ALBANY MOLECULAR RESH INC AMRI
September 10, 2014 - 6:27pm EST by
HTC2012
2014 2015
Price: 20.18 EPS $0.86 $1.51
Shares Out. (in M): 32 P/E 23.5x 13.4x
Market Cap (in $M): 652 P/FCF 24.8x 15.6x
Net Debt (in $M): 95 EBIT 42 87
TEV ($): 747 TEV/EBIT 17.7x 11.2x

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  • Manufacturer
  • Healthcare
  • Royalties
  • Pharmaceuticals
  • Rollup
  • Fragmented market
  • Lack of Coverage
  • Small Cap
  • Great management
  • Potential Future Acquisitions
  • Potential Tax Inversion
 

Description

If names like Valeant, Acatvis and Endo hadn’t proven so contentions in recent months, we would have labeled Albany Molecular (AMRI) “Valeant v3.0” (Endo being v2.0).  Instead, we will frame the investment case in a manner that contrasts favorably with that group.  AMRI is a US-based contract manufacturing (“CMO”) and research (“CRO”) organization whose customers range from big pharma to small biotech.  AMRI’s end markets (and company) grow double digits organically. If the new CEO successfully employs his roll-up strategy in a heavily fragmented market, AMRI trades at just 5x 2018 cash earnings on publicly disclosed targets.  We believe that the market fails to appreciate the investment opportunity because: (a) AMRI was generating most, and in several years more than 100%, of its earnings from royalties connected to the blockbuster drug Allegra, (b) these now declining royalties obscured the early and rapidly successful efforts to transform the company, (c) AMRI is small and covered by just 3 analysts (third picked up coverage yesterday) and (d) sales and earnings were temporarily, but materially depressed at AMRI’s important Burlington, MA facility due to FDA sanctions in August 2010, which were lifted in November 2013.  We will describe the business and its growth drivers, the new CEO’s surprisingly strong background (given that the company had a market cap of <$350 million when he joined), address the aforementioned market dislocations and lastly, dive into the stated acquisition strategy and why we believe it’s feasible. 

 

Business Description

In 2014, AMRI will generate ~$300 million and $60 in EBITDA from four key market areas that are moving to three: Discovery and Development (“DDS” - 26% of 2014E sales), API (51% of 2014E sales), Drug Product (14% of 2014E sales) and Royalty revenue (8% of 2014E sales and rapidly declining).  The over-arching theme is that from discovery to delivery, the pharmaceutical industry is increasingly moving towards outsourcing to lower costs, improve efficiency and mitigate regulatory/manufacturing induced tail risk.  Many pharma companies want to streamline their operations and their number of suppliers. AMRI offers them a full outsourcing toolkit focused for complex drugs.  From one large academic CRO: “Back when everything was in house, pharma companies would characterize materials, formulate it, test it on animals, go into the clinic, do it. Offshoring or outsourcing BIG chunks of all that, moving to working more with CMOs and CROs always, even back when [pharma companies] had their own organizations. Often you need specialized equipment hugely expensive, compliance with FDA is hard...so we’ve gone, since I started this up [2.5 years ago] from $30k in revenue to a quarter of a billion and I don’t see any slow-down.” 

 

DDS serves as the outsourced R&D arm for dozens of pharma companies. AMRI is particularly suited to provide discovery and preclinical stage drug development to both large pharma and small biotech because the company has amassed a large library of cost-effective molecules, natural products and synthetic compounds to use for screening within FDA cleared manufacturing facilities. Their particularly strong development franchise and large scale manufacturing capabilities enable faster than industry growth as the Company has a semi-captive source of clients for commercial production.  From speaking with several customers and competitors, most clients like to stay with a single CMO for as long as possible with horrific service serving as the relationship killer as opposed to price.  The newly found cost and return focus of pharma have led to increasing DD&S outsourcing and Kalorama/McKinsey expect 9-15% industry growth for this $13 billion market (outsourced DD&S) over the next several years.    AMRI currently generates $80 million (2014 company estimate) with a $200-300 million target for 2018 and a 25% EBITDA margin.

 

API, or active pharmaceutical ingredient, is exactly that: outsourced manufacturing of the key ingredients of the $825 billion global pharma market.  There is a significant trend towards outsourcing as branded companies move toward their core competencies (sales and marketing) and generic companies struggle with the complex manufacturing of certain formulations.  AMRI focuses on controlled substances (must be manufactured domestically with a lot or red tape, which limits foreign competition as well as new entrants), custom/complex chemistry, steroids/hormones (heavily regulated providing entry barriers) and peptides/proteins/biologics (often complex requiring specialized manufacturing).  These are not commoditized white powders.  AMRI focuses on smaller niche markets that do not interest bigger players, so the pricing environment is strong and the growth rates are superior.   Additionally, prior to the 2014 acquisitions, 11 customers generated 52% of sales.  Of those 11 customers, 3 are in DDS and 8 in API.  Of those 8 in API, 7 came from DDS.  This affirms (a) the synergies between DDS and API, (b) the stickiness (and price inelasticity) of customers and (c) the lack of competitiveness due to high industry barriers in AMRI’s niches.  Competitors think of AMRI as a “specialty” of CMO where TEVA, Dr. Reddys and Mylan are more mainstream white tablets.  Catalent is trying to be the specialty of the “fill finish” side of CMO (not yet API).   API costs are typically <10% of the price of a typically branded product with reliability playing a more important role than cost.  AMRI is currently ~90% weighted towards branded with generics becoming an increasing focus for the new CEO.  The estimated outsourced API market is $14 billion, growing 8% per year through 2016 (both #’s from Frost & Sullivan) and AMRI generates $156 million in sales (2014 company estimate) with a $700 million target for 2018 and a 30% EBITDA margin.

 

Drug Product is the final leg of the CMO business, which focuses on sterile drug fill/finish capabilities and other complex formulations.  The business is increasingly focused on growing in specialized delivery systems including inhalation (oral manufacturing) and patches.  The Oso Bio acquisition put meat on this leg, adding ~$60 million of standalone revenue (but closed mid-2014).  The quasi-closed Burlington facility is also part of this division, which should generate ~$16 million of sales in 2015 (from ~$7 million in 2013).  For 2014, this business will generate $42 million of sales (Company estimate) with a $200-300 million target for 2018 and 30% EBITDA margin.  Frost & Sullivan estimates the outsourced Drug Product market to be $15 billion with a 12% CAGR through 2016.  Catalent, the largest player in the space (with an arguably commoditized packaging services offering), estimates 6-10% annual growth for the advanced delivery technology market (from their S-1).  Similar to API, AMRI grows faster because they are more exposed to “growthier” niches (more discovery exposure than Catalent). 

 

The final business, which is rapidly becoming minor, but still profitable, is the Royalty business.  Like many companies in the Healthcare space, AMRI hit one homerun and the entrepreneur scientist CEO squandered most of the proceeds.  New CEO Bill Marth is actively reallocating the capital to areas of visible growth and high returns.  This business will generate $25 million of sales in 2014 with $15 million coming from Allegra (down from $35 million in 2011) and $9 million from Actavis.  Allegra went off-patent in 2012 with the agreement concluding in mid-2015.  The Actavis royalty will expire in November 2017 at which point the supply agreement could be renewed.  These royalty agreements may add additional profit on top of management’s targets, but they will not be core focuses of the new team.

 

Management Track Record

Before we discuss the track record, incentive and vision of new CEO Bill Marth, it is worth a quick analysis of his predecessor.  AMRI collected Allegra royalties of $270 million from 2004-2012 under former CEO Thomas D’Ambra.  He spent nearly $90 million in R&D, directly collected 10% of the royalties ($27 million) and the company generated cumulative losses of $68 million and generated a TSR of NEGATIVE 57% during this period.  Beyond low-return R&D spend, former management also attempted a complex build strategy, including its former Bothell and Hungary facilities, which were both closed in 2012 due to a lack of profitability.  Enter Bill Marth. 

 

Mr. Marth began on January 1, 2014.  He was previously head of Teva America where he grew the business from $400 million in sales in 1999 to $12 billion in 2012 while improving margins.  He oversaw and integrated more than 10 significant acquisitions, including Cephalon ($7.4bn) in 2011, BARR Laboratories in 2008 ($6.8bn) and Ivax ($8.5bn) in 2005.  All major deals were accretive in year 1.  The BARR synergy target was raised from $300 million to $400 million and Ivax from $200 million to $300 million.  After six conversations with former Teva employees, we are confident in Mr. Marth’s ability to set and meet/exceed targets, acquire businesses at reasonable prices, integrate them rapidly and drive both sales and cost synergies.  Multiple references admitted to buying AMRI stock following Mr. Marth’s appointment and all thought he was dramatically over-qualified to join such a small business.  Thus, the question is, why did Mr. Marth join AMRI?

 

We think money and autonomy are the most likely answers.  Mr. Marth currently owns 1% of the company with RSUs on another 0.33%. He will likely get another slug of options in 2015 beyond the 30-90% of salary.  We think there will likely be a more aggressive and clear LTIP plan beginning in 2015.  As of now, we think without major changes to the compensation plan, Mr. Marth will still be worth ~$40 million in stock if the company targets are met in 2018.  This is significantly more than any he could have earned in any role at Teva, excluding the CEO role.  Additionally, given his successful acquisitive track record on a much larger and complex scale, we believe that Mr. Marth chose this opportunity, because of his confidence in creating substantial value rapidly in his first CEO role.

 

Mr. Marth’s biggest accomplishment since joining AMRI in January 2014 has been transitioning the business away from its dependence on Allegra royalties, which accounted for 11% of revenues, 51% of EBITDA and 75% of EPS in 2013.  Through cost-cutting, organic CMO growth and two acquisitions (with most of the benefit accruing in 2015), 2014 EBITDA is set to grow 23% and EPS by 28% (Company guidance).  As a result, the Allegra patent cliff has already been more than bridged.

 

Market Dislocation

With just three sell-side analysts covering the stock (one bear from Sterne, Agee and Leach, one bull from Morgan Stanley and a new bull from JPM – as of yesterday), it is no surprise that the stock trades in-line with its peer group despite offering significantly more upside potential.  To give you a sense for the quality of coverage at Sterne, Agee and Leach on AMRI, the analyst’s 2015 earnings estimate went up from $0.48 in June 2013 (when he initiated) to $1.07 in July 2014 yet his target price remained unchanged (and yes, he also had correspondingly higher cash flow estimates).  The original source of the dislocation is among the most common in the healthcare space.  AMRI was receiving a royalty from Allegra sales that contributed >100% of EBITDA every year from 2009 through 2012.  It is understandable that the market would be skeptical (or ignorant of) a rapidly growing underlying CMO business.  The decline in Allegra temporarily masked the significant transformation that the business underwent partially in 2013 and then dramatically in the first half of 2014.  That being said, the comps have gotten easier and will continue to do so (from flat sales and -25% EBITDA growth yoy in Q1 2014 to +15% sales and +47% EBITDA yoy in Q2).  Next, both contract revenues and EBITDA were temporarily depressed due to FDA sanctions at AMRI’s Burlington, MA, in August 2010, which were lifted in November 2013.  This facility went from generating roughly $16mm in sales and ~$4mm in EBITDA pre-FDA sanctions to being forced to operate at just 30-35% of capacity, resulting in a $7 million sales run-rate and $5 million of annual losses in 2013.  In 2014, this facility should generate roughly $12 million of sales and break-even at the EBITDA level.  With no additional capex, we expect this facility to generate $16mm sales in 2015 and get back to $4mm of EBITDA ($9mm EBITDA swing from 2013 and roughly 8% incremental EBITDA in 2015 vs. 2014).  Lastly, as is typical in roll-up stories, no analyst forecasts significant growth from acquisitions.  This is the biggest, if not only reason, to buy this stock. 

 

The Acquisition Story (READ: Key Value Driver)

This is undoubtedly the most relevant pressure point requiring the greatest diligence.  Fortunately, there is some decent data available (much of which the Company and its peers have republished from third parties).  Underlying results by AMRI and its competitors largely substantiate the industry reports.  Through CapitalIQ, Bloomberg, PharmSource, Morgan Stanley’s initiation report and calls with several industry experts, it is pretty easy to gain conviction in the fragmentation of the industry.  Lastly, our VAR calls with competitors and reference checks on Bill Marth have enabled additional conviction in the feasibility of AMRI successfully employing its acquisition strategy (these notes are not for available for public consumption).   

 

Let’s start with the total addressable market for each vertical.  See page 11 in the following AMRI presentation:

http://www.amriglobal.com/img/uploads/file/Investor_Presentation_August_2014.pdf

 

If AMRI achieves the midpoint of its 2018 sales targets, they will garner <2% market share in DDS and Drug Product and 5% for API (from just over 1%).  None of these numbers appear outlandish.  The sources for the denominator appear credible and the numbers do not conflict with reports from Catalent and Patheon (PE owned peers – both with public filings/documents).

 

The next question is how much capital do they need to deploy to get there? With underlying organic revenue growth of ~12% per annum, we think they need to deploy roughly $1.4bn of capital between now and December 31, 2017 to achieve these targets.  We assume an 8.5x pre-synergy EBITDA multiple (weighted down by API acquisitions) with EBITDA margins starting at 20% and moving to 26% by year 3.  We get a bit under 500 basis points of EBITDA margin improvement from 2014 to 2018 (~19% to 24%).

 

So how will they finance this and do they have sufficient balance sheet capacity?  We think they can keep net debt/EBITDA at or below 4.0x throughout the period in question (see model).  The Company has said they are comfortable going to 4.5-5.0x net debt/EBITDA for the right deals.  If there is a large acquisition at the right price sooner than our forecast, we would not rule out a mix of stock and debt.

 

Is the universe big and fragmented enough to achieve this?  Are there other competitors employing the same strategy?  Will that result in higher acquisition prices and lower returns? 

 

From a Patheon company presentation republished in the Morgan Stanley initiation report:

CMO Est. 2013 Revenues Est. Market Share

Catalent $1,340 12%

Patheon $530 5%

Vetter $405 4%

Baxter $400 4%

Famar $368 3%

Aenova $294 3%

Fareva $294 3%

Haupt $265 2%

DPT $250 2%

Recipharm $219 2%

Nextpharma $213 2%

Hospira $200 2%

Asian CMOs $600 5%

AMRI $133 1%

Others $5,402 50%

Total $10,913 100%

 

While we believe that this reflects just a fraction of AMRI’s core business (Drug Product and large portions of DDS are largely absent from the chart above), it does provide a sense for the level of industry fragmentation. Most targets are private, generate $10-200 million in sales and there appear to be a few hundred of them (at least according to senior executives at Catalent, Patheon and PharmSource).  Catalent, recently IPO’d by Blackstone (and largely in slower growth verticals), stated in their S-1 that they “operate in highly fragmented markets in both our advanced delivery technologies and development solutions businesses. Within those markets, the five top players represent only 30% and 10% of the total market share, respectively, by revenue.”

 

There are a few public players that focus almost purely on DDS/CRO (Charles River Labs, WuXi Pharma, Evotec).  There are a few that focus on large-scale manufacturing (Lonza, Cambrex and Aceto) and there are a couple large clinical CROs that share adjacencies with AMRI (Quintiles and Covance – Mr. Marth aspires to replicate Quintiles transformation over time in AMRI’s niches).  Conversations with industry experts further validate the size and fragmentation of the industry.  From speaking with management, most deals are negotiated versus run through competitive auction.    Every competitor and customer that we asked expressed the view that the industry is plenty big and fragmented for multiple acquirers to pursue acquisitive strategies without impacting the other.

 

So what will they pay?  We think that on average they will pay around 8.5x pre-synergy EBITDA.  This multiple is weighed down by more acquisition dollars spent on API purchases (highest revenue target) and pulled up by the DDS business.  Public peers trade in this range and it is reasonable to assume a fairly significant discount for smaller private players.

 

Can they extract costs?  Thus far that appears to be the case.  Contract margins grew from 16% in Q2 2013 to 27% in Q2 2014, largely as a result of synergies from the Cedarburg acquisition.  This API acquisition closed at the end of Q1, was purchased for 8x EBITDA ($41mm and $5mm EBITDA) and should generate $1.5mm of synergies within 12 months (on a standalone sales base of ~$18mm and growing).  Pro forma for synergies, the deal price goes down to 6.3x and the EBITDA margin to 36%.  Oso Biopharma was at the other end of the spectrum.  This Drug Product business was purchased for $110mm on 7/1/14 for 11.5x EBITDA (8.8x post-synergies) and accretive year 1.  These synergy targets do not include revenue synergies from the additional spare capacity of the new assets.   Lastly, Catalent is probably the best public comp and we do expect slightly higher margins (24% vs. 20% for Catalent today) for AMRI over the medium-term, because they have more niche exposure (see above).

 

There are several risks inherent with owning AMRI even outside the obvious inherent acquisition risks.  First, non-compliant manufacturing facilities provide significant idiosyncratic tail-risk, especially given the concentration of the company’s operations.  Burlington went from a highly profitable facility to a major loss-maker.  An FDA problem at multiple plants or just the Rensselaer plant could significantly impair the value of the equity.  Additionally, the Aurangabad facility is currently underutilized and awaiting FDA approval with an inspection, which should take place by the end of 2014.  If approved, this site will be used for API manufacturing that will be sold into regulated markets (the US) at higher margins.

 

Location Square Feet Primary Purpose (from 10K)

Rensselaer, New York 276,000 Contract Manufacturing

Albany, New York 198,000 Contract Manufacturing, Contract Research and Administration

Aurangabad, India 208,000 Contract Manufacturing

Holywell, United Kingdom 68,000 Contract Manufacturing & Contract Research

East Greenbush, New York 64,000 Contract Research

Hyderabad, India 62,000 Contract Research

Burlington, Massachusetts 46,000 Contract Manufacturing

Singapore 37,000 Contract Research

Syracuse, New York 28,000 Contract Research

 

Pricing power could also be an issue.  GE Healthcare accounts for ~12% of contract revenue.  The next largest is also above 5%.  While there are undoubtedly some relationships where AMRI can push pricing, they also have major multi-national customers (Sanofi, Actavis, etc.) that can push back.  Realistically, we see this more as an opportunity than a threat.  As mentioned, we have just gone from a science-focused CEO to a commercially minded one.  While we don’t see a replication of Taro or Questcor past pricing trajectory, we do think Mr. Marth will probably generate an incremental 100-200bps of gross margin upside from pricing (mapping their limited DMFs reveals very limited competition at the end market level versus CMO peers).

 

Lastly, there is an outstanding convertible.  It can be settled in cash and is <10% dilutive if the stock doubles.  We assume this is debt for modeling purposes and will be rolled into bank debt in 2015.

 

Future M&A?

     

yes

       

Pre-Synergy Multiple

     

8.5x

       

EBITDA Margin at Purchase

   

20%

       

EBITDA Margin at Year 2

   

24%

       

EBITDA Margin at Year 3

   

26%

       

Acquired D&A as a % of EBITDA

   

5%

       

Cost of Debt

     

6.5%

       
                 

Cash capacity for acquisitions

 

 

 

 

 

 

 

($m)

     

2014E

2015E

2016E

2017E

2018E

                 

Capital Deployed for Acquisitions on Jan 1,

 

250

300

390

425

                 

Sales

     

304

512

728

1025

1350

Contract

     

279

313

344

375

405

Organic

       

12%

10%

9%

8%

Acquired from 2014

       

37

41

44

48

Avg Acquired 2015

       

147

162

177

191

Avg Acquired 2016

         

177

193

208

Avg Acquired 2017

           

230

248

Avg Acquired 2018

             

250

Royalty

     

25

15

5

8

0

                 

EBITDA

     

59

108

166

241

326

EBITDA Margin

     

19.4%

21.0%

22.8%

23.5%

24.2%

Base EBITDA

     

59

71

81

91

100

Organic

       

20%

15%

12%

10%

Acquired from 2014

       

7

11

12

12

Avg Acquired 2015

       

29

39

46

50

Avg Acquired 2016

         

35

46

54

Avg Acquired 2017

           

46

60

Avg Acquired 2018

             

50

                 

D&A

     

(17)

(21)

(27)

(38)

(54)

                 

EBIT

     

42

87

139

203

272

Margin

     

14%

17%

19%

20%

20%

                 

Interest

     

(2)

(16)

(31)

(51)

(73)

Pre-Tax Income

     

40

72

108

152

200

Taxes

     

(12)

(21)

(32)

(46)

(60)

Tax Rate

     

31%

30%

30%

30%

30%

Net Income

     

28

50

75

106

140

                 

D&A

     

17

21

27

38

54

Capex

     

(18)

(28)

(36)

(51)

(67)

Severance, Acquisition fees, etc.

 

(6)

(20)

(25)

(36)

(40)

Free Cash Flow

     

20

22

41

57

86

                 

Debt

     

125

353

613

946

1,286

Cash

     

30

30

30

30

30

                 

Net Debt/EBITDA

     

1.6x

3.0x

3.5x

3.8x

3.9x

                 

Share Count

     

32

33

34

35

36

                 

Fair Value at 20x P/E

 

 

 

$17.21

$30.11

$43.94

$60.33

$76.87

                 

P/E

     

23.5x

13.4x

9.2x

6.7x

5.3x

EV/EBITDA

     

12.7x

9.2x

7.7x

6.8x

6.1x

                 

($m)

     

2014E

2015E

2016E

2017E

2018E

SEGMENT TARGET CHECK - EBITDA SHOULD ROUGHLY MATCH ABOVE

     

DDS

     

80

187

198

250

325

API

     

156

250

400

575

775

Drug Product

     

42

75

130

200

250

Royalty

     

25

15

5

8

0

Total

     

304

512

728

1,025

1,350

Growth

       

68%

42%

41%

32%

                 

EBITDA

               

DDS

     

16

41

46

61

81

Margin

     

20%

22%

23%

24%

25%

API

     

46

74

120

173

233

Margin

     

29%

30%

30%

30%

30%

Drug Product

     

8

16

34

55

75

Margin

     

18%

22%

26%

27%

30%

Royalty

     

23

13

4

5

0

Margin

     

93%

85%

75%

65%

60%

Overhead

     

(35)

(39)

(44)

(53)

(60)

Total

     

58

105

160

240

329

Margin

     

18.9%

20.5%

22.0%

23.4%

24.4%

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

(1)    Continued strong earnings growth unmasking the value of the CMO/CRO business (quarterly)

(2)    At least one more acquisition by year-end (2014)

(3)    An inversion deal (will dive deeply into these seemingly murky waters upon announcement)

(4)    More eyeballs on the space from the sell-side coverage of Catalent (October)

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    Description

    If names like Valeant, Acatvis and Endo hadn’t proven so contentions in recent months, we would have labeled Albany Molecular (AMRI) “Valeant v3.0” (Endo being v2.0).  Instead, we will frame the investment case in a manner that contrasts favorably with that group.  AMRI is a US-based contract manufacturing (“CMO”) and research (“CRO”) organization whose customers range from big pharma to small biotech.  AMRI’s end markets (and company) grow double digits organically. If the new CEO successfully employs his roll-up strategy in a heavily fragmented market, AMRI trades at just 5x 2018 cash earnings on publicly disclosed targets.  We believe that the market fails to appreciate the investment opportunity because: (a) AMRI was generating most, and in several years more than 100%, of its earnings from royalties connected to the blockbuster drug Allegra, (b) these now declining royalties obscured the early and rapidly successful efforts to transform the company, (c) AMRI is small and covered by just 3 analysts (third picked up coverage yesterday) and (d) sales and earnings were temporarily, but materially depressed at AMRI’s important Burlington, MA facility due to FDA sanctions in August 2010, which were lifted in November 2013.  We will describe the business and its growth drivers, the new CEO’s surprisingly strong background (given that the company had a market cap of <$350 million when he joined), address the aforementioned market dislocations and lastly, dive into the stated acquisition strategy and why we believe it’s feasible. 

     

    Business Description

    In 2014, AMRI will generate ~$300 million and $60 in EBITDA from four key market areas that are moving to three: Discovery and Development (“DDS” - 26% of 2014E sales), API (51% of 2014E sales), Drug Product (14% of 2014E sales) and Royalty revenue (8% of 2014E sales and rapidly declining).  The over-arching theme is that from discovery to delivery, the pharmaceutical industry is increasingly moving towards outsourcing to lower costs, improve efficiency and mitigate regulatory/manufacturing induced tail risk.  Many pharma companies want to streamline their operations and their number of suppliers. AMRI offers them a full outsourcing toolkit focused for complex drugs.  From one large academic CRO: “Back when everything was in house, pharma companies would characterize materials, formulate it, test it on animals, go into the clinic, do it. Offshoring or outsourcing BIG chunks of all that, moving to working more with CMOs and CROs always, even back when [pharma companies] had their own organizations. Often you need specialized equipment hugely expensive, compliance with FDA is hard...so we’ve gone, since I started this up [2.5 years ago] from $30k in revenue to a quarter of a billion and I don’t see any slow-down.” 

     

    DDS serves as the outsourced R&D arm for dozens of pharma companies. AMRI is particularly suited to provide discovery and preclinical stage drug development to both large pharma and small biotech because the company has amassed a large library of cost-effective molecules, natural products and synthetic compounds to use for screening within FDA cleared manufacturing facilities. Their particularly strong development franchise and large scale manufacturing capabilities enable faster than industry growth as the Company has a semi-captive source of clients for commercial production.  From speaking with several customers and competitors, most clients like to stay with a single CMO for as long as possible with horrific service serving as the relationship killer as opposed to price.  The newly found cost and return focus of pharma have led to increasing DD&S outsourcing and Kalorama/McKinsey expect 9-15% industry growth for this $13 billion market (outsourced DD&S) over the next several years.    AMRI currently generates $80 million (2014 company estimate) with a $200-300 million target for 2018 and a 25% EBITDA margin.

     

    API, or active pharmaceutical ingredient, is exactly that: outsourced manufacturing of the key ingredients of the $825 billion global pharma market.  There is a significant trend towards outsourcing as branded companies move toward their core competencies (sales and marketing) and generic companies struggle with the complex manufacturing of certain formulations.  AMRI focuses on controlled substances (must be manufactured domestically with a lot or red tape, which limits foreign competition as well as new entrants), custom/complex chemistry, steroids/hormones (heavily regulated providing entry barriers) and peptides/proteins/biologics (often complex requiring specialized manufacturing).  These are not commoditized white powders.  AMRI focuses on smaller niche markets that do not interest bigger players, so the pricing environment is strong and the growth rates are superior.   Additionally, prior to the 2014 acquisitions, 11 customers generated 52% of sales.  Of those 11 customers, 3 are in DDS and 8 in API.  Of those 8 in API, 7 came from DDS.  This affirms (a) the synergies between DDS and API, (b) the stickiness (and price inelasticity) of customers and (c) the lack of competitiveness due to high industry barriers in AMRI’s niches.  Competitors think of AMRI as a “specialty” of CMO where TEVA, Dr. Reddys and Mylan are more mainstream white tablets.  Catalent is trying to be the specialty of the “fill finish” side of CMO (not yet API).   API costs are typically <10% of the price of a typically branded product with reliability playing a more important role than cost.  AMRI is currently ~90% weighted towards branded with generics becoming an increasing focus for the new CEO.  The estimated outsourced API market is $14 billion, growing 8% per year through 2016 (both #’s from Frost & Sullivan) and AMRI generates $156 million in sales (2014 company estimate) with a $700 million target for 2018 and a 30% EBITDA margin.

     

    Drug Product is the final leg of the CMO business, which focuses on sterile drug fill/finish capabilities and other complex formulations.  The business is increasingly focused on growing in specialized delivery systems including inhalation (oral manufacturing) and patches.  The Oso Bio acquisition put meat on this leg, adding ~$60 million of standalone revenue (but closed mid-2014).  The quasi-closed Burlington facility is also part of this division, which should generate ~$16 million of sales in 2015 (from ~$7 million in 2013).  For 2014, this business will generate $42 million of sales (Company estimate) with a $200-300 million target for 2018 and 30% EBITDA margin.  Frost & Sullivan estimates the outsourced Drug Product market to be $15 billion with a 12% CAGR through 2016.  Catalent, the largest player in the space (with an arguably commoditized packaging services offering), estimates 6-10% annual growth for the advanced delivery technology market (from their S-1).  Similar to API, AMRI grows faster because they are more exposed to “growthier” niches (more discovery exposure than Catalent). 

     

    The final business, which is rapidly becoming minor, but still profitable, is the Royalty business.  Like many companies in the Healthcare space, AMRI hit one homerun and the entrepreneur scientist CEO squandered most of the proceeds.  New CEO Bill Marth is actively reallocating the capital to areas of visible growth and high returns.  This business will generate $25 million of sales in 2014 with $15 million coming from Allegra (down from $35 million in 2011) and $9 million from Actavis.  Allegra went off-patent in 2012 with the agreement concluding in mid-2015.  The Actavis royalty will expire in November 2017 at which point the supply agreement could be renewed.  These royalty agreements may add additional profit on top of management’s targets, but they will not be core focuses of the new team.

     

    Management Track Record

    Before we discuss the track record, incentive and vision of new CEO Bill Marth, it is worth a quick analysis of his predecessor.  AMRI collected Allegra royalties of $270 million from 2004-2012 under former CEO Thomas D’Ambra.  He spent nearly $90 million in R&D, directly collected 10% of the royalties ($27 million) and the company generated cumulative losses of $68 million and generated a TSR of NEGATIVE 57% during this period.  Beyond low-return R&D spend, former management also attempted a complex build strategy, including its former Bothell and Hungary facilities, which were both closed in 2012 due to a lack of profitability.  Enter Bill Marth. 

     

    Mr. Marth began on January 1, 2014.  He was previously head of Teva America where he grew the business from $400 million in sales in 1999 to $12 billion in 2012 while improving margins.  He oversaw and integrated more than 10 significant acquisitions, including Cephalon ($7.4bn) in 2011, BARR Laboratories in 2008 ($6.8bn) and Ivax ($8.5bn) in 2005.  All major deals were accretive in year 1.  The BARR synergy target was raised from $300 million to $400 million and Ivax from $200 million to $300 million.  After six conversations with former Teva employees, we are confident in Mr. Marth’s ability to set and meet/exceed targets, acquire businesses at reasonable prices, integrate them rapidly and drive both sales and cost synergies.  Multiple references admitted to buying AMRI stock following Mr. Marth’s appointment and all thought he was dramatically over-qualified to join such a small business.  Thus, the question is, why did Mr. Marth join AMRI?

     

    We think money and autonomy are the most likely answers.  Mr. Marth currently owns 1% of the company with RSUs on another 0.33%. He will likely get another slug of options in 2015 beyond the 30-90% of salary.  We think there will likely be a more aggressive and clear LTIP plan beginning in 2015.  As of now, we think without major changes to the compensation plan, Mr. Marth will still be worth ~$40 million in stock if the company targets are met in 2018.  This is significantly more than any he could have earned in any role at Teva, excluding the CEO role.  Additionally, given his successful acquisitive track record on a much larger and complex scale, we believe that Mr. Marth chose this opportunity, because of his confidence in creating substantial value rapidly in his first CEO role.

     

    Mr. Marth’s biggest accomplishment since joining AMRI in January 2014 has been transitioning the business away from its dependence on Allegra royalties, which accounted for 11% of revenues, 51% of EBITDA and 75% of EPS in 2013.  Through cost-cutting, organic CMO growth and two acquisitions (with most of the benefit accruing in 2015), 2014 EBITDA is set to grow 23% and EPS by 28% (Company guidance).  As a result, the Allegra patent cliff has already been more than bridged.

     

    Market Dislocation

    With just three sell-side analysts covering the stock (one bear from Sterne, Agee and Leach, one bull from Morgan Stanley and a new bull from JPM – as of yesterday), it is no surprise that the stock trades in-line with its peer group despite offering significantly more upside potential.  To give you a sense for the quality of coverage at Sterne, Agee and Leach on AMRI, the analyst’s 2015 earnings estimate went up from $0.48 in June 2013 (when he initiated) to $1.07 in July 2014 yet his target price remained unchanged (and yes, he also had correspondingly higher cash flow estimates).  The original source of the dislocation is among the most common in the healthcare space.  AMRI was receiving a royalty from Allegra sales that contributed >100% of EBITDA every year from 2009 through 2012.  It is understandable that the market would be skeptical (or ignorant of) a rapidly growing underlying CMO business.  The decline in Allegra temporarily masked the significant transformation that the business underwent partially in 2013 and then dramatically in the first half of 2014.  That being said, the comps have gotten easier and will continue to do so (from flat sales and -25% EBITDA growth yoy in Q1 2014 to +15% sales and +47% EBITDA yoy in Q2).  Next, both contract revenues and EBITDA were temporarily depressed due to FDA sanctions at AMRI’s Burlington, MA, in August 2010, which were lifted in November 2013.  This facility went from generating roughly $16mm in sales and ~$4mm in EBITDA pre-FDA sanctions to being forced to operate at just 30-35% of capacity, resulting in a $7 million sales run-rate and $5 million of annual losses in 2013.  In 2014, this facility should generate roughly $12 million of sales and break-even at the EBITDA level.  With no additional capex, we expect this facility to generate $16mm sales in 2015 and get back to $4mm of EBITDA ($9mm EBITDA swing from 2013 and roughly 8% incremental EBITDA in 2015 vs. 2014).  Lastly, as is typical in roll-up stories, no analyst forecasts significant growth from acquisitions.  This is the biggest, if not only reason, to buy this stock. 

     

    The Acquisition Story (READ: Key Value Driver)

    This is undoubtedly the most relevant pressure point requiring the greatest diligence.  Fortunately, there is some decent data available (much of which the Company and its peers have republished from third parties).  Underlying results by AMRI and its competitors largely substantiate the industry reports.  Through CapitalIQ, Bloomberg, PharmSource, Morgan Stanley’s initiation report and calls with several industry experts, it is pretty easy to gain conviction in the fragmentation of the industry.  Lastly, our VAR calls with competitors and reference checks on Bill Marth have enabled additional conviction in the feasibility of AMRI successfully employing its acquisition strategy (these notes are not for available for public consumption).   

     

    Let’s start with the total addressable market for each vertical.  See page 11 in the following AMRI presentation:

    http://www.amriglobal.com/img/uploads/file/Investor_Presentation_August_2014.pdf

     

    If AMRI achieves the midpoint of its 2018 sales targets, they will garner <2% market share in DDS and Drug Product and 5% for API (from just over 1%).  None of these numbers appear outlandish.  The sources for the denominator appear credible and the numbers do not conflict with reports from Catalent and Patheon (PE owned peers – both with public filings/documents).

     

    The next question is how much capital do they need to deploy to get there? With underlying organic revenue growth of ~12% per annum, we think they need to deploy roughly $1.4bn of capital between now and December 31, 2017 to achieve these targets.  We assume an 8.5x pre-synergy EBITDA multiple (weighted down by API acquisitions) with EBITDA margins starting at 20% and moving to 26% by year 3.  We get a bit under 500 basis points of EBITDA margin improvement from 2014 to 2018 (~19% to 24%).

     

    So how will they finance this and do they have sufficient balance sheet capacity?  We think they can keep net debt/EBITDA at or below 4.0x throughout the period in question (see model).  The Company has said they are comfortable going to 4.5-5.0x net debt/EBITDA for the right deals.  If there is a large acquisition at the right price sooner than our forecast, we would not rule out a mix of stock and debt.

     

    Is the universe big and fragmented enough to achieve this?  Are there other competitors employing the same strategy?  Will that result in higher acquisition prices and lower returns? 

     

    From a Patheon company presentation republished in the Morgan Stanley initiation report:

    CMO Est. 2013 Revenues Est. Market Share

    Catalent $1,340 12%

    Patheon $530 5%

    Vetter $405 4%

    Baxter $400 4%

    Famar $368 3%

    Aenova $294 3%

    Fareva $294 3%

    Haupt $265 2%

    DPT $250 2%

    Recipharm $219 2%

    Nextpharma $213 2%

    Hospira $200 2%

    Asian CMOs $600 5%

    AMRI $133 1%

    Others $5,402 50%

    Total $10,913 100%

     

    While we believe that this reflects just a fraction of AMRI’s core business (Drug Product and large portions of DDS are largely absent from the chart above), it does provide a sense for the level of industry fragmentation. Most targets are private, generate $10-200 million in sales and there appear to be a few hundred of them (at least according to senior executives at Catalent, Patheon and PharmSource).  Catalent, recently IPO’d by Blackstone (and largely in slower growth verticals), stated in their S-1 that they “operate in highly fragmented markets in both our advanced delivery technologies and development solutions businesses. Within those markets, the five top players represent only 30% and 10% of the total market share, respectively, by revenue.”

     

    There are a few public players that focus almost purely on DDS/CRO (Charles River Labs, WuXi Pharma, Evotec).  There are a few that focus on large-scale manufacturing (Lonza, Cambrex and Aceto) and there are a couple large clinical CROs that share adjacencies with AMRI (Quintiles and Covance – Mr. Marth aspires to replicate Quintiles transformation over time in AMRI’s niches).  Conversations with industry experts further validate the size and fragmentation of the industry.  From speaking with management, most deals are negotiated versus run through competitive auction.    Every competitor and customer that we asked expressed the view that the industry is plenty big and fragmented for multiple acquirers to pursue acquisitive strategies without impacting the other.

     

    So what will they pay?  We think that on average they will pay around 8.5x pre-synergy EBITDA.  This multiple is weighed down by more acquisition dollars spent on API purchases (highest revenue target) and pulled up by the DDS business.  Public peers trade in this range and it is reasonable to assume a fairly significant discount for smaller private players.

     

    Can they extract costs?  Thus far that appears to be the case.  Contract margins grew from 16% in Q2 2013 to 27% in Q2 2014, largely as a result of synergies from the Cedarburg acquisition.  This API acquisition closed at the end of Q1, was purchased for 8x EBITDA ($41mm and $5mm EBITDA) and should generate $1.5mm of synergies within 12 months (on a standalone sales base of ~$18mm and growing).  Pro forma for synergies, the deal price goes down to 6.3x and the EBITDA margin to 36%.  Oso Biopharma was at the other end of the spectrum.  This Drug Product business was purchased for $110mm on 7/1/14 for 11.5x EBITDA (8.8x post-synergies) and accretive year 1.  These synergy targets do not include revenue synergies from the additional spare capacity of the new assets.   Lastly, Catalent is probably the best public comp and we do expect slightly higher margins (24% vs. 20% for Catalent today) for AMRI over the medium-term, because they have more niche exposure (see above).

     

    There are several risks inherent with owning AMRI even outside the obvious inherent acquisition risks.  First, non-compliant manufacturing facilities provide significant idiosyncratic tail-risk, especially given the concentration of the company’s operations.  Burlington went from a highly profitable facility to a major loss-maker.  An FDA problem at multiple plants or just the Rensselaer plant could significantly impair the value of the equity.  Additionally, the Aurangabad facility is currently underutilized and awaiting FDA approval with an inspection, which should take place by the end of 2014.  If approved, this site will be used for API manufacturing that will be sold into regulated markets (the US) at higher margins.

     

    Location Square Feet Primary Purpose (from 10K)

    Rensselaer, New York 276,000 Contract Manufacturing

    Albany, New York 198,000 Contract Manufacturing, Contract Research and Administration

    Aurangabad, India 208,000 Contract Manufacturing

    Holywell, United Kingdom 68,000 Contract Manufacturing & Contract Research

    East Greenbush, New York 64,000 Contract Research

    Hyderabad, India 62,000 Contract Research

    Burlington, Massachusetts 46,000 Contract Manufacturing

    Singapore 37,000 Contract Research

    Syracuse, New York 28,000 Contract Research

     

    Pricing power could also be an issue.  GE Healthcare accounts for ~12% of contract revenue.  The next largest is also above 5%.  While there are undoubtedly some relationships where AMRI can push pricing, they also have major multi-national customers (Sanofi, Actavis, etc.) that can push back.  Realistically, we see this more as an opportunity than a threat.  As mentioned, we have just gone from a science-focused CEO to a commercially minded one.  While we don’t see a replication of Taro or Questcor past pricing trajectory, we do think Mr. Marth will probably generate an incremental 100-200bps of gross margin upside from pricing (mapping their limited DMFs reveals very limited competition at the end market level versus CMO peers).

     

    Lastly, there is an outstanding convertible.  It can be settled in cash and is <10% dilutive if the stock doubles.  We assume this is debt for modeling purposes and will be rolled into bank debt in 2015.

     

    Future M&A?

         

    yes

           

    Pre-Synergy Multiple

         

    8.5x

           

    EBITDA Margin at Purchase

       

    20%

           

    EBITDA Margin at Year 2

       

    24%

           

    EBITDA Margin at Year 3

       

    26%

           

    Acquired D&A as a % of EBITDA

       

    5%

           

    Cost of Debt

         

    6.5%

           
                     

    Cash capacity for acquisitions

     

     

     

     

     

     

     

    ($m)

         

    2014E

    2015E

    2016E

    2017E

    2018E

                     

    Capital Deployed for Acquisitions on Jan 1,

     

    250

    300

    390

    425

                     

    Sales

         

    304

    512

    728

    1025

    1350

    Contract

         

    279

    313

    344

    375

    405

    Organic

           

    12%

    10%

    9%

    8%

    Acquired from 2014

           

    37

    41

    44

    48

    Avg Acquired 2015

           

    147

    162

    177

    191

    Avg Acquired 2016

             

    177

    193

    208

    Avg Acquired 2017

               

    230

    248

    Avg Acquired 2018

                 

    250

    Royalty

         

    25

    15

    5

    8

    0

                     

    EBITDA

         

    59

    108

    166

    241

    326

    EBITDA Margin

         

    19.4%

    21.0%

    22.8%

    23.5%

    24.2%

    Base EBITDA

         

    59

    71

    81

    91

    100

    Organic

           

    20%

    15%

    12%

    10%

    Acquired from 2014

           

    7

    11

    12

    12

    Avg Acquired 2015

           

    29

    39

    46

    50

    Avg Acquired 2016

             

    35

    46

    54

    Avg Acquired 2017

               

    46

    60

    Avg Acquired 2018

                 

    50

                     

    D&A

         

    (17)

    (21)

    (27)

    (38)

    (54)

                     

    EBIT

         

    42

    87

    139

    203

    272

    Margin

         

    14%

    17%

    19%

    20%

    20%

                     

    Interest

         

    (2)

    (16)

    (31)

    (51)

    (73)

    Pre-Tax Income

         

    40

    72

    108

    152

    200

    Taxes

         

    (12)

    (21)

    (32)

    (46)

    (60)

    Tax Rate

         

    31%

    30%

    30%

    30%

    30%

    Net Income

         

    28

    50

    75

    106

    140

                     

    D&A

         

    17

    21

    27

    38

    54

    Capex

         

    (18)

    (28)

    (36)

    (51)

    (67)

    Severance, Acquisition fees, etc.

     

    (6)

    (20)

    (25)

    (36)

    (40)

    Free Cash Flow

         

    20

    22

    41

    57

    86

                     

    Debt

         

    125

    353

    613

    946

    1,286

    Cash

         

    30

    30

    30

    30

    30

                     

    Net Debt/EBITDA

         

    1.6x

    3.0x

    3.5x

    3.8x

    3.9x

                     

    Share Count

         

    32

    33

    34

    35

    36

                     

    Fair Value at 20x P/E

     

     

     

    $17.21

    $30.11

    $43.94

    $60.33

    $76.87

                     

    P/E

         

    23.5x

    13.4x

    9.2x

    6.7x

    5.3x

    EV/EBITDA

         

    12.7x

    9.2x

    7.7x

    6.8x

    6.1x

                     

    ($m)

         

    2014E

    2015E

    2016E

    2017E

    2018E

    SEGMENT TARGET CHECK - EBITDA SHOULD ROUGHLY MATCH ABOVE

         

    DDS

         

    80

    187

    198

    250

    325

    API

         

    156

    250

    400

    575

    775

    Drug Product

         

    42

    75

    130

    200

    250

    Royalty

         

    25

    15

    5

    8

    0

    Total

         

    304

    512

    728

    1,025

    1,350

    Growth

           

    68%

    42%

    41%

    32%

                     

    EBITDA

                   

    DDS

         

    16

    41

    46

    61

    81

    Margin

         

    20%

    22%

    23%

    24%

    25%

    API

         

    46

    74

    120

    173

    233

    Margin

         

    29%

    30%

    30%

    30%

    30%

    Drug Product

         

    8

    16

    34

    55

    75

    Margin

         

    18%

    22%

    26%

    27%

    30%

    Royalty

         

    23

    13

    4

    5

    0

    Margin

         

    93%

    85%

    75%

    65%

    60%

    Overhead

         

    (35)

    (39)

    (44)

    (53)

    (60)

    Total

         

    58

    105

    160

    240

    329

    Margin

         

    18.9%

    20.5%

    22.0%

    23.4%

    24.4%

     

     

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    (1)    Continued strong earnings growth unmasking the value of the CMO/CRO business (quarterly)

    (2)    At least one more acquisition by year-end (2014)

    (3)    An inversion deal (will dive deeply into these seemingly murky waters upon announcement)

    (4)    More eyeballs on the space from the sell-side coverage of Catalent (October)

    Messages


    SubjectRe: Update
    Entry09/01/2016 11:21 AM
    MemberHTC2012

    Unfortunately it looks like I can’t add the charts to my response that I wanted to include. I've described the charts in red text below

    High level view:

    Today, we think AMRI trades with the multiple of a forgotten/collapsing business, despite years of strong organic growth and massive margin improvement, both of which we see continuing into the future. The current multiple is a reflection of a single tough quarter 2 years ago, and the vicious cycle of having a small market cap. Recently, they have closed a transformative, double-digit accretion deal and are on the cusp of seeing high payouts from a free call option in future new royalty streams (an angle no one yet grasps). We are very excited about this one and think the stock is worth in the low to mid $30s over ~18 months, which applies a 15x PE or 9.5x EV/EBITDA to our 2018 estimates, well-below peers, historical trading levels and what a business with this growth profile deserves.

     

    1)      What we’ve seen and learned since our initial post

    a.       Observation and Lesson 1: 3Q’14 earnings was painful but a) truly non-recurring and b) a lesson that this business would greatly benefit from scale to reduce lumpiness and dependency on specific facilities.

    Issue was driven by 1) weather-driven facility disruption ($7mn revenue impact in quarter), 2) a government order didn’t come through as expected ($3.5mn revenue impact in quarter but at 60-70% gross margins), 3) one customer didn’t get quota for an order ($5mn revenue).

    Our view of 3Q’14, which still appears to be an overhang today

                                                                   i.      Our VAR calls with former employees have indicated that the facility disruption was not an issue of quality control. Was truly an ‘act of God’. A lightning bolt struck the facility and caused a door to not properly seal and thus the contents of the room to be compromised.

                                                                 ii.      A couple separate calls with former employees also indicated that the communication of the issue by management to shareholders was handled appropriately and with high integrity. By the time the extent of the issue was discovered, it was within a few days of the quarter close, so management opted to spend the time to truly understand the effects on the business in the coming quarters and provide appropriate guidance.

                                                                iii.      Guidance methodology has been altered – no longer guiding to government revenues (all upside) and no longer including any quota-based revenues (all upside)

                                                               iv.      On the other side of the coin, we think 3Q’14 showed that this business really needs to scale and reduce its dependency on single facilities. The Euticals acquisition is a major help with this (more on this later)

    b.      Observation and Lesson 2: Organic Growth has been strong on average (but lumpy on a quarterly basis) and leading indicators show this will continue to materialize. We have seen lumpiness coming down and expect that trend to continue 

    [Chart 1: contract revenue organic growth: 10.6% in 2013, 6.6% in 2014, 7.5% in 2015, expect 4.3% in 2016 primarily because of transitory effects of shutting Holywell facility and moving products elsewhere]

    Even including this effect of a negative 8% organic growth quarter in 3Q’14, contract organic growth has sustained at 6% on average for the whole business over last 10 quarters – but we’ve learned that lumpiness is real. What we’re seeing in terms of leading indicators for the business (IND applications, pre-clinical volumes from companies like CRL, biologics manufacturing rates, FDA approval rates and continued penetration of generics as a % of prescription volumes) is resoundingly positive.

    Our view of organic growth

                                                                   i.      Drug Discovery Segment is turning the corner finally, which improves our view of a worst-case organic growth – led by the Buffalo project, the uptake of the library consortium and the acquisitions of Whitehouse and SSCI which are higher organic growth businesses. Two separate VAR calls with former leaders of this segment indicate that the outlook is very strong and that the library consortium has potential to generate meaningful revenues for the segment.

    [Chart 2: DDS Trailing 12 month organic growth. After falling negative for last 8 quarters, TTM growth is now turning positive – just over flat in Q1’16 and +5.5% in Q2’16]

                                                                 ii.      API organically grew 7-8% in 2014 and 2015, consistent with the long-term view. 1H’16 has been negatively affected by the closure of the Holywell facility (products take time to transfer to other facilities, especially when they need to be re-certified by new authorities, as in the case of a product being transferred to the Hyderabad facility in India). Excluding this one-time effect (which should result in the countering boost in a couple quarters), organic growth has sustained HSD growth. Q2 had a negative effect of $5mn in the quarter from this transition, which was a -10% drag. As these products are relaunched in other facilities, growth should re-accelerate meaningfully, and we expect most/all to return by year end. The fourth quarter could be a massive quarter for this segment.

                                                                iii.      Drug Product, while a smaller contributor at 15% of gross profit, continues to grow at a rapid clip – roughly 50% organic CAGR since 2013.

    c.       Observation 3: Margin improvement undeniably strong

                                                                   i.      Contract gross margins have expanded about 1,000 bps as facilities have been closed, utilization has improved

                                                                 ii.      SG&A efficiencies being realized.  

    2)      Euticals – what this acquisition does

    a.       Doubles API business overnight. Why does this matter? 1) Scale matters to customers to legitimize the supplier and provide comfort with consistency of supply. 2) reduces lumpiness of the business which should help the multiple and reduce investor skittishness.

    b.      Synergies - $13-15mn synergies excluding capex avoidance. Will drive Euticals overall EBITDA margin to AMRI average of 20%

    c.       Cash Flow – deal comes with real capex avoidance. AMRI spent $25mn on CapEx (11% of 1H’16 contract revenues) in the first half of the year and will spend under $40mn next year (5% of 2017 contract revenues). Cash flow has been relatively subdued the last few years but we see this changing materially beginning next year, helping the business delever towards mid 3s by year-end 2017.

    3)      Near term earnings and what is priced in?

    a.       Believe guidance has set a low bar for earnings for the rest of the year. 3Q will be light, as well telegraphed by management (20% of 2H’16 earnings). This is because a couple of European facilities (Euticals + Gadea) are shut down in August for maintenance work.

    b.      “Consensus” is a mess and can’t be relied upon.

                                                                   i.      Morgan Stanley hasn’t updated for the Euticals deal which closed almost 2 months ago, except to include interest expense on new debt.

                                                                 ii.      Only one other legitimate analyst covers the stock – JPM

                                                                iii.      In general, this is the last item on the priority list for any sell-side analyst, if you consider the market cap and trading revenues relative to the rest of their long coverage lists

    c.       Multiple reflects a forgotten business with $600mn market cap. What multiple is fair for this business?  Historically (last 3 yr average) the business has traded in the high teens on NTM PE, which is fair for a business that grows revenues organically MSD-HSD, provided that return on capital is double digits. However, return on capital has been poor historically in the low single digits, suggesting the business was likely trading too high historically. We think ROIC will improve meaningfully as a) incremental margins are high right now as capacity is being better utilized with every new $ of revenue, b) incremental CapEx to sustain growth is coming down given CapEx avoidance from Euticals, c) ROIC on new royalties is very high (more below on this). I would argue that the growth profile and future expected ROIC would suggest an above-market multiple, but the size and lumpiness of growth cannot be ignored. Given this, AMRI likely deserves a slight discount to the market multiple – especially when you risk-adjust for things that can go wrong. Peers trade in the high teens but have more scale, less leverage and more stability. As we move towards end of 2017, leverage and scale (by revenues) will be roughly at the average of the peer group. Lumpiness has been fading and will continue to do so. The trough NTM PE multiple for the business has been 15x historically (right after Oso issue), but right now is trading for 13x consensus NTM, which I believe is a reflection of a forgotten business which is too small for anyone to own and somehow still has credibility questions overhanging from one quarter 2 years ago. As market cap grows with earnings, and as credibility returns, the valuation multiple will improve. Our PE multiple of 15x on 2018 estimates implies about 9.5x EV/EBITDA assuming no credit for deleveraging.

    4)      Royalties à Key New Angle

    a.       Over the last 2 years, AMRI made increasing investments into R&D – consensus has been correctly modeling this increased spend, but not the return on the investments. With these investments AMRI has engaged in 21 generic development programs, and developed what is now 12+ separate agreements for 12+ separate generic molecules in development. The agreements are signed and executed documents and provide AMRI with:

                                                                   i.      Co-development fees

                                                                 ii.      Full API supply agreements once launched

                                                                iii.      Royalties on future product sales

    b.      How big is the opportunity? Management believes that the royalties should generate $200mn in cumulative revenue through 2020. The royalties are 100% margin (the R&D has been largely spent), so this could equate to $200mn in cumulative incremental EBITDA from 2017-2020 (note that “current” EBITDA base pro forma for Euticals is only $150mn). Some of the generic opportunities are first to files, meaning the revenue/royalty durability is weaker but the upfront cash flow is significantly higher. Some are products in competitive areas, some are into areas with minimal competition. Management expects the royalties to continue post 2020. We conducted significant diligence to determine the likely royalty opportunities, in order to quantify the likelihood, timing and magnitude of royalty opportunities. This includes:

                                                                   i.      Scanning a database of 30,000+ DMFs for anything filed out of an AMRI facility

                                                                 ii.      Understanding the potential competitive changes within any of the end markets for these molecules –in order to find possible development partners

                                                                iii.      Reading public filings and transcripts of any potential possible development partners, as well as monitoring updates from the FDA on ANDA approvals

                                                               iv.      Conducting VAR calls with various industry people to determine market sizing and differentiation of key opportunities

                                                                 v.      Speaking with financial professionals who have been involved in structuring historical pharma royalty development agreements –to verify a range of royalty rate possibilities

    c.       The FDA website shows 6 DMFs filed by AMRI or related affiliates in the last two years, although we know the FDA website does not disclose every drug file.

    [Chart 3: DMFs on FDA site are: dronabinol in ethanol, benztropine mseylate, atenolol, norepinephrine bitartrate, epinephrine, atropine sulfate] 

    Additionally, Eagle Pharmaceuticals (EGRX) is an announced development partner (not included in the DMFs above), which likely accounts for 3 of the 12+ opportunities

                                                                   i.      A branded orphan drug using the API dantrolenesodium

                                                                 ii.      A generic blood thinner

                                                                iii.      Generic pemetrexedfor lung cancer

    Eagle’s opportunities remain in development and should file by late 2016 or early 2017

    d.      You will notice one of these is an opportunity for generic Epinephrine. We believe the most likely partners for this are Adamis Pharmaceuticals (ADMP) or TEVA. The uptake from this opportunity could be greater than originally expected

    e.      There is a decent chance that we see royalties this year from the dronabinol opportunity. Insys just received approval for Syndros (http://investors.insysrx.com/phoenix.zhtml?c=115949&p=irol-newsArticle&ID=2181815), which is a sublingual THC-based spray approved to a) counter the effects of chemotherapy and b) prevent weight loss from AIDS. AMRI’s DMF filing appears to be the only one to contain ethanol, which is a key part of the delivery mechanism for Syndros. This could add, in itself, 5-10% to earnings next year (just free upside).

    f.        We are not yet willing to underwrite $200mn in royalty revenues until we observe the royalties coming through and gain comfort on specific opportunities. Currently we underwrite $5-10mn in 2017 and $15-20mn in 2018 (would imply <$100mn in cumulative royalty revenues versus management’s estimate of $200mn). Consensus, as well as the market, underwrites $0, yet they include ongoing R&D investment. The variant perception here can be stated simply that “we disagree that the return on R&D spend will be -100%”

     

    Besides all of this, we note that Marth is buying AMRI shares aggressively as he obtains the necessary capital by liquidating his Teva position from his years there. He purchased 30,000 shares in the open market on November 10th at $17.01 (~$500,000 total purchase), and bought another 12,500 shares in the open market on May 16th at $12.86 (~$160,000 total purchase).

     

     

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