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*** THIS IS A SPECULATIVE SECURITY, PLEASE DO YOUR OWN DUE DILIGENCE ***

This past Thursday evening, Lifecore Biomedical (NASDAQ: LFCR, “Lifecore” or “LFCR”), the owner of a high-quality CDMO business headquartered near Minneapolis, issued three concurrent press releases.

On Friday, Lifecore’s share price fell -67.3%.  The company’s stock closed at $1.67.

Investment Thesis

My thesis is the market mis-reacted to the press releases.  I believe (1) Lifecore has plenty of liquidity with a cash balance of $50M+, (2) the company received a “going concern” notice because it is in technical non-compliance with certain loan covenants as of the date its financial statements were filed, but my expectation is LFCR pays up and receives a covenant waiver or forbearance from its lenders in the next 2-3 weeks, curing the “going concern”, and (3) investor focus will then quickly shift to the strategic alternatives (i.e., sale) process announced in the press releases which I believe is likely to lead to a sale of the company within 3-6 months at a substantial premium to the current share price.

I believe Lifecore could command as much as $15-25 per share for its CDMO asset, but given potential anchoring to the headline share price, an $8-10/share level (at minimum) seems realistic and achievable.  Importantly, I believe there is strong interest in owning Lifecore’s CDMO business – and the strategic alternatives process was likely, in my view, launched in response to inbound interest.  Members of the Board of Directors own ~40% of the stock and are motivated to achieve a value-maximizing outcome for shareholders.

In the current market environment, with banks wiped out over weekends alongside credit and equity volatility, a small/micro-cap stock with a “going concern” warning carries extra risk and might strike some as unappealing given current conditions.  My view is the “shoot first, ask questions later” ethos of markets right now has delivered a compelling risk/reward.

Lifecore’s “going concern” warning is about covenants, not liquidity, which is solvable.  Lifecore’s business is not impaired, and actually just won the biggest customer in company history.  As investors dig deeper, I believe the current share price of $1.67 will be viewed as anomalous relative to an intrinsic value which should be multiples higher.

Background

Lifecore, formerly known as Landec Corporation, operated for years as a non-sensical combination of two unrelated businesses: (1) a CDMO in Minnesota called Lifecore and (2) an agricultural products business in California called Curation Foods.

I first met Landec nearly a decade ago.  The company’s CFO came by my firm’s offices.  I asked him why these businesses made sense together.  His response: “our agriculture business is volatile because it’s in a commodity industry, and subject to harvests and weather, but this volatility is balanced out by the steady growth and visibility of the CDMO business.”

Markets took a different view.  The extreme unpredictability of Curation Foods made it the only thing analysts or investors would focus on.  How the year’s green bean harvest would turn out was a recurring question on analyst calls.  Instead of rewarding Landec for the consistent and solid growth of Lifecore (which has grown top-line at +15% per year and EBITDA by +25% per year since FY15, see Exhibit A), the market penalized Landec for the volatility of Curation Foods.

                Exhibit A

Activism

In 2019/2020, well-regarded small-cap activist investor Legion Partners became involved.  Legion now owns 9.9% of the company and has two Board seats.

In part due to Legion’s pressure, the management team was replaced and the Board has been substantially refreshed.  More importantly, Landec made the strategic decision to sell its Curation Foods assets and transition to a pure-play CDMO business.

Since then, the following Curation Foods businesses have been sold:

• On August 7, 2020, a pre-operational salad dressing facility was sold for $4.85M

• On August 25, 2020, certain agricultural manufacturing operations were sold for $8.7M.

• On June 1, 2021, the minority ownership interest in Windset Farms was sold for $45.1M.

• On December 13, 2021, the Fresh Packaged Salads and Vegetables business was sold for $73.5M.

• On June 2, 2022, the Breatheway Packaging business was sold for $3.2M.

• On Feb 7, 2023, the Avocado Products business was sold for $17.5M.

The only remaining business in Curation Foods is the “O” Olive Oil business, which should be sold shortly.  I estimate this business is worth <$10M and does not impact the thesis.

It’s worth specifically highlighting the Salads business and the Avocado Products business.  These two businesses were viewed as “poison pills” for potential buyers of the CDMO asset.  The Salads business was large (hundreds of millions of revenues) and the Avocado Products business had a significant footprint in Mexico and faced regulatory issues.

With the sale of the Avocado Products business last month (the Salads business was sold in Dec 2021), I believe Lifecore – for the first time – is actually a transactable asset.

Lifecore has received inbound interest from potential buyers of its CDMO business for years, but with the disposition of the “poison pill” Avocado Products business, it’s hard to believe the volume of interest has done anything but increase substantially over the last six weeks.

The CDMO Business

The crown jewel of Lifecore (the company was renamed in Nov 2022) is its CDMO business.

A CDMO – a contract development and manufacturing organization – is a high-quality business.  CDMO’s manufacture pharmaceutical products for drug companies.  The regulatory standards are high, such that certain drugs (especially biologics) would need to be re-approved by the FDA if a new CDMO was chosen to produce the drugs.  Lifecore has many customers who have been with the company for decades.  As a relatively small but mission-critical expense in bringing a drug to market, CDMO’s are able to earn strong margins, with Lifecore’s EBITDA margins consistently approaching 30%.

Lifecore in particular is an excellent CDMO.  The company specializes in complex injectables, the fastest-growing segment of the CDMO industry.  Specifically, Lifecore has world-leading expertise in taking highly viscous liquids (a liquid so dense it barely flows) and filling these liquids into syringes for delivery to patients.  This highly-differentiated capability in sterile, injectable-grade pharmaceutical products makes Lifecore a sought-after supplier.  Until the middle of last year, when Lifecore started building its first outbound sales team, all the company’s growth came from referrals and word-of-mouth given Lifecore’s specialized offering.

The one downside to CDMO businesses is that, while annual results tend to be consistent, quarterly results can be lumpy based on the timing and margins of customer projects.  Lifecore has 29 FDA-approved commercial products and 25 products in development (54 total products spread across dozens of customers), but it is an ongoing balancing act to keep capacity utilization high while accommodating the scheduling needs of customers.

Three Misunderstandings

This brings us to the press releases from last week.

On Thursday 3/16, Lifecore released three press releases: (1) its Q2 FY23 results, (2) a customer win, and (3) strategic alternatives.

https://ir.lifecore.com/news-releases/news-release-details/lifecore-biomedical-reports-second-quarter-fiscal-year-2023

https://ir.lifecore.com/news-releases/news-release-details/lifecore-biomedical-signs-term-sheet-existing-long-term-customer

https://ir.lifecore.com/news-releases/news-release-details/lifecore-biomedical-announces-intent-explore-strategic

Within the Q2 FY23 results, Lifecore disclosed that certain customer projects had been delayed from Q2/Q3 into Q4 and FY2024.  As a result, FY23 earnings would come in light and the company would no longer be in compliance with its debt covenants, hence the “going concern” notice and sell-off in the stock.

I believe the market has made three key misunderstandings in evaluating these press releases.

One – Liquidity.  There seems to be a narrative that Lifecore is running short on cash (such as this headline: https://www.bizjournals.com/twincities/news/2023/03/17/lifecore-biomedical-chaska-considers-sale.html).  This is simply not true.  As of the end of Q2 FY22, the company’s most recent reported quarter, LFCR had $6.8M cash, $48M drawn on its revolver, and $98M long-term debt.  Since then, the company has (1) received $38.75M from a convert offering with a $7 strike price, (2) sold its Avocado Products business for $17.5M, (3) received $10M up-front payment from a customer, and (4) shortly will sell its olive oil business for ~$5M, best guess, plus (5) the same customer agreed to reimburse LFCR for $15M of cap-ex spend.  This represents an inflow of over $70M (not including the cap-ex reimbursement).  My expectation is the proceeds from the Avocado Products sale was used to pay down debt, but Lifecore likely has cash on hand today of $50M+.  The “going concern” notice had nothing to do with short-term liquidity, it was a technical filing related to the possibility that – because the company is in non-compliance with its covenants – the $98M long-term debt becomes callable at any time.  I believe calling the debt is in no one’s interest, and once Lifecore agrees to a modification of covenants or a forbearance with its lenders, the “going concern” notice will cure and investors will find Lifecore in a strong cash position.

Two – Business.  The EBITDA miss in Q2/Q3 relates to project timing, not customer losses.  As mentioned above, it is not unusual to have lumpiness in a CDMO business.  My understanding is Lifecore has not lost any customers, and indeed the company mentioned on its earnings call Friday morning that Q4 would be unusually strong as customers expected for Q3 instead show up in Q4.  In addition, Lifecore announced a major customer win which the company implied was the most important customer in the company’s history by some distance.  We believe Lifecore’s largest customer previous to this announcement likely represented EBITDA of $6-7M, so this new customer could easily add $10M EBITDA to the business once scaled up in calendar 2024/2025.

Three – Sale Process.  Lifecore took an extremely conservative position in not disclosing information about why it is pursuing a sale process.  As a result, the market took the news as though Lifecore was a forced seller.  I think this is inaccurate.  Subject to a covenant waiver or forbearance, Lifecore has cash on hand to operate the business for years.  In addition, based on my past industry conversations, I believe there is strong interest in owning Lifecore and that the volume of inbounds likely increased by an order of magnitude post the February 7 sale of Avocado Products.  I believe the sale process is therefore likely a response to strong inbound interest.  Morgan Stanley would not have taken on this strategic alternatives process without confidence it could agree a sale at a healthy valuation.

What Could LFCR Be Worth In A Sale?

Lifecore’s original guidance for FY23 was $32.5M to $34.5M of EBITDA for its CDMO business (not counting central overhead of mid-single-digit millions, which would go away in a sale).  My understanding is the outbound sales force has more than doubled the business’s customer pipeline from ~30 to 60+, and in the most recent results, Lifecore announced that three of its customers had won FDA approval and were moving to full commercialization.  Lifecore has state-of-the-art fill/finish lines entering into production over the next 3-9 months that should triple fill/finish capacity and improve throughput.  On top of all that, I believe the customer win announced on Thursday could add a further $10M EBITDA per year.

What is the right EBITDA number to use in a sale process?  It is hard to know for sure.  It could be as high as $50M, or as low as $30-35M.

What is the right EBITDA multiple to use in a sale process?  It is hard to know for sure.  It could be as high as 20x EBITDA, or as low as 11-12x EBITDA.  Catalent, a larger but lower-quality CDMO (Catalent has recently had issues with the FDA and is more commodity than specialized) was rumored by Bloomberg to be a takeover candidate last month at a 17x EBITDA multiple (https://www.bloomberg.com/news/articles/2023-02-04/danaher-is-said-to-be-interested-in-life-sciences-firm-catalent?sref=t2aWmjm4).

It’s a wide range, with upside scenarios of $1 billion and downside scenarios of $350-400M.  But right now, the company has a market cap of $58M and net debt of perhaps $80M (assuming the convert is fully converted to shares, which takes the share count from 30M to 35M).  The implied sale price range is therefore $8 per share to $25 per share, based on the EBITDA and multiples above.  If I’m right on the covenant waiver, and that the “going concern” issue gets resolved, it’s hard to see how $1.67 per share is anywhere close to the right price for the CDMO business.

Risks

There are many risks to an investment in Lifecore, including:

• Lifecore is currently not in compliance with its debt covenants.

• Lifecore currently has a “going concern” notice.

• Lifecore’s long-term debt could be called by its lenders.

• Lifecore’s business just had a hiccup due to customer delays.

• Lifecore’s strategic alternatives process may not result in a sale of the company.

• If Lifecore’s strategic alternatives process does result in a sale, the sale price may not be at full value.

• Lifecore’s stock price is under $2 per share.

• There are lots of scary things going on in the markets right now.

Conclusion

Acknowledging the risks, I remain of the conviction that Lifecore’s price action on Friday was overdone.

A covenant waiver is common practice for a company with liquidity and a business that is not impaired.  Lifecore has plenty of cash and its business has a record customer pipeline and just signed a contract with a record-size customer.

My expectation is that in the next 2-3 weeks, LFCR will likely pay up to receive a covenant waiver or forbearance from its lenders.  My expectation is that in 4-6 weeks, when LFCR next reports earnings, the “going concern” notice will likely be removed.  Once that happens, investor interest will palpably shift to speculation about the Morgan Stanley-run strategic alternatives process, and what Lifecore could achieve in a transaction.  My bet is the number is likely to be well above $1.67 per share.

It’s a crazy market out there, and eyes are rightly glued to the macro.  But in this case, I think the market has taken an extreme view on a situation that has reasonable odds of working out fairly well for shareholders.

Disclaimer

The author of this posting and related persons or entities ("Author") currently holds a long position in this security. Author may purchase additional shares, or sell some or all of Author's shares, at any time. Author has no obligation to inform anyone of any changes to Author's view of LFCR US. Please consult your financial, legal, and/or tax advisors before making any investment decisions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in LFCR US. READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE. As with all investments, caveat emptor.

Catalyst

-Lifecore receives a covenant waiver or forbearance from its lenders.

-Lifecore cures its "going concern" notice.

-Lifecore announces additional customer wins.

-Lifecore gets sold for an attractive price.