Description

NOTV declined 28% today after disclosing in an 8K (released Friday after close) that a search warrant was executed by the DOJ at one of its research model facilities. The market wiped away $125 million of value 1) over an investigation that was previously disclosed in the company’s February 10-Q, 2) concerning a single facility that contributes <1% of revenues and no EBITDA, and 3) in which NOTV is partially indemnified for. This event adds to a laundry list of headline risks that should set up for 50-100%+ stock appreciation over the next 12+ months as investor concerns recede.

Investment Thesis (Long): Inotiv (ticker: NOTV)

Inotiv is going through significant transition having acquired 10 companies in the last year, bringing run-rate revenues from $50mm to $510mm+ and increasing the enterprise value by 4x over that period. Moreover, some of the acquired assets are under-earning, and the combined business was operating at 12% EBITDA margins compared to peers at 23% and long-term guidance of 18-22%.  The new strategy is led by a turnaround CEO whose strategy is showing signs of success in organic and backlog growth (40% and 1.5x in the most recent quarter). As margins trend from 12% to 18-22% with strong top-line growth, the 40-50% valuation discount to peers should narrow significantly.

The situation is even more compelling after a series of events drove the stock from nearly $60 in November to $11 in early May. These include an S-1 filing, DOJ investigation, and USDA audit citing deficiencies. Adding further weight to the dogpile is cyclical risk due to the general lack of biopharma capital markets activity. Management took advantage of the dislocation with 9 different insiders purchasing $1.6 million of stock in Feb/March. The stock rallied 40% on 5/13 after the company reported stellar earnings but has given up a large portion of the gains due to the aforementioned DOJ search warrant.

This is an idiosyncratic thesis and with the stock trading at cheap absolute/relative multiples, we believe there is ample upside as market misperceptions and investor concerns recede.

Situation Overview

NOTV is a contract research organization (CRO) focused on drug discovery and pre-clinical development. The company traces its roots back to 1974 but the strategy was reinvented when Bob Leasure joined the company as a consultant in 2017. The predecessor company (former ticker BASI) was a mess. Systems were outdated, turnover high, customer service nil, and G&A bloated. Bob was initially brought in as a consultant to fix the company and prep it for sale. After two years of heavy lifting as a consultant, Bob convinced the Board there were greater ways to generate shareholder value. He became CEO in 2019 and his premise was that years of acquisitions by large CROs left a vacuum in the mid-market and it was difficult for smaller/emerging biopharma to get white glove, comprehensive research service. While parts of NOTV were fixed, it was still operating sub-scale, and there was opportunity to leverage the infrastructure while filling the market’s void.  In 2019, adjusted EBITDA margin was 6.5% and in 1H22 (FY ending Sep) was 15.9%.

NOTV trades at a 40-50% discount to peers and is cheap on absolute multiples (6x EBITDA and 10x EPS, FY23 ending September).  Aside from the events we list above, we believe a large portion of the valuation discrepancy is due to NOTV’s margin profile vs. peers, as well as its size, minimal analyst coverage, and nascent IR program. Additionally, the rapid pace of M&A over the last 12 months complicates the story. On an EV/Revenue basis, NOTV trades at 1.0x vs. 2.6x for peers.

The long-term thesis revolves around the M&A strategy that built a comprehensive pre-clinical CRO, which should drive margin expansion. Two decades of strong CRO industry growth (driven by increased R&D spending coupled with outsourcing) led to significant industry consolidation at the top as large CROs vie for the large R&D wallets. This left a vacuum for small-mid size biopharma as they could not garner the service from large CROs which swallowed many of the preclinical and early-stage clinical assets.

Inotive is serving two purposes in its M&A strategy. First it is leveraging its fixed cost infrastructure, which has been underutilized. Second, it filling in the gaps to become a full service pre-clinical CRO. This is a key selling point and also allows the company to capture margin that would have historically been contracted out as well.

Historically, margins were depressed as NOTV only offered one-off preclinical services and had to sub-contract out services such as toxicology, pharmacology, and research models to third-party providers. The strategic rationale of NOTV’s M&A program is it now leverages the previously under-utilized corporate sales/client structure to offer comprehensive pre-clinical services, enabling it to increase utilization and capture margins that were previously paid out. Progress has already been made as adjusted EBITDA margins expanded from 6.5% in FY19 to 15.9% in 1H22. We believe margins can expand to 20%+ over the next two years.

Envigo: The largest acquisition to date was the $590 million November 2021 purchase of Envigo. Aside from representing 60% of pro-forma sales, we believe this acquisition is a game-changer due to significant strategic value of the asset. Envigo is essentially a distributor of research models (non-human primates, canines, rats, and mice) that are essential to pre-clinical research. The strategic value is multi-fold and is ripe for years of secular and cyclical growth.

Obviously using animals in research studies has always been highly politicized and debated. Despite PETA’s efforts, scientific research cannot occur without the use of animal models. Envigo was owned by Covance and part of the reason it was sold was due to cost/benefit of the political pressure from owning such an asset. We believe this also partially prevented Envigo’s attempts to go public.  Essentially the amount of willing buyers were depleted. Research models are the bottle neck in studies and Inotiv now controls a significant source of supply. In 2020, China banned exports of non-human primates (NHPs) which further exacerbated the supply/demand imbalance and has caused NHP pricing to increase 3x over the last year.

Controlling the supply of research models will give Inotiv a significant competitive advantage in that it will not only be able to secure its own supply, but will have significant insight into its customers and competitors behaviour.

We will concede that the business itself was not well managed when Inotiv acquired it and the investigations we discuss below were launched under its prior owners.

Stock Weakness

We are going to review the stock’s 28% decline today as well as its 80% decline since November.

In its 1Q22 10Q filed in February, NOTV disclosed that Envigo received a US Department of Agriculture inspection report showing non-compliance in one of its facilities. Based on Friday’s 8-k, it appears this facility is now also the subject of a separate DOJ investigation. From our understanding the facility in question generates <1% of revenues and negligible EBITDA. Management seems committed to either fixing the deficiencies or closing it altogether. A copy of the DOJ’s complaint can also be found here and while some of the allegations deserve remedy, they are far cry from some horror stories such as Michael Vick’s dog fighting ring.

Obviously, the use of animal testing has been a target of activists for decades but the unfortunate truth is that in order to get a drug FDA approved, it needs to be tested by animals. It also just happens to be that research models are the bottleneck in drug discovery given China’s export ban and the lack of capital nor desire to increase capacity. Ironically, Inotiv’s issues will further deter new entrants and capacity additions.

Absent today’s move, NOTV’s stock had declined 80% since November 2021 and a portion of the decline was due to disclosing the USDA deficiency, an industry wide DOJ investigation into non-human primates (this is a separate investigation than the one discussed above), as well as an S-1 filing.  NOTV was a nano cap stock for most of its existence. It only broke $100mm market cap at the end of 2020 and still remains well under-covered with only two sell-side analysts despite now having an $350mm market cap. Most of its peers are large cap behemoths.

NOTV went through significant transition in the last 12 months as it acquired 10 companies for $800mm, funded by both debt and equity. Shareholders did not seem to care about the use of equity, leverage, or the pace of acquisitions, as the company was producing solid results. The stock started 2021 at $12/share and peaked near $60/share in November when a slew of events and general market weakness took hold.

Some of this is clearly market/sector related as peers declined 40-50% due to some soft industry commentary during the Q4 reporting season as well as general capital markets weakness. Here is a timeline of events:

·         April 2021 – January 2022: NOTV acquires 10 companies for nearly $800 million, including the $590mm acquisition of Envigo. Investors did not seem to mind the pace of acquisitions or the use of equity to fund them. However, as markets softened, there was likely a “WTF do I own” selling happening.

·         S-1: The company filed an S-1 on 12/23/21 and the stock fell quite precipitously in the weeks following. Our belief is that there was investor speculation that a near-term equity offering was forthcoming given the S-1 (vs. S-3) filing. Additionally, in a market of heightened concern, NOTV had decent leverage.

·         DOJ investigation / USDA Audit: In its 1Q22 10Q filed in February, NOTV disclosed that Envigo received a DOJ subpoena in June 2021 and that it received a US Department of Agriculture inspection reports showing non-compliance. These investigations began prior to Inotiv’s ownership and were known prior to effectuating the merger. The sellers have partially indemnified Inotiv in these matters.

·         May 20: 8-K filed disclosing the DOJ conducted a search warrant for violations of the Animal Welfare Act.

With the stock closing -28% and wiping out $125 million in equity over this disclosure, the market is telling us that it is either insane or this is the first shoe to drop of something that is systemic at Envigo. We have done countless channel checks and do not believe this instance or the other DOJ investigation will amount to something material. This market has proven it is unforgiving of any hairy situation and NOTV has some hair. As the #2 provider of research models in a supply constrained industry, we do not believe the government could or would allow Envigo to fail.

Valuation

Aside from this noise, investors have the opportunity to invest in a mini Charles River (CRL) at a 50% discounted valuation. Based on our estimates, we believe NOTV will generate $610 million of revenues, $115 million of EBITDA and $1.40 of EPS, which puts it at 0.9x, 9.4x and 6.0x.

Risks:

The two biggest risks are the DOJ complaint is just the tip of the iceberg and the investigation morphs into something systemic and the lack of capital markets funding for biotech halts growth. There are plenty of thought pieces from the sell-side on the CRO industry concerning the industry’s performance and valuation relative to the cycle if you are looking for background data (cliff notes: the stocks are already pricing in a 2023/24 recession).

Catalyst

1. Resolution of investigations or closing down problem facility. 

2. Earnings.