Description

This is NOT a “Pharma” Investment or Bet on the FDA

Recro Pharma (“REPH”) is quickly transforming from a drug developer to a specialized manufacturer of pharma products known as a contract development and manufacturing organization (“CDMO”).  A good writeup was posted on REPH last May, but the story has evolved materially and the market does not seem to notice.  Hence, I thought another writeup would be useful.

Historically, REPH focused on developing drugs under its Acute Care segment while basically using its CDMO segment as a source of funding.  For context, REPH (a < $250mm market cap company) burned > $100mm from 2015 to 2018 funding intravenous meloxicam (“IVM”).  IVM’s drug application was rejected for a second time by the FDA this March, so REPH is now transitioning into a standalone CDMO.

CDMOs are Attractive Businesses

CDMOs develop, formulate, and manufacture drugs for pharma clients.  CDMOs benefit from:

1.       Secular tailwinds: pharmas outsourcing manufacturing as they focus on R&D and cutting costs.

2.       High switching costs: CDMOs are written into pharmas’ drug applications, so must resubmit this to the FDA if wanting to change CDMOs.  The FDA can then reject the application for any reason.

3.       Sticky revenue stream: CDMOs often have multi-year contracts and > 90% renewal rates given the difficult of switching CDMOs.

4.       Reputation critical (another barrier to entry):  Clients’ drugs must be manufactured properly, so CDMOs must be extremely reliable and have established track records. 

5.       High margins: Top CDMOs have > 25% EBITDA margins due to the reasons above and specific expertise required.

REPH’s CDMO is Particularly Attractive

REPH’s CDMO is an unappreciated gem that seems more compelling than most CDMO because:

1.       5-year contracts for > 85% of revenue.

2.       Can’t be fired by the customer for the majority of its revenue b/c REPH owns the patents.

3.       Due to its patents, REPH receives royalty revenues resulting in > 40% EBITDA margins.

4.       Focuses on complex production of extended release, oral solid pills.

5.       Holds DEA licenses so can produce controlled-substances.

Substantial Growth in 2019

REPH guided to 2019 CDMO EBITDA increasing by 70% y/y due to three primary factors.

First, new business is boosting REPH’s topline.  After paying little attention to its CDMO for a few years, REPH hired Heather Sugrue in 2Q18 to lead business development (“BD”) efforts.  Heather is an industry veteran who spent the prior five years leading the West Coast BD team of Patheon (“PTHN”), which was a CDMO acquired for > 17x EBITDA in 3Q17.  REPH’s BD efforts appear to be gaining traction as management hopes to exit 2019 with ~10% of revenue coming from new products. 

In addition, REPH is benefitting from its customer (Teva) gaining share with REPH’s largest product (Verapamil SR).  Mylan was manufacturing a competitive product but closed its plant due to quality control issues.  Teva has capitalized by locking-in customers to multi-year contracts.  I think Mylan will likely struggle to win these customers back even if/when the plant comes back online and contracts expire.

Lastly, a key customer has been raising pricing on a product that REPH manufactures and benefits through a profit-sharing agreement.  I believe REPH’s 2019 CDMO EBITDA guidance of $45mm (midpoint) will prove conservative.  The CDMO has historically generated more EBITDA in the second half of the year.  REPH’s CDMO produced $53mm of run-rate EBITDA in the first half of 2019 and $60mm run-rate 2Q19.  But for conservatism, I assume $45mm in our valuation section. 

Acute Care Spinoff

After IVM received its second FDA rejection in late March, REPH leadership swiftly added an activist to the Board (Engine Capital) and announced plans to eliminate all expenses not tied to seeking an FDA approval & monetization of IVM.  In August, REPH announced it would spinoff the Acute Care segment (including IVM) by 4Q19.  As a result, REPH will become a standalone CDMO.  Historically, REPH has allocated corporate overhead to Acute Care.  Though the CDMO has its own management team, REPH management has indicated the CDMO would have $3-5mm of public company costs post-spin. 

Severely Mispriced CDMO

The closest public comp to REPH’s CDMO is likely Cambrex (“CBM”) due to its focus on small molecules (instead of biologics).  In early August, CBM announced it would be acquired for 16x EBITDA (or $2.5b) by Permira Funds.  Despite spending > $0.6b on acquisitions in 2018, CBM guided to a ~10% y/y drop in 2019 EBITDA because > 25% of its 2018 revenue (and even more of its profits) was tied to a product (Gilead HCV franchise) with rapidly-declining demand.  CBM also only has a ~25% EBITDA margins.

Given REPH’s growing significantly, has > 40% EBITDA margin, and owns the patents to key products, I think REPH’s CDMO is a better business than CBM.  It is worth noting that CBM also paid ~16x EBITDA for Halo, which is comparable to REPH. 

Based on its $45mm EBITDA guidance, REPH only trades for ~8x EBITDA or a ~50% discount to the relevant M&A comps.  Deducting for $4mm of corporate costs, the company is valued for only ~8.5x.

Potential Double in a Sale in < 12 Months

I think it is telling that the spinoff is taxable (so the CDMO can be sold) and being executed with urgency.  It is possible a buyer may have already approached REPH about its CDMO, but that is pure speculation.  Most likely, I think REPH will be sold as a standalone CDMO in 1H20.  It seems that the key players would want this: 1) Engine Capital has a history of pushing for sales, 2) the 14%/largest shareholder is a VC firm w/two board seats that has been invested for over a decade, and 3) REPH’s CEO likely wants to lead a pharma company (if anything given she’s approaching 65 years old) not a CDMO.

Applying 15x to $45mm of EBITDA then deducting ~$95mm current net debt and adjusting for warrant/option dilution implies a fair value of $22 per share or ~100% upside.  If the CDMO continues its 1H19 run-rate EBITDA and generates > $50mm, then the company could fetch ~$25 per share.  Even using the low-end of guidance and 11x EBITDA, then implies REPH is still worth ~$15 per share or ~40% upside. 

I ascribe zero value to IVM.  REPH is appealing the FDA’s rejection of IVM and hopes for a resolution by 1Q20.  If approved, IVM could be worth > $1b based on similar drugs/companies (PCRX and Ofirmev to name two) but not betting on this.

Catalyst

Spinoff of Acute Care, guidance increase, sale of REPH.