Description

SUMMARY THESIS

Cambrex (ticker CBM) is an intriguing short opportunity with an asymmetric risk / reward profile suggesting 30%+ downside to shares on conservative valuation and operating assumptions. - a thesis management seems to agree with given the unprecedented levels at which they’ve been selling stock. CBM is under the radar with short interest just over 3%. a sleepy long only investor base, and limited Sellside coverage (Stephens /  Craig Hallum / Longbow /  First Analysis / Jefferies) that will rarely publish beyond beyond a post-quarter recap

By way of brief business background, CBM provides various products and outsourced services to pharmaceutical companies (in healthcare speak it is what’s known as a CMO  - “contract manufacturing services organization”) with a dominant business line that involves the manufacturing of APIs (active pharmaceutical ingredients), which are effectively the raw materials that comprise a given drug / pill. CMOs are volume driven businesses where margins are largely a function of effective capacity utilization. The stock is flirting with its all-time highs after a ~40% move since early November (vs. the S&P up 12%) and now trades at ~19x 2017 EPS, in-line with peers on the expectation that CBM will be able to sustainably grow the top and bottom line at comparable rates. This expectation is misguided for two primary reasons:

1. Unlike its peers, CBM has the unfortunate distinction of having ~40% of its revenues (disclosed) and ~60% of its current EBITDA (my estimate) derived from a single customer (Gilead, or GILD) / product (Gilead’s Hepatitis C drugs, or HCV) in rapidly accelerating terminal free fall.  Per its guidance earlier this month, GILD expects HCV volumes to decline in upwards of 50% in 2017 with an increasingly challenged backdrop thereafter (Abbvie will be launching a highly competitive HCV drug in late 2017). Despite these material growth headwinds, current expectations for CBM’s implicitly suggest that the ~$180 million of HCV revenues the Company earned in 2016 will not only remain stable, but somehow sustainably GROW for multiple years. Our diligence suggests the opposite will happen

2. The stock is baking in an expectation that CBM will be able to maintain its currently inflated peak margin profile in perpetuity. The unprecedented demand for Gilead’s Hep C drugs fueled not only CBM’s top-line but also margin as CBM was able achieve unmatched capacity utilization levels.  CBM’s current 30%+ EBITDA margin sit ~1000 bps above best-in-class peers that in some cases carry 10x the revenue scale. Our diligence suggests margins are poised to erode at least 200 -300 bps in the near term and will continue to decline longer-term as the Gilead growth trajectory reverses
   
   

With neither of these two dynamics reflected in Street numbers and the recent run in shares, the short setup offers intriguing optionality. If the short thesis plays out, it doesn’t require a whole lot of reaching to get to 30%+ down from here and a stock price that CBM has traded at multiple times in the last two years. On the flip side, the thesis would likely to have to be REALLY wrong for the stock to see much upside from here. For perspective, If one assumes NO Gilead top-line pressures, aggressive growth across its ex-GILD business,  and a modest 200 bps of margin erosion (a dynamic the Company acknowledges as highly likely regardless of what happens with the top-line), CBM will earn about $3.00 in 2018 (vs. Street at $3.25), representing flat YoY growth from the midpoint of the Company’s 2017 guidance. Subscale flat growers in healthcare services  don’t trade at ~19x, but If you assume CBM can still maintain its current multiple you’ll get to a $55 stock. Assuming some modest top-line headwinds as well, CBM earnings growth turns negative to something closer to $2.60-$2.70 in 2018. At an arguably still generous 15x multiple, this gets you to a roughly ~$40 stock

KEY ELEMENTS OF THE SHORT THESIS

• Gilead’s Hep C Franchise Transformed CBM’s Top and Bottom Line Operating Trajectory - The GILD / CBM relationship began with an initial supply agreement in late 2012  when Gilead needed to begin the Hep C product manufacturing process in advance of the Q413 launch.  Shortly thereafter, Gilead’s HCV franchise experienced arguably the the most successful drug launch of all time. Gilead’s annual HCV sales exploded from $0 to $20 billion 24 months after hitting the market.  Driven almost exclusively by this Hep C “golden era”, CBM doubled its revenues and more than tripled EBITDA. While headline revenue growth was close to 15% in the last five years, the business ex Gilead grew only 3.5%. The unprecedented demand for Gilead’s Hep C drugs also drove a massive margin inflection as CBM was able to operate at peak capacity. For perspective, CBM’s current 31% EBITDA margin sits nearly 1000 bps above best-in-class peers that in some cases carry 10x the revenue scale
  
  

• In Early 2016, Gilead’s Hep C Growth Began Reversing to a Powerful State of Rapid Terminal Decay at an Accelerating Rate  - The dramatic 30% decline in GILD shares since the beginning of 2016 can almost exclusively be attributed to inital signals of HCV. The only real problem with Gilead’s HCV drugs are that they are “too good” in that Hep C patients that take GILD’s drugs effectively become completely cured, resulting in a continually decreasing market opportunity that will eventually reach zero (there is a finite supply of Hep C patients in the world). While the terminal nature and finite nature of the HCV market opportunity has been well understood for some time and not the reason the why GILD lost $40 billion of market cap, the growing recognition that GILD’s share of the shrinking pie would be smaller than originally believed along with timing, magnitude and accelerated pace of the inevitable growth reversal caught everyone off guard, including Gilead. Most recently, GILD’s recent 2017 HCV guidance was about as disastrous as it could get, sparking a ~10% selloff despite what were already incredibly low HCV expectations going into the print.  Guidance implied as much as a 50% YoY HCV revenue decline and CC commentary was dire, For added perspective, the midpoint of 2017 guidance matched where Street 2021 HCV revenue expectations stood coming into the print

• With the Onset of Gilead’s Initial Hep C Pressures, CBM Investors (Long and Short) Incorrectly Rushed to Judgement on How and When the  Pressures Would be Manifested in CBM’s P&L - The precipitous nearly 40% decline in Gilead’s share price since late 2015 can almost entirely be attributable to the rate and magnitude of the unforeseen slowdown in its Hep C franchise. Given CBM’s exposure to Hep C, it should be of no surprise that CBM’s shares started declining in lock step with Gilead while short interest tripled. However, while Hep C pressures caused Gilead to progressively disappoint throughout 2016,  CBM continued to report solid quarters. Shorts started covering and the stocks moved in the opposite directions

With the stock trading back at its highs, the lack of an immediate linear pull through of Gilead’s initial 2016 Hep C pressures to CBM’s quarterly results appears to have given many a false sense that a potential Gilead headwind is overblown / non-existent. The more plausible explanation ismore nuanced and influenced by a number of dynamics, including:

• CBM Benefitted from Certain Contracting Dynamics Creating a  “Lag” Between CBM’s Hep C Revenues and what Gilead Is Experiencing in Real-Time -  The contracting dynamics are such that a significant portion of the business CBM derives from Gilead in a given year is based on a purchase order Gilead places towards the end of the prior year predicated on the upcoming demand Gilead is envisioning for its Hep C product. When Gilead was going through this process in late 2015, they weren’t forecasting 2016 Hep C volumes to be anything close to where they ultimately came in. Both in my conversations with Gilead’s management team and their public commentary, GILD is very candid about the fact that they were completely blindsided by the intensifying volume pressures over the last few quarters, which provides a nice segway to the next point

• Gilead’s Initial Hep C Revenue Pressures were Driven by Pricing Headwinds and Revenues CBM Derives from GILD are Exclusively Based on Volumes -  The pricing / volume story for Gilead has now flipped. Future Hep C revenue declines are now expected to be predominantly volume related. With Abbvie’s competitive product slated to come to market in late 2017, tough to imagine the road getting much easier for CBM in 2018 and beyond. When i caught up with GILD after their Q416 call, I couldn’t help but get the impression that Hep C is now being left for dead with the Company resigned to the fact that the franchise is in run-off mode where they’ll get what they can while cutting off all investment in this franchise. This includes sales and marketing, which could only add to the eventual volume headwind likely to rise from the upcoming Abbvie launch

In addition to a structurally smaller market opportunity that originally envisioned and increasing competition, Gilead’s Hep C volumes will continue to be adversely impacted by the movement to shorter duration therapies (e.g. treatments require less pills and thus less CBM APIs) as Gilead made a point to highlight in the below slide from its recent earnings deck

• Implications of Gilead’s Use of Multiple Suppliers - Gilead uses multiple suppliers for the manufacturing of its Hep C APIs and while the “pain” associated with terminally declining Hep C volumes will inevitably be felt by all, it is not necessarily shared equally and all at the same time. For example, just because Gilead projects Hep C volumes to be down by 40% does not mean they will slash the business it does with each one of its suppliers by 40%. They may start be leaning on smaller suppliers where they care less about the relationship before moving on to their preferred vendors. While this dynamic may have allowed CBM to “hold the line” so to speak, a repeated theme from our channel checks was that it is not sustainable when the proverbial pie is shrinking to zero as it is with Hep C
  
  

• CBM’s Reported 2016 Revenues Benefitted from a One-Time Tailwind Related to a New, Alternative Hep C Product - In the face of rising competition (Merck, Bristol Myers, an soon to be Abbvie), Gilead launched a new Hep C product, Epclusa, intended  to serve as a better alternative (shorter treatment length, simplified regimen, higher cure rate, etc.) to its existing Harvoni / Sovaldi therapies. I believe is the second HCV API (Harvoni being the first) CBM manufacturers for Gilead. Gilead has commented that the Epclusa launch was accompanied by a “warehousing effect” where pent up demand in advance of  the launch drove outsized initial uptake. While CBM management will not explicitly disclose what the second API is, in my discussions with them they did admit that the hyper growth seen in “API 2” during 2016 should be thought of as “one-time” in nature in response to new product launch dynamics. Common sense and process of elimination would thus imply that this API is Epclusa
  

• Deteriorating Deferred Revenue Balances / Revised Risk Factor Language Signal Increasingly Challenged Gilead Growth Outlook - CBM didn't start disclosing Deferred Revenue as a discrete line item on the balance sheet until Q3 2012. Considering this was the exact same quarter CBM signed its initial supply agreement with Gilead and one can reasonably assume that the majority of this line item relates to Gilead. It’s thus not surprising to see that deferred revenue trends were extremely strong during the Hep C boom from 2013 up through preparation for the Epclusa launch before but then began to reverse dramatically in Q216 as soon as  Gilead started to experience its severe HCV volume declines.  In the eleven quarters leading up to Q216, CBM’s deferred revenues revenues grew on average nearly 40% YoY vs. declines of 70%, 82%, and 54% in the final three quarters

Additionally, and not to be too much of a “conspiracy theorist”, worth flagging that CBM added the word “significantly” to its risk language around potential Gilead volume headwinds in its recent 10-K

• Street is Mismodeling CBM’s Top-line Trajectory   - CBM likes to talk about its revenue base across three primary service lines (1) Innovator (which includes GIlead) (2) Generic APIs and (3) Controlled Substances. On its Q4 call, management gave the below guidance around each of these service lines to bridge the Street to the midpoint of its ~$536mm 2017 revenue guidance (where:the Street sits today)
  
  

“Accordingly, we expect full year 2017 net revenues in the Innovator product category to grow in the high single digit to low double-digit percentage range.”

“For 2017, we expect net revenues from generic APIs to grow in the low to mid-single-digit range.”

“For 2017, we expect net revenues from Controlled Substances to grow by mid- to high single digits compared to the full year 2016.”

After this year, the Street is predictably just flat-lining this guidance post 2017 to arrive at a slightly moderated high single digit growth rate that, as outlined in the table below, looks completely reasonable on the surface

The overarching problem with this approach is that they are slapping a double digit growth rate across the entire Innovator segment despite the fact that  55% of Innovator revenues now come from Gilead - a business facing a meaningfully different growth trajectory than the rest of Innovator. CBM management intentionally tries to mention GILD as little as possible, but you can reasonably impute from their FY17 guidance commentary that Gilead is projected to be flattish to best case maybe up 5% at the midpoint of their guidance. After 2017, if one were to assume no growth slowdown in Generic APIs and Controlled Substances and that Innovator (ex-Gilead) can maintain low double digit growth (note Company has indicatedthis type of growth would represent the high-end of the run-rate potential of this segment, which conceptually makes sense ecognizing historical growth trends and the fact that double digit was achieved in 2016 off an extremely weak comp), Gilead revenues would have to grow double digits in 2018 for CBM to maintain it’s high single digit top-line growth rate


                    

Cut another way, for Cambrex to sustain a high single digit top-line growth rate and hit Street numbers the following two things have to occur:

(1) CBM”s ex-Gilead business can maintain a close to best case multi-year organic growth trajectory (note organic ex-Gilead growth over the last four years circled in green below) and

(2) Gilead pays them 15%+ more money in 2018 than they did in 2016.  

While i can get on board with item (1) for the sake of conservatism, item (2) does not appear to be a credible possibility for all the reasons mentioned above. Recognizing that Gilead’s 2018  Hep C volumes are likely to be down something in the neighborhood of 70% vs  what they reported in 2016 and past idiosyncratic tailwinds becoming increasingly in the rearview, I don’t think it’s crazy to suggest that Gilead 2018 revenues will be flat to down 15% as outlined below. This would equate to a flattish OVERALL top-line growth (again using fairly aggressive assumptions for the ex Gilead business) vs. a high-single digit trajectory being priced into the stock today

• Inevitable Margin Erosion Can Make the Short Work Even Without Top-Line Underperformance - CBM historically maintained a margin profile in-line with peers, but after the Gilead / Hep C explosion margins quickly inflected 50% higher and now sit roughly 1000 bps above peers today, which  is  particularly impressive given CBM has a fraction of the scale. For 2017,  CBM guided to ~50 bps of YoY margin expansion at the midpoint, a dynamic that at least in part contributed to the strength in shares after the print.  In my conversations with the Company immediately after the call, however, I was left with the impression that:
  
  

• Q4 margin strength was primarily due to one-timers, such as FX
  
  

• The most appropriate way to think about margins is flat relative to 2016 (note that flat margins at the midpoint of the revenue guide implies EPS at the low end of their $2.94 to 2017) and tha tthe margin outlook for 2017 is less visible than the top-line
  
  

• After 2017, near-term margin erosion of at least 200 bps to 300 bps should be expected given the evolving mix shift away from revenue streams carrying a 75%+ contribution margin (e.g. Gilead) towards those in the 20s . With the Street currently flatlining margins longer-term, below is how their 2018 numbers would  assuming modest margin erosion  The opportunity to be dead wrong on  CBM”s post 2017 top-line opportunity and still see a double digit earnings miss because of misconceptions around margin creates compelling optionality

• Key Insiders have been Selling Stock at Unprecedented Levels  -  All together, the C-Suite (CEO, ex CFO / New BD Head, COO) currently own less than 0.5% (~$7.5 million) of the outstanding common, half of which is required of them by the Company’s ownership guidelines for senior management. Given each of these management team members has been at Cambrex for 10+ years where 85%+ of their comp is equity-based awards,  it would certainly be no problem for them to own much more stock that what’s required of them. Recent selling activity of note includes:
  
  

• 2/18/2017 - CEO sold ~22% of stock (at the time of the sale) at prices in the $52 / $53 range
  
  

• 2/7/2017 - CFO sold 60% of stock (at the time of the sale) at $54.88
  
  

• 11/16/2016 - CEO sold ~40% of stock (at the time of the sale) at $50.87

VALUATION

• CBM is Being Priced as a Sustainable Mid-to-High Single Digit Top and Bottom-Line Grower -  CBM now trades in-line with peers at ~19x 2017 EPS on headline Street numbers that assume no Gilead related growth headwind. The operating expectation thus appears to be CBM is similarly positioned for sustainable peer-like high-single digit / low double digit top and bottom line growth. where its subscale operating profile, and significant customer offset are seemingly offset by superior margins and debt-free balance sheet

• 30%+ Asymmetric Downside Risk to Shares - To get to my bull case 2018 EPS number of $3.19 (vs. Street at $3.25), I have to assume the following:
  
  

• 0 bps of EBITDA margin erosion (something the Company itself will likely tell you isn’t possible)
  
  

• Gilead revenues to GROW mid-single digits in 2018 (matching the growth implied by current 2017 guidance)

• Ex Gilead revenues to grow  12% in 2017 and 9% in 2018 vs. achieved organic growth of negative 0.5% in 2015 and 7.5% in 2016
  
  

CBM’s more realistic 2018 earnings potential is likely between the below bear /  base scenarios, each of which would represent an EPS decline relative to the $2.87 earned in 2016. Under these earnings scenarios, one doesn't have to stretch too far to get to a stock price 20%-30%+ down from here (levels the stock was trading at less than three months ago)

For those seeking a more cash flow centric view, the valuation looks even worse. For me to get to a $50+ stock, I need to assume the following:

• CBM’s GILD HCV revenues never turns negative and grow in perpetuity (management has publicly admitted this isn’t possible) despite HCV volumes poised to decline as much as 70% over the next two years and continue a s terminal decline thereafter. Note CBM’s current supply agreement with GILD expires in 2020
  
  

• Ex GILD revenues grow at a mutli-year organic growth trajectory of nearly 10%, well above anything it’s ever done historically and above the orgnaic growth expectations for any of its peers
  
  

• CBM maintains its 2016 peak margin profile of over 31%. in perpetuity  (management will also readily admit this also isn’t possible)
  
  

• CBM converts this 50% of this  EBITDA to FCF in perpetuity (vs. the ~15% conversion its averaged over the last 10+ years and ~30% achieved in 2016 and also expected in 2017
  
  

• A modest 8% WACC and 2.5% assumed perpetual growth rate (as a reminder, ~60% of CBM’s current EBITDA is going away
  
  

PRIMARY RISKS / MITIGANTS

• While CBM’s Gilead HCV Revenues will Eventually Begin to Progressively Decline, Capacity will Free Up and Allow CBM to Serve Customers they Previously had to Turn Away -  There is likely some truth to this statement, just not enough for CBM to able to deliver the type of sustainable financial profile necessary to justify the current stock price. With so much manufacturing capacity devoted to Gilead HCV APIs over the last five years, it would make sense that the anemic growth they’ve been reporting outside of Gilead has been understated simply because GILD induced bandwidth constraints. That said, even on modest assumed GILD HCV revenue declines,  the idea that CBM will be able to inflect ex-GILD revenue to the relatively astronomical levels (circled in red below) that would be required to sustain something close to a 10% CAGR doesn’t smell right, particularly considering that CBM averaged top-line growth of just 1.6% in the five year period before it even met GILD and there is not a single peer expecting to even grow double digits organically. Even if they do, it won’t be at anything close to the same contribution margin so the end result would still be earnings / cash flow underperformance
  
  

• With a Largely Debt Free Balance Sheet and Access to a Half a Billion Revolver, CBM Could Offset Organic Growth Declines with M&A -   There is likely some truth to this statement as well and the Company doesn’t hide its newfound comittment to buyside M&A. Longstanding CFO Greg Sargen recently moved to run BD to help spearhead the effort (a move he is seemingly so bullish about that he immediately dumped 60% of his stock and know owns fewer shares in the Company than he has at any point since 2009….).  Most recently, CBM did a small tuck-in (HighPoint) where they acquired $2mm of EBITDA (12.5.% margin)  at 12.5x, with both the target margin and acquisition multiple on par with you typically see in the space. CBM’s renewed focus on M&A could be interpreted as a signal of internal recognition that there is an upcoming void of business that will need to be replaced. However, in this instance the magnitude of any potential significant earnings accretion (relative to current Street expectations) is marginalized by the significant margin difference of CBM vs. potential targets. If CBM buys their way to a high single digit top-line CAGR (which if the current Street ORGANIC growth expectation), it will be at margins at half of their current (a dyanmic management candidly acknowledges) so it would still be tough to get anything close to $3.25 in 2018. If CBM swings for the fences and tries to do some large transformational MOE, it would be dilutive to near-term earnings and pitched to investors on its  “highly strategic” with the opportunity for longer-term synergies.  Given there hasn’t been a single HC Services MOE since Lehman where the acquirer has traded up (and in most cases meaningfully down) on the deal announcement, it’d be a surprise to see this be how to lose money on the short side in such a scenario

Catalyst

(1) Earnings / 2018 Guidance

(2) Continued negative Hep C market commentary

(3) Growing awareness of the name