net result is a high margin, high ROIC business, with a high proportion of predictable cash flows.
The contract manufacturing industry is undergoing consolidation and the business characteristics also make it an attractive space for private equity. In September of ‘17, Catalent (NYSE: CTLT) purchased a private bio CDMO competitor, Cook Pharma, for 17.3X trailing adj EBITDA. 3SBio (SEHK: 1530) purchased another private biologic CDMO, Therapure Biopharma, for 15.7X adj EBITDA. Although it was a much larger transaction, Thermo Fisher Scientific (NYSE: TMO) purchased Patheon for 17.3X trailing EBITDA back in May of ‘17.
In 2016, before the construction of the company’s second production facility, the manufacturing division was reporting unpolluted financials. I estimate Avid’s legacy facility is worth at least $170mm+ based on comparable transactions, 30% more than the company’s current enterprise value of $130mm.
Now the company has over twice the installed capacity that it did in 2016, with a unique facility that will allow them to double installed capacity yet again with only $30mm of incremental capex. I don’t believe the company is worth less now than it was then.
The Road to Profitability
Avid screens as highly unprofitable on a historical basis, but there are four reasons to think that the future will not look like the past:
1) The R&D operation was a big loss producer and that is now essentially shut down going forward.
2) Avid’s in place manufacturing capacity includes a newly built facility, and now supports over $100mm of revenue. Yet currently, the company is guiding to $50-55mm of revenue for fiscal year 2018 (ending in April ’18). Roughly $10mm of that is revenue that was moved from 2017 into 2018 due to revenue recognition rules, and so the company is only truly operating at a 40-45% capacity utilization. Profitability in contract manufacturing is utilization dependent. I believe the company will be able to grow utilization rapidly as explained in the next section.
3) Over 20% of the year-to-date revenue is low margin cost-plus revenue that Avid earns when it validates a new manufacturing process. Due to the installation of the company’s additional capacity, the amount of validation revenue was very high. Once processes are validated, the company earns more normal gross margins, which are in the 40-50% range at full capacity.
4) SG&A expenses have been too high, bloated by the R&D operation and a management team/board of directors that was running the company for themselves. This line will continue to trend down even after the hiring of the sales force.
After its secondary offering, the company has approximately $49.7mm in cash. The company expects that it has enough cash to operate for at least the next twelve months, assuming no new business. However, the company will almost certainly acquire new customers (it announced two new customers on the latest conference call but did not name names or amounts yet). I estimate that the company needs about $60-65mm of annual revenue to be profitable, and that this is possible on a run rate basis within 12 months. The company will probably be cash flow positive even sooner as new customers make cash deposits up front to reserve capacity.
Prior to the slow down this year, the company grew revenue at a 40% CAGR, despite not having a sales force and being an excess capacity provider (customers fear being kicked out if Avid’s drug development is successful, and they fear Avid going out of business if the drug development operation is a bust). Much of the slowdown in the 2nd half of fiscal year ’18 is due to Avid’s top customer (~55% of sales), Halozyme (NASDAQ: HALO), pulling back on purchases. This is temporary because the pullback is due to the planned transition to Avid as sole provider for Halozyme’s collaboration with Roche. The transition is expected to be complete by the end of fiscal ’18 (4/30/18) as Roche works down the excess inventory they built up in anticipation of the transition.
Avid’s valuable relationship with Halozyme is not being properly recognized by the market. Halozyme itself has an incredible drug in its rHuPH20, which Avid manufactures for HALO. rHuPH20 loosens the cellular matrix below the skin to allow for better absorption of injectable pharmaceuticals. For example, certain oncology drugs are administered through an IV over four hour+ periods. The same drugs, mixed with rHuPH20, are injected under the skin and fully effective within 5 minutes. Not only is this a great improvement in the patient’s standard of living, it frees up space in overcrowded oncology departments. Finally, new formulations with rHuPH20 are given patent protection, allowing companies to use rHuPH20 as a tool to protect against biosimilar competition on the inferior standalone drug.
Roche released a new drug in the US, Rituxan Hycela, that is guided to increase Halozyme’s royalty revenue by ~25% in the coming year. Avid will be the sole supplier for Halozyme’s active pharmaceutical ingredient (API) in this drug. Halozyme entered into an agreement with Bristol-Myers Squibb to license Halozyme’s API in up to 11 different targets, and Avid will be a top contender for the supply contract. Halozyme has a lot of growth ahead of it with two products in phase 3, four products in phase 1, and a history of successful approvals. Avid will be a beneficiary of Halozyme’s growth for many years to come.
The industry itself is growing like a weed. Catalent management guided to their biologic manufacturing division revenues growing from 13% of the company to 20% organically over a 3-5 year period. This is despite Catalent’s facility never having produced a commercial product, a big negative to prospective customers who risk having to change manufacturers if they make it to commercial production. Cook Pharmaceuticals, the other CDMO that manufactures for Halozyme (jointly with Avid on Shire’s HyQvia), was acquired by Catalent. Guidance for Cook’s facility was to increase utilization from 40% to 100% within 3-4 years on a larger revenue base. Competitor Therapure Biopharma, a Canadian based biologic CDMO of similar size, has been growing at over 50% a year for the last couple of years and is guiding to 30% revenue growth going forward. WuXi Biologics grew revenue from US based companies (ie. US revenue) by 100% this year.
Finally, the new management of Avid has hit the ground running and is presenting to a handful of the large pharmaceutical companies. The company has already received several RFPs and signed a few smaller deals. Several board members have been CEOs of CDMOs and Dr. Lias, the current CEO of Avid, was recently a consultant to development companies looking for manufacturing facilities. The Avid management team is well equipped to find customers. Contracts generally range from $2-8mm in size and of course it’s easier to grow quickly on a percentage basis when you’re working off of a small revenue base.
Given the high revenue growth and variability in margins, earnings are difficult to project. However, I believe the company can reach $100mm of revenue in three years given the continued success of Halozyme, the high industry growth rate, and Avid’s competitive positioning within the industry. Steady state, the company is capable of earning 40-50% gross margins and high 20%s net margins. With $100mm of revenue, that’s a 20% earnings yield on today’s market cap for a company that ought to trade at a premium multiple.
With that being said, I expect that the company will be acquired at a significant premium. Someone who can replace the high cost preferred stock with low cost debt and fill the unutilized capacity will generate a fantastic return on investment. I believe other traditional CDMOs are likely to follow Catalent’s successful strategy and enter the faster growing biologic space. The regulatory track record of Avid and the potential for further low-capex capacity expansion would serve as a solid base on which to build a mammalian CDMO business.
Contract wins or a buyout.
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