Description

Catalent, Inc. – Long - $90.56/share – 5/2/22

Executive Summary

I believe Catalent (“CTLT” or the “Company”) is an attractive long-term investment at today’s price of approximately $90.50 per share.  The Company is a leading contract development and manufacturing organization (“CDMO”) with an emphasis on biologics, the fastest growing area in biopharma where experience and capacity are key competitive advantages.  Additionally, in the past several years the Company has invested more heavily in cell and gene therapies, believed to be the next large category of therapeutics which should propel the next several years (10+) of growth beyond traditional protein-based antibodies.  Catalent has a strong balance sheet, has demonstrated years of stable and profitable growth, and has a strong competitive position through its years of experience in biologics development and manufacturing and strong track record of FDA compliance.  Simply stated, Catalent is a reliable strategic partner in an industry where customers look to minimize risk wherever possible.  Critical to the investment case, Catalent’s business is increasingly weighted to higher margin and faster growing biologics that should accelerate its revenue and cash flow growth over the next five years versus recent history.  Overall, assuming continued execution and a return to historical trading ranges for biologics CDMOs and premium valuations for cell and gene therapy providers, I believe Catalent can compound at a 28-39% IRR over the next three to four years with limited downside risk.

Why does This Opportunity Exist?

• Weakness in the XBI and growth stocks generally. 

• Some potential short-term weakness due to a slowdown in biotech funding.  Catalent is well-diversified and works with nearly every major biopharma customer in developed markets.  Conversely, a tougher funding environment for biotech increases the value of critical outsourcing partners that can lower capital requirements and risk.

• Weakness in COVID beneficiaries as the sense is that COVID is behind us.  Catalent had approximately $500mm worth of COVID revenue in FY21, though the relationships and capabilities it has built in vaccines and other fill/finish areas leads the Company to believe there will be no cliff due to a return to normal conditions.  Even if they are wrong, $500mm is a little over 12% of CTLT’s business and is dwarfed by continued growth in its broad biologics business. 

• CTLT is a stock and right now people don’t want to own stocks.

Capitalization / Financials Snapshot

Business Description

Catalent is a leading contract development and manufacturing organization (CDMO), with a leading position in biologics, as well as oral and specialty delivery technologies and clinical supplies.  A brief snapshot of the business is below (LTM through 9/30/21):

As already highlighted, biologics is the bread and butter of the Company and has quickly grown to be over 50% of total revenue.  The most significant pieces of the business are cell and gene therapy, which are the fastest growing parts of the industry and monoclonal antibodies, where Catalent specializes in smaller scale (<2000L bioreactors) production, considered to be the growth engine of the industry.

Industry Highlights

The Catalent thesis is relatively straightforward.  They are a leading provider in the biologics CDMO industry and the industry is growing rapidly.  As I highlighted in a different write-up on Avid Bioservices (“CDMO”, which I continue to love), an investment in Catalent then is as much about understanding why this is such a good industry to invest in as much as it is about Catalent itself.

• Sticky Customers - Once you win a customer you rarely lose them.  In Catalent’s case, they work with some of the largest customers in the biologic space, which is a good place to be given future growth.  In this industry the product is the process in many respects, which is why your manufacturing partner is written into your FDA application and manufacturers undergo extensive scrutiny before biologics are approved.  Changing manufacturers is usually expensive and time consuming.

• Cell and Gene Therapy – Although there is a capacity shortage for traditional monoclonal antibodies, the supply shortage is even more pronounced for cell and gene therapies.  Catalent has become a leader in the space after purchasing Paragon years ago and has positioned itself well to continue to capitalize on this trend.  The Company estimates that the gene therapy and cell therapy pipelines will grow 3.5x and 3x, respectively, over the next 5 years. 

• Strong barriers to entry – Although returns on invested capital are high, we have not seen an influx of capital from new entrants to capitalize on the opportunity.  In the CDMO space, manufacturing track record and a clean record of FDA compliance is paramount.  As a result, this is typically an industry where existing parties build more capacity and build on their intangible asset track records, or new entrants buy their way into the industry.  Industry acquisition multiples are quite high, with biologics deals frequently done in the mid 20s on an EBITDA basis and recent viral vector deals being done at 8-10x revenue multiples.

• Continued reliance on outsourcing -  As industry pipelines grow, more and more biotechs are seeking CDMOs for manufacturing needs.  Biotechs have increasingly realized their value add to be research/science related and not manufacturing.  As capital becomes tighter, I would expect the outsourcing trend to accelerate.  As I already stated, CDMOs are increasingly seen as strategic partners and help with process development, scaled up manufacturing, navigating the FDA regulatory approval pathway and much more.  For a biotech innovator, outsourcing to a reliable CDMO significantly reduces the execution risk to bring a compound to market.  For Catalent specifically, because the business is spread out across many parts of biopharma, they have a great sense of where to deploy capital and front-run capacity expansion to meet the needs of their customers.  That’s a big benefit in an industry that seems persistently tight on capacity.

Valuation

Unfortunately, I have no crystal ball for any short-term period so I cannot tell you if CTLT stock will go lower before it goes higher.  What I can say with reasonable confidence is that I expect CTLT to go meaningfully higher over the long-term and I think it will do so without an investor taking too much risk.  This is a business with quasi-recurring revenue in an industry with a favorable supply/demand dynamic and with meaningful barriers to entry.  The rich typically get richer in CDMO-land and once you have established yourself as a player, margins are high and stable and cash flow is plentiful.  I think all those dynamics deserve an above average multiple of EBITDA or my preferred metric of EBITDA-Maintenance CapEx. On the FY22 numbers they will report in about three months (so almost an LTM number), Catalent trades at approximately 15.5x EBITDA and 22.1x EBITDA-Maintenance CapEx.  That’s cheap today for a business that has grown its revenue and EBITDA by 18.1% and 23.3%, respectively, over the past four years.  Catalent has typically traded closer to 20-22x forward EBITDA, though I recognize we are in a market environment where that may not be the norm again for a few years.  Still, this is hardly some ludicrous SaaS valuation or non-sensical revenue multiple for a business with no hope of achieving profitability and one does not need an aggressive multiple to have strong returns owning the stock.

Going forward, assuming long-term trends for the industry prevail, I believe CTLT can achieve its long-term objective 2026 objective of $7.5bn in revenue at a 30%+ EBITDA margin.  It is worth noting that the company achieved its 2024 target by the end of FY 2022, and it has a history of beating its own expectations (i.e., they tend to sandbag).  If that holds, I believe CTLT can return to its modest premium valuation to the market and achieve an enterprise value of ~$47-$50bn in three to four years, which is an IRR of 28% to 39%.

Risks

• Covid has helped the industry, and CTLT had direct Covid exposure.  It is hard to tell how much in FY22, but this was a business that had grown steadily pre-covid too and I expect the next several years to be strong

• A weaker economy is a poorer funding environment for biotechs.  With that said, that should actually increase the reliance on outsourced manufacturing and capable providers with a track-record should have an edge in winning business

• As with all CDMOs, there is always regulatory risk and it would be bad if Catalent had a significant number of issues after FDA inspections

Catalyst

• More accretive/strategic M&A.  Catalent is not bashful about their large corporate development team and constantly being on the hunt for the right deal.  More deals in biologics would likely be viewed positively.

• Continued operating performance.  The Company achieved its 2024 target about two years early and I’d expect them to continue to outperform