Description

I believe EuroAPI (EAPI FP) trades at a significant discount to its peers and the value of its medium-term earnings potential. Based upon my estimates, there is an opportunity to return >80% on the March 10, 2023 stock price to ~€21 over the next 12-18 months as the company executes and the market gains confidence in its medium-term margin guidance. This is a standard spinoff special situation at a cheap price.

Key Stats

• 7.1x 2023E EBITDA
• Peers trade in the teens
• 7-8% revenue growth
• 2021A Adj. EBITDA margin: 12.3%
• 2023E Adj. EBITDA margin: 14.4%
• 20% medium-term EBITDA margin guidance
• Peer’s EBITDA margins: 20% – 30%

Business Overview

EAPI is a European active pharmaceutical ingredient (API) manufacturer and contract drug manufacturing organization (CDMO) with 6 manufacturing sites across Europe. APIs are biologically active components of drugs for which manufacturers like EAPI supply to customers across large pharma and small biotech companies. CDMO activities are more comprehensive formulation processes where drug development and manufacturing are fully outsourced by large pharma and biotech companies to improve capital efficiency (in large pharma’s case) or provide fully outsourced production (in smaller biotechs’ case). EAPI believes it is the leading global manufacturer of small molecule APIs and the second largest manufacturer of APIs broadly. Within CDMO, the company has an ambition to grow operations to be a top 5 player in the global marketplace by 2025. EAPI offers a critical service in the healthcare ecosystem and a lengthy (9 - 40 month) and complicated regulatory process makes it difficult for new entrants to enter the market.

Situation Overview

Spin Dynamics

EAPI was spun out of Sanofi (SAN FP) in May 2022. Under the Sanofi umbrella, EAPI was mostly captive to Sanofi. The company was focused on filling Sanofi capacity and potential pharma / biotech clients were suspicious of sharing IP directly with a competitor. In 2021, Sanofi represented 49% of EAPI’s revenue and the company was generally underinvested in its commercial strategy. The transaction featured some classic spin-off dynamics: forced selling as EAPI market cap was just 0.5% of SAN, arm’s length agreements with Sanofi, and a new, dedicated management team. The spinoff MSA included a few key clauses such as a price-volume corridor, Sanofi capacity reservation, some raw material cost pass through. The agreements are mostly neutral for EAPI as a portion of savings related to Sanofi volumes would have to be retroceded to Sanofi. There would be a limited ability to increase Sanofi related margins, but they were able to lock-in revenues from their largest customer. While part of Sanofi in 2021, API activities were 75% of revenue with CDMO at 25%. EAPI’s focus post-spin was to place an emphasis on CDMO (typically higher-margin), focus on customers-ex Sanofi, and shift the marketplace view from competitor to capable manufacturer.

Financial Targets

At the time of the spin, the company was expecting a 6 - 7% growth CAGR out to 2025, decreased reliance on Sanofi, and EBITDA margins accelerating to >20% by 2025 from 12.3% in 2021.

Recent Developments

Temporary Manufacturing Shutdown

During early December 2022, EAPI issued a profit warning for 2022 and guided revenue and EBITDA down for the year. EAPI had identified a documentation deficiency during a routine facilities check at its Budapest site. The company’s Budapest operations are responsible for prostaglandin (complex lipid-like compound) production and are part of EAPI’s API segment. The Company guided 2022 revenue down to €980m from €1bn and EBITDA to 12 - 13% margin from 14%. The shutdown was temporary, actions were proactive (i.e. weren’t shut down by health authorities), and the CDMO business was not impacted. In response, the equity sold off ~17% on a temporary guide-down.

FY 2022 Results & Medium-term Guidance Delay

2H 2022 Financial Results

EAPI reported in-line 7% revenue growth in 2H, driven by 18.3% growth in CDMO. EBITDA margin was 12.3% vs guidance of 12.5%. Management noted that the prostaglandin shutdown decreased margins by 150bps over the year. Excluding the shutdown and a 30bps Hungary tax impact, margins would have been 14%, in line with the initial guidance of 14%. The company increased CapEx to increase future manufacturing capacity, recording €138m of CapEx in 2022 with 45% growth CapEx.

Guidance

While 2H 2022 results were fine, EAPI’s 2023 EBITDA margin guidance came in below consensus expectations at 12 - 14% (13.4% - 15.4% ex temp shutdown and Hungary tax impact) vs consensus closer to 16%. EAPI missed expectations due to higher total inflation costs across raw materials, energy, and wages and some discontinuation of early-stage projects at Sanofi for which they will need to shift allocated capacity. While EAPI is able to pass through inflation to non-Sanofi customers, the MSA somewhat limits price taking and heightened margins for Sanofi revenues.

Medium-term guidance of >20% EBITDA margin by 2025 was pushed out to 2026, with the 2025 target now 18% EBITDA margins. Revenue growth CAGR ticked up to 7-8% from 2023 - 2026 from 6-7% from 2021 - 2025 on the back of CDMO strength, double digit growth across the board outside of Sanofi, and increased capacity from CapEx investments. Total CapEx from 2022 - 2025 was maintained at a total of €510m or an average of ~€125m / year from 2023 – 2025.

Reaction

The equity sold off as market participants lost confidence in the 20% EBITDA margin target. However, I believe the 20% medium-term margin is reasonable given the increased mix to CDMO and pushing out the target by 1-year amid a difficult European macro environment should not have been met with as much selling. [Pick your “greedy when others are fearful” quote]. Further, the FY 2022 results presentation (page 15) presented a bridge from 2021 EBITDA to 2022 Adjusted EBITDA (see below). To me, the bridge shows that EAPI is already at an almost embedded 20% margin. In other words, net Price + Mix & Raw Materials caused margins to decrease 6% vs adjusted margins at 14%. Management needs to better match pass through costs with rising inputs, and I think they will be able to do so through non-Sanofi business where there is no price-volume corridor like the Sanofi supply agreements. If they can achieve this, then the 20% target would seem conservative with better mix to a double-digit growth and higher margin CDMO business.

Recent CDMO Traction

As previously mentioned, EAPI’s focus post-spin was to place an emphasis on CDMO, and at this point the question is likely, how is the CDMO business actually doing? Well, the company won 22 CDMO projects in 2H 2022 and 19 in 1H 2022. That compares to 23 projects won during ALL of 2021. CDMO RFPs more than doubled from 120 in 2021 to 230 in 2023. In my view, recent performance in CDMO was responsible for the guide up on revenue CAGR. CDMO project wins do not show up in financials overnight. These are highly value-add specialized services that are often quite complex. The company expects the lag between project attribution and revenue recognition to be between 6-12 months. Thus, we should expect 1H 2022 CDMO projects to start impacting the P&L during 1H 2023. While we are already seeing some traction as 2022 CDMO revenue grew 18.3% vs 2021, I expect the recent pipeline additions and future additions to buoy growth expectations and the margin outlook.

Valuation

EAPI is currently trading at:

• 7.1x 2023 Adj. EBITDA less leases
• 6.2x 2024 Adj. EBITDA less leases
• 4.1x 2026 Adj. EBITDA less leases at 20% guided EBITDA margin

Closest peer, Siegfried (SFZN) trades at 11.3x 2024 EBITDA on almost 22% 2024E EBITDA margins. Siegfried benefits from a longer track record in CDMO (Products segment) and a greater share of revenue from these higher-margin activities—~40% of revenue at SFZN vs ~27% at EAPI. I feel that EAPI should trade in-line with Siegfried over the next 12 – 18 months as the company establishes itself in the CDMO market, revenue from CDMO increases to mid-30s% of total revenue, and margins righten towards peer levels.

At SFZN’s 11.3x 2024 EBITDA multiple, we would see EAPI trade up to a €2bn Enterprise Value and a share price of ~€21, good for 86% above 3/10/2023 prices. The trade will require patience as the company manages near-term macro challenges, but I think there is a realistic path to margin expansion at a multiple that is comparatively far too depressed. From an absolute valuation perspective, I feel comfortable paying a ~7x multiple for a conservatively leveraged business growing 7-8% in a highly integrated industry with high customer switching costs.

Peers

In addition to Siegfried (SFZN), other peers include PolyPeptide (PPGN), Lonza (LONN), and Bachem (BANB). These companies have stronger margin profiles than EAPI, which I view as a testament to the potential margin appreciation opportunity, especially within CDMO.

2023 consensus margin expectations:

• EAPI – 14% (guide ex temp shutdown)
• SFZN – 21%
• PPGN – 22%
• LONN – 31%
• BANB – 30%

The broader list above also trades at a substantial premium to EAPI. 2023 consensus EBITDA multiples:

• EAPI – 7.1x
• SFZN – 12.7x
• PPGN – 10.8x
• LONN – 19.4x
• BANB – 33.0x

While I view Lonza and Bachem as highly aspirational multiples for EAPI’s CDMO unit, I believe the margin profiles exhibited by each illuminate the segment prospects. Additionally, recent private transaction multiples support high-teens EBITDA multiples. Examples include Metrics Contract Services, Cambrex, Recipharm, and PCI Pharma. Given the number of transactions and interest in the space from PE & strategics, I wouldn’t rule out a potential takeout of EAPI at a mid-teens multiple.

Upside / Downside Case

I considered upside and downside cases to the medium-term 2026 guidance by toggling the 2026 EBITDA margin.

• Upside
  • Hits guidance of 20% margin by 2026
  • 8.3x EBITDA
    • 1x turn discount of SFZN 2026 multiple
  • >100% upside
• Downside
  • Margins stay at 14% (2023 adjusted levels)
  • 6.3x EBITDA
    • 3x turn discount to SFZN 2026 multiple
  • 10% upside

I view the risk / reward as especially attractive here. It seems as if the market is attributing far too low of a probability that margins expand over the next few years as CDMO activities gain traction.

Catalyst

Margin appreciation

Continued CDMO traction

Management of cost inflation & price taking mismatch