Description

Halozyme (HALO) – Long - $47.57 – 05/08/21

Executive Summary

I believe Halozyme (HALO, or the Company) is an attractive long-term investment, with years of profitable growth and cash flow in front of it and optionality on new platforms or collaboration customers.  After shelving its drug discovery plans in November of 2019, the Company has focused on its ENHANZE license business, a scalable drug delivery platform that combines with existing therapeutics to shorten infusion times for patients and generates stable royalties on partnered drugs.  The Company has signed numerous collaborations over the past several years, setting the stage for what should be a high 20s% revenue CAGR from 2020 through 2027E at incremental margins of 100% for much of the revenue.  Additionally, the Company does not have many traditional biotech risks or meaningful economic sensitivity, as the drugs are typically in life-saving categories such as oncology, neurology, rare diseases and autoimmune diseases and because patients, biopharmaceutical companies and providers all benefit from ENHANZE technology.  Assuming continued execution, I believe HALO can compound at 20-25% for 5+ years with relatively low risk and higher with strategic M&A and continued share buybacks, making this an attractive long investment for patient investors.

Why Does this Opportunity Exist?

• Although this doesn’t have many characteristics of a traditional biotech as this is now a royalty platform, some probably dismiss this investment without digging further.

• HALO has a history of losses largely because it previously invested millions in R&D as part of its drug discovery business.  The Company did not become EBIT positive until Q2 2020 so it may still screen poorly.

• The Company is not statistically cheap today, but should grow at a high rate with relatively low risk for a long period of time.  An investment in HALO requires some patience and given recent events (GME, etc.), maybe that is too much to ask.

 Capitalization / Financials Snapshot

Business Description

Halozyme is a biopharma technology platform that partners its core enzyme, rHuPH20 (“RH”), primarily with existing injectable drugs to improve patient experience and provider efficiency.  The Company refers to the application of rHuPH20 to facilitate the delivery of other drugs as its ENHANZE drug delivery technology, which it licenses to drug innovators to improve their products in exchange for a mid-single digit royalty as well as various upfront payments and sales and regulatory milestones.  RH works by breaking down an enzyme present in a majority of the body’s skin and cartilage to temporarily increase the absorption of injectable biologics under the skin (subcutaneous delivery) as opposed to intravenous administration.  The benefits to patients are obvious, with infusion times reduced to minutes versus traditional injectable treatments requiring hours and the potential for fewer treatments.  For biopharma companies, partnering with Halozyme provides differentiation and insulation from eventual biosimilar (generic) competition, and extends patent protection as several ENHANZE products have been granted exclusivity.  For providers, ENHANZE products allow for home administration, reducing operating costs and increasing flexibility.  This is a win, win, win.  Not surprisingly, some of the largest biopharmaceutical companies have reached agreements to partner with Halozyme, paying upfront for a specified number of potential targets and agreeing to milestones and royalties going forward on any approved product.  Customers include Roche, Eli Lilly, Pfizer, Janssen, and Bristol-Myers Squibb, just to name a few of the 10 current collaborations encompassing 57 total target molecules.  More recently, biopharma companies have entered into partnerships with Halozyme for products that haven’t yet been approved, a sign of confidence in RH’s risk profile and success rate in pairing with injectable compounds.  To my knowledge, there have been no failures of RH combination products in clinical trials, which also makes potential partnerships attractive to biopharma companies.

Historically, the Company also had a drug discovery business which was developing a pancreatic cancer treatment.  This was shuddered a few years ago in a large restructuring, which gives me confidence that management will do the right thing when it comes to capital allocation.  In my opinion, the history of losses generated while the Company had this segment may also be a reason why the stock hasn’t been on the radar for many investors (i.e., this has transitioned from biotech dynamics to a stable and growing royalty business).

Halozyme generates profit primarily in three ways:

• Royalty revenue – This is what it sounds like.  On approved products that utilize ENHANZE technology, Halozyme typically generates a mid-single digit percentage of revenue royalty.  Aside from general operating costs and incremental R&D spend, this revenue stream is growing and is essentially 100% gross margin, as HALO does not participate in any of the sales or marketing related to the products once approved.  Royalty terms are typically for the latter of 10 years from the first sale of or the last expiring RH patent, with royalty rates declining by 50% if the last patent expires during the 10-year window post commercial sale.  For this reason, co-formulation patents are important for both the biopharma company (to insulate against competition) as well as HALO, as this extends the duration of the royalty stream beyond 10 years and can also push out the time to royalty step-downs. 

• Product sales – Halozyme generates revenue from selling bulk RH to collaboration partners for both approved drugs and collaboration trials.  HALO uses two approved contract manufacturers, Avid Bioservices (which I’ve previously written up and am bullish on, partially for this reason), and Catalent.  HALO typically charges a 20% markup to partners for bulk API (active pharmaceutical ingredient).

• Revenues under collaboration agreements – These include upfront payments related to collaborations and sales or regulatory-related milestones.  Typically, the company receives $160mm per target over time, with $30-$40mm upfront for 1-2 targets, 40-60% as the product develops, and 40-60% as sales targets are met.  It depends on how you look at it, but given the product and company already exist, I view incremental partnership revenue as nearly 100% incremental margin.  The R&D and SG&A costs of the company that are undoubtedly being spent partially to help with partnerships are largely fixed in nature.

Overall, Halozyme has a very sticky business model that should grow strongly over-time at very high incremental margins.  There is no significant competition from other players that accomplish the same things for biopharma, so it is not surprising to see the biggest names in the business partner with HALO and provide a reasonable royalty rate going forward.  Additionally, HALO takes almost none of the risk of development and spends no time with post-approval marketing.

Future Growth

Halozyme is a compelling investment because of what should be stable growth for a long period of time.  The Company describes its growth as coming from future “waves” of approved products, though at a high level the categories below are how I think about it.

• Growth from existing partners as more than 20 targets out of 57 need to be selected by existing partners

• Growth from products seeking approval that have already been selected by collaboration partners

• Growth from new partners

• Growth from existing drugs that continue to convert to subcutaneous formulations and underlying growth in branded drugs overall

• Growth from product sales that should be correlated to royalty revenue over time

• Growth from milestone revenue as products continue through the development funnel

• Beyond 2027E, potential “wave 5” launches and new partnerships or technology acquisition

It is worth noting that the backdrop for monoclonal antibodies (mAb), which are typically paired with RH, continues to be very strong.  There are ~500 mAbs in early clinical trials today, and another ~79 in late-stage trials.  This compares favorably to the 79 approved mAbs on the market.  Thinking through the company, the general framework is that approved drugs grow over time, and the penetration of those drugs that convert to subcutaneous delivery also should increase, giving HALO the potential for a leveraged effect on growth for individual drugs.  As a recent example, and to demonstrate the attractiveness of the platform, Darzalex Faspro, the ENHANZE version of Darzalex, achieved 40% subcutaneous penetration in just five months after launch in the US.  A summary of the Company’s “waves” of projected growth is depicted below.

Add all that up, and Halozyme believes it is on a path to $1bn+ of royalty revenue by 2027, driven primarily by wave 3 and 4 launches, which represents a high margin 40% CAGR from 2020.  The projection uses internal projections for subcutaneous penetration rates, external assumptions (Bloomberg, Evaluate Ltd) on total drug revenue, and a total of 21 approved products at that time – five existing and 16 incremental targets that have already been selected, though not necessarily disclosed.  It is worth noting that this projection is not risk-adjusted.  With that said, HALO has a great track record when paired with innovator monoclonal antibodies, and the monoclonal antibody market generally has much higher approval rates than small molecules.  Finally, as mentioned above, although these numbers are not risk-adjusted, they also do not include any benefit from any new partnerships, which they have been winning more of, and approximately 36 other potential targets, 20 of which still need to be selected.  Keep in mind, biopharmaceutical companies view HALO technology as a significant value-add and often try to pair it with some of their best performing and largest drugs.  A HALO co-formulated product provides for differentiation and helps insulate products from other competitors and the eventual threat of biosimilars.  If anything, I lean towards the $1bn in royalty revenue as not being the high watermark for the company over time.

Patents and Protection

As previously mentioned, Halozyme collects royalties based on the latter of the last-expiring patent or ten years post commercial sale.  For this reason, the Company’s strategy continues to be geared towards co-formulation patents with biopharma, as this extends the product protection well beyond the initial ten years and at higher royalty rates.  The flip side is that any coformulation patents for any given therapeutic category may prevent future partnerships with other drugs in the same category, though if the drugs are reasonably similar the ENHANZE delivery is probably a significant competitive advantage.  For RH, the Company has a number of patents in the US and Europe that cover manufacturing and methods of use, with a US issued patent expiring in 2027 and a European patent expiring in 2024, both of which are believed to cover existing collaborations.

Valuation

Valuation here is admittedly more of an art that science, and I haven’t taken the step in this instance to try to precisely model the next seven years.  I think as a starting point, the factors I’ve described and targets under development do make it seem likely that they can achieve $1bn in royalty revenue by 2027E.  Given the typical mid-single digit royalty rate, that would amount to $20bn of topline sales on subcutaneous formulated products.  For perspective, on just the five drugs currently commercialized, total topline sales are expected to be $22bn in 2024.  Additionally, as royalty revenues ramp up, API sales should be proportional over time, which is additional revenue though obviously at lower margins.  This business should scale incredibly well, as incremental costs are required only if Halozyme chooses to pursue other technologies.  If anything, the Company has a history of doing the right thing as it exited its drug development business when it became clear it was not producing results and it has returned excess capital to shareholders through share buybacks that were partially financed through cheap debt.  Below is a dummy model of what the path from 2020 through 2027 MIGHT look like.  I’d focus most of your attention on 2027E.

What’s that worth?  Given that these projections don’t include numerous unspecified targets or new partnerships, I don’t think 20x EBITDA (effectively EBIT) in 2027 is unreasonable  This is a sticky business that should grow well beyond 2027, and there is the potential for bolt-on M&A of other technology platforms that can leverage existing infrastructure.  Additionally, the Company continues to deploy cash into share repurchases.  Using a 20x terminal multiple and 15% discount rate, which I think is overly conservative, I get a present value that is about 50% higher than today’s enterprise value.  There are a lot of variables here.  The bigger picture point is that I think this is something that you could own for a very attractive IRR over the next several years, which could prove to be even more attractive if there are changes in capital gains tax rates.  Ignoring interim cash flows, if this trades at 20x forward EBITDA in the middle of 2026, you’d have a 24% IRR for the next five years.  Sorry this isn’t an electric vehicle company or blockchain…but sign me up.

Conclusion

I believe Halozyme is an attractive long-term investment, with a highly scalable business model and reasonably predictable growth over the long-term.  The combination of new partnerships, increased royalty revenue and potential M&A should all propel HALO much higher over the next several years.

Risks

• No new partnerships going forward.  Seems unlikely as they continue to sign them and are projecting another year of milestones and partnerships.

• Some kind of new discovery that this compound hurts people.  Seems unlikely as this has been out for years now with no negative data on safety or efficacy.

• A competing product.  This could happen eventually, but so far some of the largest and most successful biotechs in the world are spending lots of money to pair with HALO.

• Management does something dumb with cash.  So far they’ve mostly done the right thing and moved away from their R&D business to create a high margin royalty business.

Catalyst

• More deals signed to collaborate with HALO technology

• Continued growth in royalty revenue and cash flow.  Potentially an increase in long-term royalty guidance

• Less likely as I cannot think of a logical strategic buyer, but people like cash flow so I also wouldn’t be shocked if this happened.  Maybe Royalty Pharma could buy it.