Description

Landec Corporation (LNDC) operates two businesses which have zero in common except they both employ workers and are located in the United States.  One of the two businesses, Curation Foods, is a mediocre business that sells fresh cut vegetables, ready mix salads, guacamole, olive oils and vinegars.  The second business is Lifecore, which is an outstanding Contract Development and Manufacturing Organization (“CDMO”) business.

Shareholders have figured out that the Curation Foods business is low margin and highly volatile.  In fact, over the last several years Curation Foods has produced many notable earnings misses.  We believe it is highly likely the food businesses could be separated and sold to a strategic buyer who could run the operation even more efficiently through adding additional scale especially in manufacturing, raw material sourcing and retail distribution.

Almost every Landec earnings call or presentation is dominated by a discussion about Curation Foods.  While we can appreciate the reason why this happens, it puts the focus on the worst part of Landec.  In the last several years this focus has generally been on how Curation Foods managed to repeatedly miss earnings.  The rest of this write-up will focus on the crown jewel – Lifecore. 

But first, we would like to raise up front one important point that is not often talked about with this company.  We think that Landec is an excellent ESG investment given the profound impact that its products have on the environment and social issues.  Curation is heavily focused on sustainable farming techniques, 100% clean ingredients and utilizing curbside recycleable packaging and Lifecore is helping to bring life changing drugs to market like HTX-011 which should substantially reduce opioid use worldwide.

Lifecore operates two facilities in Chaska, Minnesota.  Lifecore’s heritage is in producing premium-grade hyaluronic acid (“HA”) from biomaterials.  HA historically was produced from the red comb on a chicken’s head.  The chickens (likely) didn’t appreciate this activity, so a process using fermentation was developed to make the same chemical in the laboratory.  Through optimizing this process, Lifecore became one of the leading firms in this space.  Interestingly, HA is notoriously difficult to handle due to the fact that it is highly viscous (almost a solid).  Lifecore spent substantial effort solving the handling of HA and that knowledge base makes them a leader in applying that same know-how (this is highly technical chemical process) to other pharmaceutical products.

Lifecore is in the process of building a highly valuable development pipeline.  Drug development is a long process and over time emerging biopharmaceutical and biotechnology companies have realized that there is little point in developing their own drug manufacturing capacity.  In fact, the effort to manufacture is both a capital-intensive and time-consuming effort to start up.  Accordingly, many of these emerging biopharmaceutical and biotechnology companies have determined to spend their finite resources on developing products and then partnering with CDMO firms like Lifecore to actually work through the manufacturing from pre-clinical to commercial production.

Since drug development can take over a decade from start to finish, it is not possible to quickly enter this business and merely having substantial capital to deploy is not the only barrier – or even the primary one.  Substantial time is required to find companies with promising products and then you need a world-class facility that has a solid track record of FDA inspections.  Further, once you begin commercial production the facility where the pharmaceutical product is manufactured will have been approved by the FDA specifically for the production of that product, making it extremely difficult to subsequently move production to another facility without going through an entirely new FDA approval.  As a result, the Lifecore business is very slow to build and has very sticky long-term revenues.

The development pipeline that Lifecore has built has taken substantial effort.  They not only evaluate the probability of success, but they also want to partner with companies that have the financial viability to survive a multi-year drug development timeline.  The pipeline today totals 16 customers, some of which have more than one product.  The phases of development include firms that are pre-formulation (5 companies), working through formulation development (6 companies) and scale up development (6 companies).  The pacing of work in the pipeline should allow Lifecore and its partners to bring one to two new products to commercialization each year.  Currently, one product HTX-011 is under FDA review and has previously been approved in Europe.

The exciting part for shareholders is that Lifecore has unused capacity.  For many years, Lifecore was used for its cashflow by Landec.  Dollars were routinely sucked out so that the food business could make investments.  Over the last several years, the dollars have been used in Lifecore to build capacity.  Lifecore has installed a new multi-purpose filling line and now has capacity to handle 22 million units annually broken into 18.5 million syringes and 3.5 million vials.  For the most recent fiscal year Lifecore used 6.5 million units of this total capacity.  Going forward, Lifecore will again increase capacity to 30 million units of total capacity.  Some have speculated that management is building crazy amounts of capacity with no production volume coming soon; however, since the lead time to build filling capacity takes 3 to 4 years from the time equipment is ordered until final regulatory approval is received, Lifecore monitors projected filling capacity needs based on the commercialization rate of the products within its development pipeline.  In other words: The buildout of capacity is not some highly speculative bet, but rather a measured thoughtful expansion of their capacity for the pipeline of products they are developing including the two $1 billion dollar products they have in the pipeline.  One of these is HTX-011 which we will go into greater detail on shortly.

To further outline the growth plan, management pointed out in the Q1 earnings release the other requirements beyond the filling lines to actual manufacture product.  These other components include investments in hiring people and adding testing capabilities and packaging equipment.  Since these expenditures (some capital and some operating) have shorter lead times, they are added closer to production utilization.  The 22 million units of capacity will solve production needs through 2025 and another 8 million units will be needed by 2030 which will expand the total capacity to 30 million units.

Jim Hall, who operates the business, pointed out to us on our most recent visit plans for future expansion at the site of the Lifecore headquarters as the company plans for future capacity.  The next obvious move would be to move the administrative offices out of the Lifecore main manufacturing building and expand manufacturing inside that building to utilize all square footage.  There are benefits to doing this since the facility already has FDA approval vs. breaking ground on a new building for manufacturing which would need to go through a full FDA site inspection.  Longer term, Lifecore has substantial dirt at its primary site in Minnesota to build additional buildings.

We expect HTX-011 will be approved by the FDA in the next six months.  This will be a big event for LNDC as commercial production for the US begins.  HTX-011 already had been approved in Europe.  This drug is still investigational in the US.  HTX-011 is used post-surgery to help patients deal with pain and avoid the use of opioids.  The reason why this is so important is that HTX-011 is effective in reducing/eliminating post-surgical pain and this means that prescriptions for opioids are not written and opioids are not dispensed.  One study that looked at hernia repair surgery estimated that annually 24 million opioid pills would be prescribed to these patients post-surgery, but that only 7.2 million of the opioid pills would actually be consumed by the patients leaving 16.8 million opioid pills in the patient’s medicine cabinets.  These leftover pills represent a huge risk to be misappropriated by patients and their relatives and caregivers and likely could lead to further opioid addiction issues.  As Heron points out in its investor presentations, the market for non-opioid pain relief is large and waiting for an effective solution.  HTX-011 appears to have a good shot at taking substantial share and the US market for post-surgical use is roughly 30 million procedures per year.  Heron estimates the total market potential here at $5.8 billion with the primary target market being $2.8 billion in value.  Keep in mind, this is just the next product in the Landec development pipeline and there are 15 other products behind this one and at least one that we’ve heard is rumored to be even larger than HTX-011.

We think the LNDC valuation is very interesting.  Since this write-up is focused on Lifecore, that is the lens through which we will consider valuation.  Lifecore did $86 million in revenue in fiscal year ended May 31, 2020.  Management has guided that the business will grow mid-teens between 2021 and 2025.  This implies $170 million of revenue by 2025.  We see EBITDA by 2025 growing to $46 million for Lifecore.  We value this EBITDA at multiples of 15x to 18x and then discount that back to today – which is $429 million to $514 million, respectively.  The present value of the Lifecore cash flow over the next five years is $14 million.  This number is low because Lifecore is building out the theoretical production capacity from 22 million units to 30 million units.  We estimate that Lifecore will spend about $25 million on maintenance capex ($5 million per year) and $70 million on growth capex over the next five years and this is inclusive of the $20 million they have announced for the current fiscal year.

We expect that by early 2022 the entire Curation business will be sold for net value (after paying down all debt) of between $50 million to $100 million.  Using these estimates, we see current discounted value of LNDC shares of $17 to $22 per share.  We admit that our numbers are likely pretty conservative since they don’t have Lifecore doing anything with the net cash from Curation and don’t have Lifecore adding any leverage to expand faster.

Catalyst

LNDC is catalyst rich: Refinance balance sheet, begin hitting financial guidance, monetize entire food business by March 2022, HTX-011 FDA approval.