Description

Recommendation

Most would agree that investing in a business conducting studies and supplying animals to preclinical drug studies brings a unique risk.  Unfortunately for NOTV and its investors, this proved to be accurate late last year when the DOJ indicted its Cambodian non-human primates (NHP) supplier for illegally exporting endangered species into the U.S.  This forced the Company to immediately pause Cambodian NHP imports and sales which have since negatively impacted the Company’s operations and profitability.  The Company is now expecting EBITDA for FY23 to be $75mm, significantly below the $115mm+ that analysts were expecting prior to the indictment.  

Buy 3.25% senior convertible notes due ’27.  The convert trades at ~47 and offers a CY of 6.9% and a YTM of 22.0%.  Assuming the Company can generate EBITDA of $70mm per annum, the convert creates the business at an undemanding 4.6x multiple.

Leverage is now a cause for concern particularly as the max leverage covenant steps down later this year.  While the Company expects to remain in compliance of its covenants this year, I’m not as convinced as there are some assumptions baked into the guidance that may prove a bit too aggressive.  Having said that, should the Company trip covenants, I do expect lenders to be cooperative allowing for some flexibility to manage through these unexpected challenges.  Currently, the Company has sufficient liquidity to operate, and the guidance implies that it will be close to cash flow breakeven for the year.

The equity with a market cap of $184mm trades at 8.3x EBITDA and screens somewhat cheap if you comp it to its larger competitors that trade in the teens.  However, given the risk of a covenant trip and the potential for a dilutive capital raise, I’d wait to for some positive developments on the NHP front before stepping into it.  The upside here would be considerable if favorable regulation allows for NOTV to recapture the lost NHP revenue and profitability.   

Current Situation

In November 2022, U.S. federal prosecutors charged eight people with allegedly illegally poaching hundreds, perhaps thousands, of endangered primates from Southeast Asia and shipping them to the U.S. for research purposes. At the time, NOTV disclosed that executives at its primary NHP supplier, Nafovanny, in Cambodia were indicted.  Cambodian wildlife officials were charged and accused of taking payments to facilitate the scheme, which allegedly took monkeys from national parks and protected areas in Cambodia and falsely labelled them as “captive bred”.  

Cambodia is a critical supplier of NHPs to the U.S., representing over 60% of imports according to the CDC.  The U.S. research labs have traditionally used long-tailed macaques for drug testing. Despite being endangered, these monkeys are normally bred in captivity in the U.S. or abroad, but market shortages led to wild monkeys being sourced illegally.  The shortfall intensified amid a surge in demand for NHPs during the prioritized search for covid vaccines to combat the pandemic and a 2020 ban on the sale of wild animals by China – previously one of the biggest global exporters of animals for drug research.  All the covid vaccines developed in the U.S. and Europe utilized NHPs.  Additionally, given the proliferation of biologic drug development activity in recent years, NHPs have been in high demand. 

NOTV was the second largest importer of NHPs after Charles River Labs.   Given the strong demand and shortage of supply, NHPs were going to be a major driver of growth for the Company.  Since the news broke, both NOTV and Charles River have stopped importing from Cambodia.  NOTV has disclosed that imports won’t resume until supplier audits are completed over the next several months.  Charles River does not expect supply to resume till later in the year, at best.  NOTV has resumed selling from inventory NHPs originally sourced from Cambodia once it was reasonably confirmed that they were legally acquired.  These sales are at lower volumes than they were prior to the events of November.

So how does the NHP situation get resolved?  To be honest, I’m not sure.  Whether the negative headlines are warranted is not something I want to debate, but the reality is many organizations around the world view animal studies as inhumane and wage public relations campaigns against these activities, despite animal studies being a necessary step to creating life-saving drugs.  On the other hand, scientists are urging the U.S. government to increase investment in lab monkey breeding programs as the Cambodia scandal risks worsening a shortage of test animals. By way of background, NHPs are the most scientifically relevant large model for the regulatory required safety testing of biologic drugs as mandated by the FDA and other international regulatory agencies.  Essentially, biologic drugs cannot be approved for commercial use without NHPs.  Scientists pursuing studies already face delays of up to a year due to the difficulty in sourcing NHPs.  These delays will impact the approval of vaccines and drugs which harms public health and national security.  

Given the critical nature of this situation, I’m hopeful that there will be a resolution that is not only humane but also comes with strong compliance oversight so that another scandal such as this one can be avoided.  

Company Overview

Founded in 1975, NOTV is a vertically integrated, full-service contract research organization that provides nonclinical and analytical drug discovery and development services to the pharmaceutical and medical device industries.  It also sells research-quality animals and diets to these as well as to academia and government clients. 

Under the leadership of CEO Bob Leasure, a turnaround executive brought on by lenders in 2016, the Company has embarked on an aggressive M&A strategy.  The goal was to consolidate small single service CRO providers in pre-clinical space to build a full-service scaled CRO that can serve as a comprehensive service provider to clients.  In this industry, smaller CROs with limited service offerings are underutilized and often take on overflow work when the larger competitors don’t have capacity to handle the business.  By acquiring new services and growing capacity, NOTV’s strategy was to create a business that would have more of a steady revenue stream with higher utilization rates and higher margins.  The Company has closed 14 acquisitions since 2018 with 7 in 2022 alone.  In total, the Company has spent over $760mm on these acquisitions.  Initially, management focused on and had success rolling up and creating a sizable DSA (described below) business from a very small base.  However, the deal for Envigo in 2021 for $545mm changed the profile of the entire Company given that the acquisition was three times larger than the DSA business at the time.  

Below are two charts that show NOTV’s acquisitions and explosive revenue growth under current leadership:

The Company operates out of two segments: Discovery and Safety Assessment (DSA) and Research Models and Services (RMS). Within the DSA segment, the Company works with researchers and clinicians to support the discovery and development for primarily small molecule drug candidates, as well as biotherapeutics and biomedical devices.  Services include both in vitro, using chemical reagents and harvested animal tissue, and in vivo, typically in rodents.  Clients range from small biotechs to large pharma companies.  

Within the RMS segment, the Company provides a wide range of small (mostly rodents) and large (mostly NHPs) animal research models for basic research and drug discovery and development, as well as specialized models for specific diseases and therapeutic areas.  Small animal models are generally bred in-house while large animal models are mostly sourced from a third party.  Through its Teklad product line, the Company also sells lab animal diets, bedding and enrichment products.  Clients include biopharmaceutical companies, CROs, and academic and government organizations.

The chart below summarizes the Company’s various businesses and how they interact with each other (note that the revenue percentages are based on the run rate business prior to loss of NHP supply from Cambodia):

LTM revenue breakdown by business segment is as follows (note again that this won’t fully reflect FY23 revenues on account of the NHP situation):

Preclinical services: 38%

Large animal: 36%

Small animal: 15%

Teklad: 9%

Other: 2%

Summary Financials

NOTV was well on its way in executing its growth/acquisition strategy before running into problems in November.  Revenues were skyrocketing but more importantly, EBITDA margins were steadily trending upwards towards its longer term target of 18 – 22%.  The business was being positioned by management to achieve above-market revenue growth rates and margins were expanding due to a combination of price increases, increased organic sales growth, acquisition synergies and facility expansions, and benefits from ongoing site optimization initiatives.

As for FY23, NOTV is guiding to at least $580mm revenue and at least $75mm EBITDA.  At first glance, this feels a bit aggressive as it implies EBITDA margins of ~17% for Q2 – Q4 period.  Q1 is already in the books where the Company generated -$5mm EBITDA in the immediate aftermath of the NHP scandal.  Furthermore, in comparison to NOTV management, Charles River was more conservative in its remarks for when they expect to start importing and selling NHPs again.  

Having said that, whether or not they hit their guidance this year, $75mm annual run rate EBITDA is not a totally unrealistic number.  Nafovanny represents ~70% of its NHP imports and NHPs represent ~30% of total revenues.  NHP margins are on par with the overall Company margins and thus annual gross profit attributable to Nafovanny supply is ~$40 – 45mm.  Assuming no material reduction to overhead, the loss of this supply would reduce the Company’s EBITDA by 30 – 40% from the ~$115mm that was projected before the NHP scandal.  

Longer term, management believes it can grow the top line of the business at high single to low double digits and generate EBITDA margins of 18 – 22%. Obviously, acquisitions are on hold for the foreseeable future and annual capex is targeted to be no more than 5% of revenues.  

Capitalization

The Company has $272.5mm of term debt comprised of the original $165mm term loan, $40mm additional term loan tranche, and two $35mm delayed draw term loan tranches.  The interest rate on these loans is accruing at ~10% per annum.  All tranches of the bank debt mature in November 2026.  

The 3.25% converts with a face value of $140mm were issued in September 2021 as part of the financing package for the Envigo acquisition.  The notes mature in October 2027.  The conversion price is currently way out of the money at $46.05/sh. 

There are also a handful of small seller notes that total $6.5mm in obligations.

The Company has liquidity of $36mm as of December 2002 which includes balance sheet cash of $21mm and availability on an undrawn $15mm credit facility.  This should be sufficient to fund operations for at least the current fiscal year.

In total, net debt is ~$400mm, or 5.7x FY23 EBITDA. This is uncomfortably high and if management does feel the need to raise additional capital from an opportunistic investor, I suspect it would come in at a junior level, i.e. preferred stock (credit positive).  But I wouldn’t completely rule out something getting done at a second lien or unsecured level (credit negative).  

The loans come with a max secured leverage covenant of 4.25x that steps down to 3.75x beginning with the September 2023 quarter.  Additionally, there’s a 1.10x fixed charge coverage covenant.  Management expects to be in compliance with both covenants for FY23.  Even if they manage to not trip it, things will be tight and it would not surprise me if the Company ends up raising some new money.  

Thoughts on Valuation & Recoveries

I’ve valued NOTV at $360 – 545mm based on an EBITDA range of $60 – 75mm and a multiple range of 6.0 – 7.0x.  Clearly, there’s no upside recovery built into this valuation range.  Any positive developments on the regulatory front that brings back lost RMS revenues will increase the value of NOTV considerably.  Given NOTV’s near-term debt issues, heavy NHP exposure, and the makeup of its biotech client base, I believe the Company should trade at a material discount to its most relevant competitor, Charles River, which trades at ~13x EBITDA.  

At this valuation, the secured debt is fully covered, the convertibles are 60 – 186% covered, and the equity is worth $0 – 5.00/sh.  

Catalyst

* regulatory resolution of the NHP scandal

* resume imports of NHPs from Cambodia