Description

Columbia Laboratories is a high growth pharma royalty business trading at an absurdly low valuation of 3.1x FCF.

Columbia is fairly unique in the public markets in that it is essentially just a royalty business, and so the company’s revenue stream is of very high quality. Not only have they outsourced all sales and marketing, but they’ve also ceased all research and development activities as well. As a result, the remaining business has minimal operating risks and no capital requirements as there is no marketing, no salesforce to manage, no product development, and no internal manufacturing -- it’s just a clean high margin royalty income stream that will continuing growing rapidly on the backs of their marketing partners’ efforts.

Gross profits organically grew 40% in 2012 and 57% year-over-year in the TTM. EBIT and FCF have been growing even faster due to significant leveraging of corporate costs, a phenomenon which will continue for the foreseeable future. Going forward, 20-25% gross profit growth will translate into 40-50% annual growth in EBIT and FCF.

Despite the company being a high quality royalty business with very attractive near-term and long-term growth profiles, it shockingly trades for only 3.1x FCF. I believe the company is conservatively worth $17 per share, which is around 14x FCF.

The CEO would seem to agree that the stock is undervalued as he bought $50k worth of shares a few months ago.

Crinone

The company’s core product is Crinone, a progesterone gel that is used in infertility treatments. Crinone is over 97% of revenues, so it is effectively the entire operating business now. Crinone is marketed through Actavis (formerly Watson) in the US and Merck Serono internationally. The two agreements are structured very differently from each other, so I will address them separately.

Crinone International - Merck Serono

The international sales through Merck Serono generate 77% of gross profits and is a phenomenal business for Columbia. They first commercialized Crinone through Merck Serono in 1995, so the relationship is now 18 years old. Merck Serono’s international rights are in the form of a license and supply agreement whereby Columbia sells product to them for the greater of a) 30% of the net selling price or b) manufacturing cost plus 20%. The actual manufacturing is in turn, of course, outsourced by Columbia to 3rd parties. This arrangement results in a 50-55% gross margin revenue stream, and margins have actually been steadily climbing as the bulk of the growth is in high priced markets that benefit from receiving 30% of the net selling price.

This agreement wa-s due to expire in May 2015, but they just extended it for another five years to 2020 on essentially the same economic terms, thus taking any potential license renewal risk off the table.

Merck Serono is the world leader in infertility treatment, making them an ideal partner for Columbia. They market Crinone in over 60 countries, and so the business is very dispersed geographically, but they continue to see strong growth rates in these markets. The international revenues and growth rates over the last few years are as follows:

• LTM        $21.3 M      +34% growth
• 2012      $17.2 M      +18%
• 2011      $14.6 M      +41%
• 2010      $10.4 M      +20% 
• 2009      $8.6 M

As you can see, growth over the last 3-4 years has been stellar and does not seem to be abating. The future outlook is also very bright with both continued in-market growth, and some territorial expansion from some attractive markets that Merck Serono has yet to enter with Crinone. They are apparently pursuing Russia and South America at the moment. They will also eventually enter Japan, although it will probably take around 2 years there due to the regulatory process. Japan is of course the 3rd largest pharmaceutical market in the world.

The risk of eventual generic competition is minimal partly due to the small size of this market, but management also notes that as a topical therapy any generics would require a full-scale clinical program that would be particularly cost prohibitive. Furthermore, in the international business around 65-70% of revenues actually come from markets with no patent protection, and this mix continues to rise as it comprises some of the product’s fastest growing geographies. The huge success of Crinone in non-patent markets is further evidence that the other 30-35% of revenues (and shrinking) is successful due to Crinone’s strong brand and Merck Serono’s marketing efforts rather than any IP protection the product has in those markets.

Crinone US - Actavis

The US Crinone business generates around 23% of gross profits and is thus comparatively much less important. Columbia sold all of the US rights to Actavis in July 2010. As part of this deal, Columbia is entitled to a royalty of 10-20% of sales of progesterone products until 2020. They also sell product to Actavis at cost plus 10%. Actavis is developing a next generation Crinone product right now and Columbia will receive royalties on this product as well. Actavis is only operating at the 10% royalty level right now.

This has also been a double-digit growth business, although not quite as robust as the international revenue stream. Looking at the royalties:

• LTM        $3.4 M      +19%
• 2012      $3.1 M      +16%
• 2011      $2.7 M

Management has stated that they expect royalties to increase at a double digit rate for the foreseeable future.

Crinone is on-label in the US for infertility treatment and is essentially the standard of care with over 60% market share of progesterone for this indication. Columbia and Actavis sought FDA approval to also market the product (under the name Prochieve) for the pre-term birth market, to be used in pregnancies where the mother has a short cervix, but they were turned down. Doctor’s can still of course prescribe the product for off-label use for this indication, and I suspect that growth in usage for pre-term birth has helped, and should continue to supplement growth in the core infertility market.

Why is the stock so cheap?

And the end of 2011 the stock was $20 per share. As shown above, the business has grown considerably since this time, they’ve gone from losing money to generating significant profits, and yet the stock has fallen by 70% -- so how could this be? The primary reason is due to the FDA rejecting Prochieve for approval in the pre-term birth market. While this was no doubt a negative event for the company, Crinone is a pretty exciting business in the infertility market alone. They have been growing in the high teens in the US and even faster internationally, and they have strong future growth prospects in both markets even without on-label approval for pre-term birth. Furthermore, while on-label approval would have no doubt significantly ramped the PTB market for them, it still remains a growth opportunity for the company and any recommendations for off-label use from various physician boards and other professional societies should help drive further adoption in this market.

Secondly, with the company ceasing all R&D activities, I think that the stock became a lot less interesting to the more traditional healthcare investors that were invested in the stock at the time. While a clean royalty business like Columbia is a value investor’s dream, I believe the lack of any exciting new products in development to dream on led to a mass exodus of shareholders and helped contribute to the significant decline in stock price.

Acquisition on the horizon

The company has $31 M in cash today and is looking to acquire a business. Management fortunately understands their role in the world -- being a service provider to Merck Serono -- and is thus looking to acquire a business that helps them build on that relationship. Furthermore, the company has $153 M in NOLs, and so they are clearly incented to purchase a profitable business to further monetize the NOLs, and have stated as such. And so while there is some uncertainty as to what exactly management will buy, it has been made clear that it will be a profitable business with no regulatory or R&D risk. Management is also not looking to make any large gambles here, and so I would expect a small acquisition at first and potentially other small ones down the road if they are successful with it.

Given all of the parameters, I think it’s highly likely that Columbia ends up buying a contract manufacturer, where they can leverage their existing relationship with Merck Serono to potentially drive more business to it. Also, due to the NOLs, the company is well positioned to earn a very attractive ROI from an acquisition like that.

Valuation

I have valued the US and international businesses separately due to their different profiles. In addition to differing growth rates, international has terminal value as Columbia owns the international assets, but in the US there is a defined-life as they sold the US rights and receive a royalty until 2020.

First and foremost, the company has $153 M in NOLs and so the company will not be paying any taxes for a very, very long time.

To value the US royalty stream, I just applied a 5% annual growth rate and a 10% discount rate until 2020. Considering that these revenues have consistently grown in the high teens and management expects double digit growth going forward, these figures are very conservative in my opinion. That gets you around $22 M in net present value. They will also sell around $10 M in product to Actavis over the next 2 years, but they only receive a 9% margin on these sales, so it only adds around another $1 M to the net present value. Actavis will likely bring the manufacturing in house after that point, so I have not included any product sales for after 2015.

The international business generated $12.1 M in gross profits in the TTM. I have assumed they grow revenues 16% and gross profits 17% over the next year (which is well below the current growth rate), which gets you to $14.2 M in gross profits a year from now. These gross profits are essentially free cash flow as there are no other costs beyond corporate overhead (which I accounted for separately). I have valued this royalty stream at only 13x FCF, which I think is very conservative when you consider how high quality this business and how strong it’s growth outlook is. That gets you to a value of $185 M for the international business.

Finally there is $1.8-1.9 M per quarter in corporate costs. At 7x costs, I subtracted $52 M from the sum-of-the-parts.

So in total:

• Cash                 $31 M
• Crinone US        $23 M
• Crinone Intl       $185 M
• Corporate        ($52 M)
• Total value      $187 M      $17.00 per share

Catalyst

Consummation of an acquisition of a low risk, profitable business