Embrex EMBX W
April 27, 2004 - 6:34pm EST by
round291
2004 2005
Price: 12.08 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 99 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

OVERVIEW
Embrex (EMBX) is in the business of providing the worldwide poultry industry with productivity improving mechanical and biotechnological solutions that reduce mortality and ultimately support increased bird weight. The Company offers a method of introducing vaccines “in ovo”, or directly into the unhatched egg. In an increasingly vertically integrated and process driven industry, the benefit of this form of administering medicines over doing so through feed or water systems include: 1) precise dosing 2) less waste 3) process consistency, and 4) less environmental impact.

Embrex estimates that its Inovoject system inoculates in excess of 80% of the nine billion broiler chickens produced in the US and Canada. Approximately 70% of the world broiler production, however, takes place outside of these key markets. The company currently generates only 32% of its revenue outside of its key markets but has Inovoject systems operating under contract or trial in 35 countries. Furthermore, there is every reason to believe that the broiler chicken industry in developing Europe, Latin America and Asia will follow a similar development path (integrated mass production) as has been pioneered in the US to great effect. This bodes well for EMBX as its systems reduce variability at a very early and critical stage of the production process.

During 2003 EMBX generated $46.0mm in total revenues, $9.9mm in EBITDA, and $7.6mm in net income. Trading at $12.08, there are approximately 8.15 mm shares outstanding for an equity market capitalization of $98.15mm. The 12/03 balance sheet showed $10mm in cash and marketable securities and debt of $1.2mm.

The stock trades, on a TTM basis, at an EV/EBITDA multiple of 9x and a P/E of 12.9x.

INVESTMENT THESIS
Embrex is a unique business that currently faces limited direct competition. It’s has near-term opportunities to 1) grow device placements internationally 2) upgrade existing placements in North America 3) grow revenue per installed device as a result increased throughput and consumer demand, and 4) introduce a range of vaccines developed using its antibody-antigen complex (AAC) technology. These opportunities are available to be layered upon a solid and consistently profitable recurring revenue stream and will help over time to associate the company in the mind of investors with other high multiple biotechnology companies.

Although I do not have a specific price target for EMBX, I would not be surprised should the shares double within the next 24 months, driven be earnings growth and multiple expansion.

INDUSTRY OVERVIEW
In order to get a handle on the changes that have taken place over the last few decades in the way chicken meat is farmed, the following table is useful:

U.S. BROILER CHICKEN PERFORMANCE

Days to Mkt Feed/
Year Mkt Weight Weight Mortality (%)
1925 112 2.50 4.70 18
1935 98 2.86 4.40 14
1945 84 3.03 4.00 10
1955 70 3.07 3.00 7
1965 63 3.48 2.40 6
1975 56 3.76 2.10 5
1985 49 4.19 2.00 5
1995 47 4.67 1.95 5
2000 46 5.02 1.95 5
Source: National Chicken Council

This table shows that it takes far fewer days, a lot less feed, and fewer hatches to prepare a substantially plumper chicken for market than it did some years ago. In addition, the quality of the meat has improved dramatically even as prices have remained flat or declined (in 1948, the live weight price of broilers was 36 cents per pound, compared to 39.3 cents in 2001). Today broilers offer the best feed conversion ratio of any domesticated land-based animal, making it a very competitive source of protein.

Leading firms accomplished these successes by reorganizing their methods of production and vertically integrating key process.

Key production stages, by order of operation, include: breeder farm, hatchery, feed mill, grow-out farm, processing plant, and final packing. Most major processors control and manage these operations directly or do so indirectly through resource providing contracts entered into with separate entities. These contracts typically specify a payment per pound of live broilers produced, depending on the grower’s relative performance.

Processors breed the parent stock, produce hatching eggs, and hatch the eggs. They contract with growers to raise the chicks and provide baby chicks, feed, veterinary services, and advice. Growers provide the chicken houses and labor. The grown broilers are then slaughtered and dressed for market.

By introducing vaccines and other medications in ovo (ie, before chicks are sent to grow out farms and put in contact with other birds) sophisticated processors like Tyson (which represented 20% of EMBX 2003 revenue) are able to eliminate a great deal of variability from the production process.

The US controls an estimated 46% of world trade in broilers but other producing countries are gaining share including Brazil (22%), the EU (12%) and China (8%). In order to compete effectively in the world markets, producers in these countries will increasingly adopt methods of organization and production developed here in the US. An increasing focus on manufacturing efficiency and product quality will very likely lead to further adoption of in ovo disease preventing solutions.

CURRENT BROILER MARKET
Demand for chicken meat continues to grow worldwide and is driven by increasing affluence in developing countries, and the competitive advantages of chicken protein over other meat sources (shorter biological cycle, cost per unit of protein, relative protein quality) and dietary preferences in more affluent countries. Growth in US production of around 2-3% is projected over the 2004-2006 period, though worldwide production is expected to grow at twice that rate.

While moderate industry growth is expected in the US, stronger growth is expected in the developing world, assuming continued economic growth.

BUSINESS REVIEW
Embrex currently offers the following equipment under lease arrangements to chicken processors: 1) Inovoject – injects vaccines into eggs at rates up to 60,000 eggs per hour 2) Vaccine Saver – prevents vaccine administration to dead eggs 3) Egg Remover – out sorts dead eggs. Additionally, the company is introducing a system called Gender Sort that separates male from female eggs to support the practice of separately rearing chicks.

Equipment is offered under lease with payment tied to the number of eggs processed. Some devices are sold. Device revenue represented 94% of total revenue in 2003.

The strategy on the device side is to grow international placement of Inovoject systems and upgrade existing Inovoject systems with the various add-on’s mentioned above.

Embrex generates 4% of its total revenue from the resale of Bursaplex, a vaccine EMBX developed to combat Infectious Bursal Disease. Bursaplex is the first drug developed using the company’s patented antigen-antibody complex (AAC) technology. Essentially, this package of technologies enables safe administration of both the live virus and its antibody in ovo, and on a single pass. Previously the virus and antibody were introduced in sequential stages. From a processors perspective, the AAC technology improves cycle times and hatching capacities. Bursaplex addresses a worldwide $60mm annual market.

A number of new drugs, based on ACC technology, are in the development pipeline. Newplex is a vaccine used to combat a Newcastle Disease and addresses a worldwide $50mm annual market. The product has received USDA and a number of foreign approvals and is currently being marketed.

Pending USDA approval is a drug called Inovocox used to combat Coccidiosis. The worldwide market for this vaccine is estimated at $350mm. This will be the first drug manufactured in-house and the company just announced the opening of a new $11mm production facility in South Carolina.

What’s attractive about the new drug opportunities is that markets already exist for these vaccine types. EMBX offers a more effective delivery system and formulations (“razors and blades”) for these vaccine categories that work particularly well in automated hatching environments. As these drugs grow in acceptance I would expect to see improvement in overall gross margins as well as on the top line.

CUSTOMERS
Embrex does 37% of its business with three customers: Tyson (20%), Pilgrim Pride (12%) and Customer X (8%). The Tyson contract is up for renewal later this year.

The loss of any one of its top three customers would significantly harm the business. However, there are approximately 50 integrated poultry companies in operation in the United States. The top 10 integrators, as shown below, account for more than 60 percent of all the broiler production.

1. Tyson Foods, Inc.
2. Pilgrim’s Pride Corporation
3. Gold Kist, Inc.
4. Perdue Farms, Inc.
5. Wayne Farms, LLC
6. Sanderson Farms, Inc.
7. Mountaire Farms, Inc.
8. Foster Farms
9 Cagle Farms
10. House of Raeford

As the company claims to process 80% of broiler chickens raised in the US and Canada, I assume that there are specialized, non-integrated hatcheries that serve a portion of the 50 poultry companies. To the extent that work done by service providers is eventually taken in house, EMBX might be able to lease more systems in the US and Canada without necessarily increasing its share of eggs processed.

COMPETITION
Primary competition comes from post-hatch systems that administer vaccines through feed and water. These systems prove increasingly inefficient and given to variable results as the productive scale and level integration grows. There are, however, four known direct in ovo competitors, none of which has experienced significant commercial acceptance. One installation of an in ovo system is in place in North America. It is purported to be running below plan.

FINANCIAL REVIEW
As a lessor (and, to a lesser extent, seller) of the Inovoject system, EMBX has experienced five-year compound revenue and EPS growth rates of 10% and 22% respectively. During that period the company invested heavily in equipment to support the growth and in a new drug manufacturing facility, took on little debt, and used the remaining cash to buyback stock and partially offset dilution caused by stock options.

With 23% of sales dollars generated over the past three years expended on R&D, I believe the fruits of the multiple development efforts described above are likely to be forthcoming. Moreover, drug sales should lead to improved operating margins relative to 2003 considering the significant amount of R&D dollars spent last year, including the write-off of monies advanced a vendor associated with the development of the Gender Sort system.

Embrex presents revenue in three buckets. Revenues for 2003 and my swag estimates for growth are as follows:

Revenue Source 2003 2004-2006 Assumptions
Device Revenue $43.5 2-5% Tyson renewal
1-2% egg sets growth
new Inovoject placements
Gender Sort launch(2006)

Product Revenue $2.0 30-50% Bursaplex and Newplex sales
Initial bump up in 2004

Other $0.6 0%

Total Revenue $46.0

Gross Margin $27.1 58-60%

EBITDA Margin 30% normalized for R&D spending

Tax Provision 30-35%

Challenges with distributors have hampered international growth in the past few years. Product sales in 2003 were negatively impacted by inventory pipeline filling at a Japanese distributor in 2002. I assume that the problems encountered last year are worked through this year. In previous years the company experienced problems with a distributor in Europe that was settled through litigation. Additionally, vaccines are required to pass through approval processes similar to the USDA process. Delays here could be costly, though there is little indication that this should be a problem.

Earnings for Q1 are due to be announced on May 5th. Guidance for the year, given on the year-end conference call and at the height of the avian flu outbreak, was as follows:

Revenue $51-$55 million
Pre-Tax Earnings $5.1-$6.5 million

Management affirmed its low-end pre-tax earnings objective. I believe these estimates might be conservative (I hate saying that!).

VALUATION
The current uncertainty (impact of Avian Flu) voiced by management on its last conference call, against a backdrop of multiple new device and higher margin product launches, presents a good entry point for shares trading at 13x earnings.

Roughly speaking, on 2005 estimated revenue of $53-$55mm, EBITDA margins of at least 30%, and an enterprise multiple of 10x it is not unreasonable to see a stock price of $19-$20 dollars. This target could well be achieved in the next 12-18 months depending on the momentum in revenue and earnings during these coming quarters.

WHAT COULD GO WRONG?
1) Loss of Tyson due to non-renewal of its contract expiring later
this year
2) Delayed USDA approval of Inovocox
3) Downturn in developing economies

WHAT COULD GO RIGHT?
1) Announcement of multiple Inovoject systems leased to a large
foreign poultry company
2) Further absorption of costs associated with international
infrastructure leading to increased margins.

Catalyst

None
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