|Shares Out. (in M):||63||P/E||0.0x||0.0x|
|Market Cap (in $M):||560||P/FCF||10.5x||10.5x|
|Net Debt (in $M):||-40||EBIT||90||90|
The easiest way to look at Nordion is as a combination of one long-lasting high-quality business, another high quality business with a potentially finite life, and a few free options that have relatively high probabilities, and significant payoffs. We’ll go through each of these parts in a sum-of-the-parts analysis of the entire company, describing each business/asset, its qualitative features and industry dynamics, relevant financial data, and the resulting valuation. In preview, we think the current price of the stock fairly values the pieces of the business that have relatively certain outcomes, and completely misses those assets with an uncertain future (but easily estimable minimum values) as well as any upside optionality (some of which will be determined in the course of six months and worth potentially 50-100% of the current market capitalization).
This is easily the highest quality Nordion business (and the one with the least “hair” on it). In this segment, Nordion is the world’s leading provider of Cobalt-60, a radioactive isotope which is used mostly in the sterilization of single-use medical devices, but is also sometimes used in the sterilization of food. Currently, about 40% of the world’s single-use medical devices are sterilized with Co-60 based, or “gamma,” sterilization, and that proportion has been historically increasing due to the advantages of gamma sterilization over the other two primary forms of sterilization - electron-beam (which beams do not penetrate as effectively as gamma and can therefore not be used as effectively on already-packaged products) and ethylene dioxide (which has the unfortunate disadvantage of being classified as a human carcinogen, with its attendant bad publicity and environmental impact).
Nordion has 75% market share in the global gamma sterilization market, with one other competitor based in the UK possessing the rest. Nordion’s competitive advantages in this business are based on two major factors:
Handling nuclear isotopes is not an easy business to break into. Nordion’s activities include securing Co-60 supply deals with the limited number of nuclear reactors around the world that actually have the capability of converting Co-59 into its Co-60 isotope, shipping the Co-60 to Nordion’s facilities where it is processed and encapsulated, and then sold to customers. The regulatory, safety, and logistical requirements of moving radioactive isotopes around the world does not lend itself to easy competitive entry. Nordion has decades-old relationships with the supplying nuclear reactors and a long track record of safety in its handling of the supply chain. Additionally, managing the supply chain in the context of radioactive isotope shipment is complex with all the regulatory, customs, and safety precaution boxes that need to be checked.
For the customer to use the encapsulated Co-60 to irradiate the products it is sterilizing, it needs to have the equipment to do so in the form of a production irradiator - the machine through which the medical devices pass through in order to get sterilized. Conveniently, Nordion is the world’s largest seller of production irradiators, and of the 170 production irradiators currently in existence, 120 of them have been designed and built by Nordion. This provides Nordion with an installed base of customers that have signed long term Co-60 supply deals with Nordion at the inception of their irradiator operation. When these deals come up for renewal (staggered, from a time-perspective, considering that Nordion only sells a few irradiators each year) they can either sign another long term deal with Nordion, or go to the one existing competitor. Given the complexity of the business, and the institutional memory, this is not the type of thing for which you switch vendors to save a few bucks.
Given the above, we think that Nordion is fairly safe in this business. Its growth profile over the last two decades has been 5-6% annually, but it has been extremely lumpy due to two key logistical issues - 1) the fact that the nuclear plant supplying the cobalt has to stop operations in order to Nordion to extract the Cobalt and 2) the customer must temporarily shut down its irradiator equipment when it receives a delivery of Cobalt. Both of these factors, but especially the first, make the actual growth rate in any particular year unpredictable. In the long run, though, the rate of growth of this business will depend primarily on the growth rate of single-use medical device units in addition to the continuous share gains of gamma sterilization over the other two primary forms.
We expect gamma sterilization to gain share over other types of sterilization, especially in the developing world, where the current detrimental side effects of EO do not really matter very much. Further, in order to expand in these markets, Nordion has recently developed an irradiator equipment platform (GammaFIT) that is modular in nature so that the customer has a much smaller startup cost (half the cost of a standard production irradiator) and can easily expand infrastructure by adding a module. Nordion has only started in the most recent quarter to go out and sell this, and expects this year to only begin the sales process. All in, we expect the future growth rate of revenue in this business to be in the same 5-6% range we have seen in the past, with the potential for near-term acceleration if the GammaFIT reactor proves to be well-accepted. As for the cash flows the business generates, earnings will grow moderately faster than revenue given the high fixed costs and associated operating leverage.
Sterilization EBITDA was in the $46-47M range for the past two fiscal years, and Nordion expects this to be the case for the current fiscal year as well. Subtracting about $3M in capex, $4M in allocated corporate SG&A, and using the company’s tax rate of 27% (it will be zero over the next few years due to NOLs, which we’ll get to in the end), gives us a run-rate FCF of about $30M. At a 15x FCF multiple, which we consider conservative for such a high-quality growing business, we value the sterilization business at about $450M.
The Medical Isotopes business is a bit more complex than the sterilization business. Historically, this has been an arguably even better business for Nordion than sterilization, but the events of recent years have changed that, and there’s a decent that this business gets even worse in a few years. Medical Isotopes are used primarily in diagnostic imaging procedures such as PET and SPECT scans. Of the total procedures every year using medical isotopes, 80% of them - or 30 million - use Technetium-99 (Tc-99). Tc-99 is derived from Mo-99, which is the primary product sold by Nordion in this segment.
As with Co-60, the logistical issues involved in the medical isotopes business are quite significant. But with Mo-99, these issues are magnified exponentially due to the fact that Mo-99 has a half life of 66 hours vs. the 5.2 years of Co-60, which means that once the Mo-99 is extracted from the reactor, it’s a race against time to get the product to the hospital for use in tomography. Moreover, the majority of the global supply of Mo-99 comes from 5 nuclear research reactors, all of which are over 40 years old. Before May of 2009, the medical isotope market was in a state of what we’d call fragile stability. Nordion supplied 40-50% of the global market with Mo-99. Nordion’s supply came from the NRU reactor in Canada. The NRU reactor is owned by Atomic Energy of Canada Limited (AECL), which is a Canadian-government-owned corporation (AECL has historically operated in the medical isotopes market by providing the Mo-99 to Nordion in return for a split in the revenues).
Up until 2008, with the knowledge that the NRU reactor was quite old and was nearing the time at which it would need to be decommissioned, AECL was working on a replacement reactor that went by the acronym MAPLE (Multipurpose Applied Physics Lattice Experiment). Over the years, and over a series of reworked agreements, Nordion had contributed $350M into this project, with the understanding that that MAPLE facilities would provide a continuous supply of medical isotopes to Nordion. In May of 2008, AECL and the Canadian government announced that the work on the MAPLE facilities would be discontinued. In the meantime, though, Nordion’s supply of medical isotopes from the NRU reactor would be unaffected. Unfortunately, the age of the NRU reactor became a key issue about a year later when, in May of 2009, the NRU reactor had to be shut down for 15 months due to a heavy water leak and the resulting safety concerns. Overnight, Nordion went from a company that supplied the global market with half of its Mo-99 needs to a company with almost no supply of medical isotopes. The market itself was also thrown into disarray, though it adjusted through increased Mo-99 output from the other reactors around the world, as well as increases in the efficiency of Mo-99 use and some substitution of Mo-99 with less reliable medical isotopes.
After the 15-month shutdown, NRU came back online, although it now has a 30-day planned maintenance shutdown once a year. Its license, which expired in 2011, was renewed until October of 2016. Unfortunately for Nordion, the Canadian government has expressed its intention of permanently shutting down the NRU reactor on that date. Thus, Nordion essentially has the NRU-based medical isotopes business for another 4.5 years. Until then, the most important results of the 15-month shut-down (as well as the year-long shut-down of a key medical-isotopes-producing reactor in the Netherlands starting a year later) have been:
The significantly reduced market share that Nordion has in the marketplace both as a result of 10% less supply (due to the 30 day annual shut-down) as well as Nordion’s customers (mostly isotopes giant Lantheus) diversifying their supply base due to the shock they had to undergo when Nordion basically went “off the grid” for 15 months without notice. Nordion’s share has now come down to about 20% of the market from its 40-50% pre-shutdown.
As Mo-99 is now in short supply, its price increased significantly. That accounts for the significantly reduced market share of Nordion (cut by over 55%), but not very significantly reduced revenue (cut by about 15%).
The shutdown-induced shortage sparked governments around the world to start funding initiatives dedicated to coming with new ways of generating Mo-99 or Tc-99. If you do a search on Google for Mo-99 or Tc-99, you are going to find tons of different initiatives claiming that they’re very close to finding the holy grail of safely and abundantly produced medical isotopes. Most of these technologies are outright unworkable, or at best, will take many years to work out. The most prominent example of this was a JV between GE and Exelon, which was shut down in the latest quarter because it was simply uneconomical to go ahead with the project given the current cost advantage that the five incumbent reactors have. Either way, it is important to note that there’s a lot of research going on in this arena, but it will take time - at best a few years - to generate reliable results. And odds are, given the extremely inexpensive method through which the current reactors generate Mo-99, that any new methodology would cost a lot more.
Nordion, in addition to funding and participating in much of the research discussed in the previous bullet point, has also started to diversify its own supply of Mo-99 through a JV with the Russian nuclear company Rosatom. The JV, named (somewhat appropriately) “Isotope” was originally planned to have been able to supply 20% of the world market in the next few years. Things have not exactly gone as planned, though, and Nordion now says that while it’s confident they will eventually be sourcing Mo-99 from Isotope, it will be at quantities “significantly less than” the original 20% of world supply expectation.
So where does that leave us on valuation? For the current fiscal year, Nordion expects the medical isotopes segment to generate about $95M in revenues. We expect that on those revenues, Nordion will generate about $30M in EBITDA, which will translate into about $20M in free cash flow after capex and taxes. We know that the $20M in FCF has a few headwinds and tailwinds over the next four and a half years including slow price decreases as the market continues to normalize from the ‘09 shutdown, as well as potentially new customers that will buy Mo-99 (after all, Nordion still has access to more supply of Mo-99 than it is selling, and it has thus far been moderately successful in procuring new customers - we expect that to continue), and finally, significant price increases (and probably all-out chaos) as we approach the October, 2016 D-Day when the NRU reactor will no longer be supplying medical isotopes. For our valuation, we assume $20M in FCF over the next 4.5 years, which, discounted back at 10%, gets us to the $65-70M range valuation.
Beyond October, 2016, we assume that the JV with Isotope will be able to provide only 10% of global demand, or a bit less than 50% of Nordion’s current revenue base. There are a lot of moving parts here, but it’s important to realize that the less Mo-99 supply there is on the market, the more Nordion will be able to sell of its non-Mo-99 isotopes, so revenue will not decline by anything near 50% (at worst, we expect a 40% decline). Thus, based on extensive sensitivity analysis, we think this segment will still be able to crank out $10M in FCF. Valued at 10x at that point, and discounted to the present, that adds another $60M to our valuation. Besides that, Nordion has a formidable collection of assets and intellectual property in this segment that, even without Mo-99 supply from Isotope, would command some value in the marketplace. As a result, adding up the various parts here gets us to, conservatively, $100-125M.
Optionality & Uncertainty
Nordion currently trades at a market cap of about $565M. If you take our valuation of the sterilization and medical isotopes business, and add the $40M of net cash on the balance sheet, you get $600M - and that’s at valuations that we think are conservative (the sterilization business, for example, could easily be acquired at richer multiples than our valuation suggests, or could be levered up to increase ROICs). Further, Nordion has $100M in “tax benefit of losses carried forward” that it will be fully using up in the next five years (they had $116.5M at the end of 2010, and reduced the amount by precisely their tax bill in 2011 - i.e., they did not pay a dollar of cash taxes in 2011, and will not for the next few years). Just to be clear, these are not NOLs - this is a sub-category in the deferred tax asset account that is a full offset to cash taxes. Depending on how long it takes Nordion to use these assets, and giving them a 40% haircut, the present value of this tax benefit is about $50M. But there are two other parts of Nordion that we think have significant value: the optionality of arbitration and the Therasphere business.
Optionality of Arbitration
For the long history of the relationship between Nordion and AECL, you can look at Nordion’s annual and quarterly filings for the past decade (all available at sec.gov), There, you will read pages of small text, which outline the history of the MAPLE deal, from conception to the trash bin. In our mind, the key facts are as follows:
The original agreement between Nordion and Canada, in 1988, stipulated that AECL would supply medical isotopes to Nordion for 23 years while, in the interim, it would work on building the MAPLE facilities in order to secure a truly long term supply of medical isotopes. This was part of the original agreement that had Nordion buy the medical isotopes business from the Canadian government.
In 1996 the agreement was revised such that Nordion would be the owner of the two nuclear reactors at the MAPLE facility, which would be developed by AECL. At the time, the MAPLE facilities were required to achieve certain operational criteria by the year 2000 (ed. - haha - it does really go to show you how tough it will be to figure out a new source of medical isotopes given that we are now 12 years later with no real progress). Nordion was to invest C$145M in the project.
By 2005, costs had doubled, and Nordion’s investment total hit C$350M. The agreement was revised again. This time, Nordion gave up all ownership of the MAPLE reactors in return for a 40-year supply of medical isotopes from the MAPLE reactors plus $22M in cash, a $46M non-interest-bearing note receivable, and some raw Mo-99 material.
In May of 2008, the Canadian government shelved the entire project and Nordion and AECL are currently in arbitration over the matter.
Now, if you read that and think that Nordion has a pretty good case, you’re not the only one - we think so too. Frankly, we have no clue how the arbitrator will rule. Nordion is suing for $1.6B - a number that we flat out do not understand - OR specific performance, i.e. the actual building of the MAPLE reactors. The latter outcome would mean that Nordion would have sole rights to an enormous supply of medical isotopes in North America and could essentially control the market. It’s not tough to play around with a back of the envelope valuation of what such an outcome is worth but it’s easy to get to medical isotopes FCF of $40-50M, which would probably command a multiple in the range of what we conservatively gave the sterilization business. In other words, such an outcome would double the intrinsic value of Nordion overnight.
If, on the other hand, the arbitration ends up awarding Nordion cold hard cash in lieu of specific performance, it could mean anywhere between 50 and 100% of the current stock price. We doubt it would be the full $1.6B being sued for, but that is the upper range. Even something much smaller would result in a grand slam here.
Of course, it’s possible that Nordion gets nothing, but given the facts of the case, we find that to be extremely unlikely. Plus, you're not paying anything for it. Arbitration ends next month, with a decision expected in the ensuing few months.
Therasphere and Uncertainty
Thus far, we’ve totally ignored what Nordion management considers the most exciting part of Nordion - the Therasphere treatment and associated assets. Therasphere is a novel non-invasive procedure that involves, you guessed it, radiation, in order to treat liver cancer. Nordion takes glass beads that contain specialized material that, when irradiated in a reactor, is converted into Y-90. These beads are injected into patient livers using a delivery apparatus also developed by Nordion. The entire procedure is carried out via catheter, thus delivering an extremely targeted radiation dosage to the tumor without overly affecting adjacent areas of the liver.
Most of the revenue that Therasphere currently generates (at an annual run-rate of $45M and growing fast) is in the US, under the FDA’s HDE (Humanitarian Device Exemption) rule, which allows Nordion to sell Therasphere in an extremely limited fashion - with marketing and promotional materials basically non-existent and with each customer applying for approval from the hospital’s Institutional Review Board before administering treatment. Nordion currently sells Therasphere under HDE only to an extremely sick subset of liver cancer patients - those with unresectable hepatocellular carcinoma (HCC) So far, the farthest Therasphere has gone in clinical trials is an extremely successful Phase II. In Europe, Therasphere is approved for use in metastatic liver cancer in addition to HCC, but is reimbursed very sparsely given the limited clinical data.
Nordion thinks that they have something big with Therasphere and have been ramping up expenses in two ways:
They have initiated 3 Phase III clinical trials of Therasphere, corresponding to 3 different indications:
Primary Liver Cancer
Secondary/Metastatic liver cancer
A randomized trial in a subset of primary liver cancer patients - those with portal vein thrombosis (PVT) where Nordion thinks Therasphere has the most to offer.
Ramping up a sales force and support staff in anticipation of Therasphere growth as well as potentially leveraging that sales force by in-licensing other non-invasive cancer therapies.
The goal of the clinical trials is to expand the treatable indications and obtain favorable reimbursement status both in the US and in Europe. The R&D costs associated with the Phase III trials will run to about $45-60M (in total) over the next five years.
The reality is that we don’t know how successful Nordion will be with Therasphere. But we think the value of this segment is at least its value without the clinical trials and extra staff, i.e. the $10M in EBITDA Therasphere would generate on its own without the extra costs. In other words, you can add at least $60-100M in valuation to Nordion just for Therasphere. If these clinical trials are successful over the next few years, this can be an enormous revenue generator (liver cancer is the third most common form of cancer in the world, and while it’s uncommon in the US with 30,000 diagnosed cases per year, it is extremely common in Asia and parts of Europe; globally, 700,000 cases are diagnosed each year; a therasphere treatment runs about $15K - the numbers for Nordion would potentially be staggering).
Nordion’s market cap is $565. You’re getting at least $650M in operating businesses with no taxes for a while, and two enormous free options - one that may get exercised in the next six months and one longer term in nature. Throw in a management team that consistently buys back stock with free cash flow and the 4.1% you get paid while waiting, and this seems like a very attractive story.