Description

Knight Therapeutics had been written up twice on VIC over the last 5 years. The thesis was to bet on Jonathan Goodman, who had an amazing 20 year run at Paladin Labs before the timely sale of the company. The sequel has thus been a dud, as Mr. Goodman had sat on the majority of the cash pile citing high valuation. There is clear investor fatigue with the lack of progress on deal making, and sentiment is also likely hurt by a bizarre proxy fight with an activist shareholder. As a result, the stock had retreated from $11 in early ’17 to around $7.3 recently, just above book value (most of which are cash and investments). After monitoring the name for a few years on the sidelines, I think the current set-up is quite attractive – worst case is dead money which I can live with, and Knight may be finally closer to being able to deploy the capital on accretive deals, as some of the specialty pharma names may need to make divestments. The market is obviously obsessed with “outsider” CEOs/compounders like Leonard at Constellation Software, yet we are not paying anything for that potential value creation now at Knight.

Proxy Fight: I want to get this out of the way, as I think it is largely noise and should get resolved fairly soon. The background is Knight chose to collaborate with Medison in 2015, a private Israeli company owned and controlled by Mr. Jakobsohn. The two companies had cross ownership – Knight became a 28% shareholder of Medison, and Medison received 10% of Knight shares, which subsequently decreased to 7%. The relationship soured over the years, likely due to disagreements on strategies. The two parties wanted to separate ways, but probably couldn’t agree to the price. My educated guess is Jackobsohn wanted to buy back the Medison shares at a discounted price and/or sell Knight shares at a premium, and Knight refused to play ball. Medison is a private company, so disclosure is very limited. The dispute got so ugly that Knight had to sue Medison to force it to pay dividends as required by contracts. Jakobsohn fought back by waging a proxy fight nominating a new slate of BoDs, citing poor performance of stock and conflict of interest of Goodman between Knight and his family business.

The leading proxy advisory firms had recommended electing a couple of directors from Jakobsohn’s slate, but importantly not Jakobsohn himself (who is currently on the board). They made the argument that the current board lacks independence to a degree, but Jackobsohn’s proposed change of strategy is too risky and a change of control is not appropriate at this time. Personally, I am firmly in the corner of Goodman, having followed Paladin and Knight over the years. I think the conflict of interest angle is overblown, which is now a moot issue anyways as Goodman had put his shares in his family business in blind trust. Most importantly, I identify with Goodman’s conservatism and prudence, especially given his track record and his personal ownership of over 15% of Knight.

I think the most likely scenario is Goodman maintains control of the board and the company, reaches a ceasefire with Jackobsohn and finds a mutually agreeable price to part ways. Knight may need to take a modest write-down in its investment in Medison, but the proxy fight puts some additional pressure and motivation on Goodman to show progress, which is not a bad thing.

So why has the stock lagged?

Goodman’s 19 year run at Paladin was well documented. Paladin was a specialty pharma company focused on acquiring or in-licensing innovative pharmaceutical products for the Canadian and select international markets. Importantly, Paladin (and now Knight) shun development risks and thus early stage compounds, and instead take on commercialization risks in Canada where they know the market. Goodman has famously said “If Canada was efficient, I wouldn’t exist”. After a 100 bagger at Paladin, Goodman sold the company to Endo for $3.2B and started Knight on Feb 2014. Through the initial IPO and several rounds of subsequent secondary offering, Knight is sitting on cash/investments/loans close to current market cap. Goodman’s vision was to use the same playbook at Paladin, buying assets at 5-6x EBITDA while the public market give them a 10-11x multiple. Wash, rinse, repeat.

Except it hasn’t played out that way last 5 years – deal making and licensing have been painfully slow, and most of the products are too small to move the needle. Goodman would cite high valuation prevalent in public and private markets, and he has refused to pay up. I think it is also likely that Paladin’s success had attracted copycats and competition and the Canadian market is more efficient. Another problem was Paladin started out very small ($6m in market cap) and could pursue small deals, but Knight quickly raised close to $1B capital. In many ways, Goodman’s discipline on valuation resembles the same dilemma “value” investors are facing in today’s environment. I will sheepishly admit I have a soft spot for the likes of Goodman and secretly root for them to succeed again.

Why won’t it remain a value trap?

It is possible that Knight remains in status quo, continuing its current measured pace of deal making. I think the market Knight competes in has become secularly more efficient, but these things go in cycles, and there may be some cyclical opportunities for Knight to pounce on. In particular, many of the specialty pharma names had fallen on hard times – many were banking on price increases that have now gone in reverse, and aggressively pursued deals paying fancy multiples using cheap debt. Just a quick glance of the stock charts would show many trading at multi-year lows with heavy debt load slowly but surely facing rollover issues.

Case in point, Endo International (ENDP), the very company that acquired Paladin years ago. ENDP sports a market cap of $1.8B and has net debt of $8B+ (adjusted for litigation reserve). The company did $638m EBITDA last year – I have no idea whether consensus estimates of $1.3B EBITDA for ’19 is accurate, although that seems awfully high at 45% EBITDA margin. But it is safe to conclude it is a highly levered company – it is rated junk and some of the debt trade at 11-12% yield. ENDP’s international segment (essentially all legacy Paladin now) are supposedly doing well at run-rate of $150m USD sales and $60m EBIT. It is a tiny part of the ENDP with $3B sales, so neither mgmt nor analysts seemed to care about it, and it may be a perfect candidate for divestment for debt reduction. Part of Knight’s pitch during original fund raising was to eventually buy back the old Paladin, and Goodman even supposedly had a standing offer to buy that business. This would be a home run scenario for Goodman if he can buy it at 6-8x EBITDA, who has repeatedly said he just wants to hit singles/doubles.

In summary, Knight is a cash substitute for me at current price. It is possible that the stock could languish here or even dip a bit more. It is also quite possible that a proven money maker like Goodman hasn’t become stupid over night, and he is more motivated than ever to prove the doubters wrong, while the macro environment is finally tilting his way. I think he came across very well in this recent interview.

https://www.bnnbloomberg.ca/video/knight-therapeutics-ceo-i-made-a-mistake-in-selecting-my-partner~1652451

Catalyst

resovling proxy fight

sizable deals