Description

Executive Summary

I am recommending a long position in Avid Bioservices (CDMO, “Avid” or the “Company”) at a price of 6.82 / share (aftermarket price).  Avid Bioservices is a pure-play biologics contract manufacturer, with a base of commercial customers providing stability, a growing backlog of customers in all stages of development, and a state-of-the-art asset base.  Importantly, I believe Avid is at an interesting inflection point for profitability given the visible growth, operating leverage inherent in the manufacturing business, and continued progress with sales and marketing plans as the Company has fully-transitioned from an excess capacity manufacturer to a dedicated CDMO.  Additionally, the Company is not meaningfully economically sensitive, has a sticky customer base in a double-digit secularly growing industry with a capacity shortage, space on-site for meaningful capacity expansion, does not require significant capital to grow, and has a relatively clean balance sheet and a Board that is committed to long-term shareholder value.  Finally, as I will detail later in the Customers and Revenue Growth section, a little-known customer/program is expected to contribute meaningfully to growth in profitability and revenue in a few years, which I believe will set Avid up for a premium market valuation and is a true differentiator for the investment.  I believe this customer alone has the potential to add nearly $50mm in EBITDA in a mid-case scenario. Though it is not my base case, the entire CDMO industry has been consolidating, and I would not be surprised if Avid was ultimately acquired at an attractive valuation in the next two to three years.  I believe Avid can trade to $15+/share in the next two to three years, which is an ~27% to 48% IRR from today’s levels and meaningfully higher if I am correct that the market will discount the customer above.  Over the long-term, absent a fluke event of some kind, I believe downside is limited given the highly visible growth and operating leverage in the business and lack of meaningful economic sensitivity.

Why does this opportunity exist?

·         This is a smaller capitalization business with “bio” in the Company name.  I think that’s a pass for many, even though the reality is that this is a much easier to understand manufacturing business with great industry dynamics.

·         Some people will pass because they believe there is biotech risk.  While that may be true for some of Avid’s customers, much of Avid’s projected future revenue is from stable, multi-billion dollar companies with commercial products.

·         Avid currently is breakeven or only slightly positive from an EBITDA perspective.  This is not cheap on today’s EBITDA levels obviously, so it isn’t likely to show up on many value screens.  The combination of expected revenue growth and significant operating leverage can change that quite quickly.

Capitalization

Company/Business Overview

Avid is a pure-play CDMO (contract development and manufacturing operation) providing a range of services from early-stage process development and cell line optimization to commercial manufacturing for biopharmaceutical products derived from mammalian cell cultures – more specifically, monoclonal antibodies (mAbs).  In short, Avid makes biotech drugs for people and helps optimize the “recipe” for making those drugs. Relative to small molecule compounds which involve mixing chemicals together, biologics are materially more complex. Although contract manufacturing might seem unnecessary for many biotechs, as discussed later, increased outsourcing is a trend in biopharmaceutical manufacturing, especially for smaller R&D-centric organizations as more innovation is from VC-backed entities and as therapies are for smaller populations of patients.  Importantly, Avid has a long history of commercial production, a differentiating factor versus many other CDMOs, by virtue of its relationship with Halozyme (HALO). Avid has two primary facilities, both located on its campus in Tustin, CA; an older facility, Franklin, with predominantly stainless steel bioreactors (old way) and which has subsequently been partially refurbished and used for process development work and its new state of the art Myford 1 facility, which is 42k square feet and uses single-use bioreactors up to 2,000L scale.  Single-use manufacturing is the current standard and has many advantages over older stainless steel manufacturing techniques. Importantly, the Company is in final stages to expand to a Myford 2, which is next door to the Myford 1 facility and should provide approximately $150mm of incremental revenue capacity once complete. Today’s revenue capacity between both process development services and commercial manufacturing is approximately $100-125mm.

Prior to 2018, the Company was named “Peregrine Pharmaceuticals” and was primarily a research and development focused biotechnology company with a mostly crooked management team and Board.  Manufacturing for third-party clients was largely an afterthought and existed only to continue to funnel money into drug development and to line the pockets of the previous regime. During 2017, an activism campaign highlighted the egregious conduct, ultimately leading to a replacement of the Board and management team and a shift in focus to a dedicated CDMO, also partially driven by the failure of the lead R&D candidate.  The Board is now a top-notch collection of industry executives, all with extensive experience growing and ultimately selling companies. More on that later…The Company is now fully transitioned and is slowly winning new customers, growing existing customers, and improving capabilities as a dedicated CDMO. It is important to note that this is a significant change and it does take time. The perception of Avid had to change significantly in the marketplace – from an excess capacity player run by a joke management team to a legitimate full-service CDMO with several multi-billion dollar clients.  As the Company continues to present at industry conferences and outsourcing events, I believe the fruits of their labor will be rewarded, especially considering the tight supply/demand dynamics in the industry.

Today, Avid is generating approximately $64mm-$67mm in revenue and should be breakeven to slightly positive on an EBITDA basis this year.  It is worth noting the business is lumpy quarter to quarter. Production runs can be significant amounts of revenue and their timing is heavily customer-dependent.  I think investing in Avid and understanding this industry means you look at this on a long-term basis and understand that the outlook is quite bright. Although it is only slightly EBITDA positive today, operating leverage is quite significant as most of the operating costs are fixed.  As a result, it is not unusual to see incremental EBITDA margins in the 65-70% range as revenue grows from here (CFO said 50-70% on the last quarterly call). Ultimately, many biologics CDMOs have margins in the low to mid 30s (Catalent actually says high 30s%). Anywhere close to those numbers would make an investment in Avid a wild success from here.  Finally, as of the last 10K released in July of 2019, the Company finally removed its going concern language. That is a significant positive, not only because customers likely viewed the language unfavorably, but because when auditors remove this language it is based on projections and an assessment of future profitability and sustainability. I believe this is a very positive sign that the future at Avid is strong.

Positive Industry Backdrop

Although many know the positives of the CDMO space, it is worth quickly rehashing why these tend to be very good businesses, why biologic manufacturing specifically (as opposed to small molecule manufacturing from CDMOs such as Cambrex or Recro) is even more advantageous, and why Avid’s particular scale is the sweet spot for the industry.  A number of factors are contributing to the sticky double-digit growth in biologics today and for the foreseeable future:

·         Trend towards biologics vs. small molecules – Although there is growth across the CDMO space, biologics in particular are projected to grow in the double digits for the foreseeable future.  Biologics are an increasing percentage of the R&D pipeline and an increasing percentage of total drug approvals. Additionally, as several blockbuster biologics come off patent, biosimilars will be another opportunity for the CDMO space.

Source: Stephens

·         Trend towards outsourcing and smaller scale biologics – As the biologics industry overall is expected to grow significantly, an increased trend towards outsourcing yields torqued growth for biologics CDMOs.  There are several reasons for the incremental outsourcing. First, many of the “mega” therapeutic categories have largely been pursued already. Many of the drugs in the pipelines today are to treat smaller populations and are typically backed by VCs.  These smaller research-centric firms are the lifeblood of the biotech industry, as the larger players focus more on established compounds, sales and marketing, and ultimately buying the successful research-centric companies. Because of the smaller scale and the fact that these companies are typically more capital constrained, they almost always find contract manufacturers to help with development and production as opposed to building their own manufacturing capacity.  Few small biotechs want to take unnecessary risks in manufacturing. It is hard enough to develop the science behind these therapeutics so companies would rather focus on their competitive advantages (research) and be able to scale quickly and reliably with contract manufacturers. Additionally, smaller scale CDMOs (2K Liters) are important because smaller biotechs feels like they have a real seat at the table as opposed to contracting with behemoths such as Lonza or Samsung Biologics.  Finally, building a single facility makes little sense for any single smaller biotech. By taking multiple customers, CDMOs are able to leverage regulatory expertise and manufacturing capacity.

Source: Zion market research

·         High switching costs – Once CDMOs win business, it is typically very sticky.  Data on manufacturing and inspections of facilities are actually part of the FDA application for biologics.  Because biologics are produced from animal cells, you cannot really guarantee every production run is exactly the same.  Because of this, the FDA is even more rigorous in its approach and ensures manufacturing processes are part of biologics approvals.  Companies typically do process validation runs in later stages of drug development that provide inputs for the application process. This step is expensive (tens of millions in some cases), so companies are reluctant to repeat them to switch manufacturers, especially when the existing manufacturer is already doing a good job.  This also applies in the case of mergers as it is typically the case that the manufacturing does not move in-house after biotechs are acquired if the products are commercial or are in the later stages of development. High switching costs also tend to help CDMOs win incremental molecules from the same customers that have already vetted the facilities, processes and regulatory track record.

·         High Barriers to Entry and Low Capital Needs – CDMOs are good businesses in my opinion, because the barriers to entry are typically regulatory experience/track record-based.  As previously mentioned, few small biotechs want to risk engaging in business with CDMOs that are unproven or have a large history of failing inspections or other regulatory issues.  Additionally, the process to produce commercially is long and complex, and having experience is very important to prospective customers. Biologics are akin to making a 747 vs. small molecules which is more like assembling a car.  For these reasons, it is very difficult to simply build a new manufacturing facility as an outsider and expect to win meaningful business. I think this is exactly why new entrants to the space typically buy their way in at prices that are well in excess of traditional “replacement cost” metrics.  The barrier isn’t really about the facility alone, but more about one’s experience in using the facility. It is true a risk would be overbuilding by existing industry players, but there is no evidence that is occurring today and the industry is pretty vocal about not building facilities on speculation.  Additionally, because the lead time to build is a few years (between physical plant and regulatory validation) and the industry is growing rapidly, demand continues to outpace supply, pricing remains strong, and players with capacity today are advantaged. Because of this intangible barrier to entry, capital costs tend to be low relative to the unit economics achievable.  CDMOs are highly cash generative businesses when manufacturing sites are full.

In short, for the CDMO space, the rich seem to be getting richer.  In my opinion, this is a space that will continue to see strong M&A multiples given the growth and strong dynamics for existing players.

Avid’s Competitive Advantage

·         Strong Regulatory Track Record – In my view, this is the single strongest thing that Avid possesses.  They have gone through multiple FDA inspections with no 483 violations and they have a long track record of manufacturing success, including process validation work which is critical for biologic license applications (BLAs) filed with the FDA.  Importantly, you cannot just create a regulatory track record, except for executing over a long period of time. As a result, Avid’s barrier is not a capital expenditure barrier, but a know-how barrier, leading to higher ROICs and justifying larger multiples for acquisitions in the space.  Essentially, in this industry the rich get richer, and new entrants buy their way in.

·         State of the Art Facilities – Having spoken to several industry experts who have both toured the facilities and evaluated it seemingly from an M&A perspective years ago, the Myford facility truly has a “wow” factor.  It is a single-use bioreactor facility which is the current industry preference, and the new process development labs show very well to new customers.

·         Geographic Advantage – Avid is located in southern California, which is a hotbed of biopharma activity and is partially why they won the initial business from Halozyme.  It is ripe with biopharma human capital and new potential customers.

·         Scale Benefits – Somewhat perversely, Avid is advantaged partially because they only have 2,000L bioreactors.  Although others in the space have more capacity, many of the new molecules being developed do not require such large volumes and the economics will not work at scales meaningfully larger.  Additionally, smaller, newer, and perhaps single-product biopharma companies are reluctant to engage with the larger CDMOs as they know they will be treated like the low man on the totem pole.

·         Commercial Manufacturing Track Record – Avid is one of the few CDMOs out there that has extensive commercial manufacturing experience.  They can take a product from development stages, scale the process, help with necessary regulatory approvals, and produce at commercial scale.  If you are a biopharma company, this is a large benefit to you, as the last thing you want to do is switch contract manufacturers at various stages in the process.

Customers and Revenue Growth

Although revenue growth will be lumpy quarter to quarter, and potentially even year to year, there are many clues that point to a bright future for Avid.  First, at its 2018 Annual Meeting, the Company’s CEO stated that the existing customers already have enough projected future demand to fill all of Myford 1 and 2, though obviously not for several years.  Still, since that time the Company has continued to win new customers and diversify revenue away from their core commercial customer, Halozyme. A snapshot of Avid revenue and backlog is below:

Backlog only represents signed commitments, but the reality is there is a much larger “soft backlog” in addition to this number because no company would start certain stages of the process without continuing to later stages unless the product failed.  On an LTM basis bookings are above $80mm. The Company has done a good job of diversifying revenue in recent years as can be seen by revenue from the “Other” category increasing. As time goes on, they have also won new molecules from existing customers, another vital source of growth.  Finally, the Company completed a new process development laboratory, which will help win early-stage molecules that will hopefully ultimately become commercial products.

Below is a summary of Avid’s key customers, which I believe gives confidence on the growth outlook, as well as massive upside potential for the equity in a few years, specifically from Coherus.  Importantly, Avid has recently completed three process validation campaigns, which are typically done prior to the launch of commercial production or relevant BLA filings.

Halozyme (HALO) – Any discussion of Avid starts with a discussion of Halozyme.  Halozyme is a biotech company that makes a compound (rH for short) that is paired with other drugs to allow for subcutaneous administration which rapidly shortens the time to treat patients.  So, for many chemotherapy drugs, Halozyme’s product can be paired with the chemo drug to reduce multiple hours of infusions down to only a few minutes, which is a major patient advantage and helps innovator drug companies fend off generic competition.  Halozyme is paid a royalty on sales of drugs that use rH, as well as for the raw material rH they sell to their partners. As Halozyme has transitioned away from its R&D pursuits to focus only on its royalty business, I expect partnerships to increase over time which will increase the need for raw material to be used in trials and eventually for commercial use.  HALO exclusively uses Avid and Cook (now owned by Catalent) for manufacturing. Although Halozyme revenue for Avid has decreased recently, it is because Roche, a large customer for HALO, was transitioning from Avid’s Franklin facility to the newer Myford facility, which requires validation runs and re-filing with the FDA. It is expected that Roche will start to build inventory again (creating the need to purchase more from HALO) now that process validation is complete.  Roche is also expected to file another NDA for rH in combination with Perjeta/Herceptin in early 2020. As Halozyme continues to grow, I believe Avid will also be supplying to other potential Halozyme customers, and the Avid management team already believes some of the product is going to parties besides Roche. It is important to note that HALO isn’t really that risky when it comes to trials. The product works with other medicines that are already approved – I do not believe they have failed any trial yet.  This is mostly about blocking and tackling when it comes to partnering, running the validating trials, and ultimately selling the rH with the partner drug to collect royalties. The following quotes from HALO are helpful in understanding how they think about the trajectory of long-term API sales:

Question from 5/7/19 Call: “…if you think about $1bn in royalties in 2027, what would be the level of API sales supporting that $1bn in royalties.”

Answer: “…We have said that they would increase substantially year over year, and in fact, kind of going back to even above the 2017 sort of levels.  And again that’s being driven by partners as they’re getting ready for more clinical studies and potential commercialization…And then as far as the future, it – over time, certainly API sales should approximate the volume in the market, but our partners are ordering in a not regular pattern…so you can’t necessarily equate API in any given year to…the amount of [royalties] in that year.  But certainly over time, they will approximate each other.”

Royalty revenue for HALO is expected to grow at a 40% CAGR from 2020 to 2027.  If that happens, API sales should grow significantly and Avid will benefit strongly from today’s HALO revenue levels.

ADC Therapeutics – I don’t know too much about this customer as they were disclosed in the most recent 10K.  As far as I know, this is a pre-IPO biotech (actually pulled their IPO in September) focused on cancer treatments with a current private valuation in excess of $2bn on a recent $300mm Series E financing, so it seems legitimate.  Avid has been doing work for ADC for the past few years, suggesting they are probably in Phase II or beyond. I am just speculating, but it is possible one of Avid’s process validation campaigns was for ADC, in which case this is probably for their lead drug ADCT-402.  That would likely mean commercial production in 2021, as ADC is expected to file its FDA biologics license application (BLA) in the second half of 2020.

Top 10 Pharm Customer – Obviously, I don’t know who this is, but it was announced in July of 2019.  I view it as a positive that a top 10 global pharma customer would enter into a contract with Avid, because they would have diligenced all the facilities and capabilities of the Company. 

Coherus (CHRS) – Using commentary from the previous management team, current management, revenue trends from Coherus, and the timing of the final process validation run, I believe it is highly likely that Avid is the manufacturer for Coherus’ biosimilar of Humira.  In fact, I believe the Myford facility was actually built expecting enormous demand from Coherus, only to see them lose the patent challenge and have to delay market launch until 2023.  I think reading old transcripts from 2017 make this pretty clear. Humira, in case you are unfamiliar, is the largest drug on the market today, with expected branded sales approaching $15bn by the time biosimilar competition hits.  There are a few approved biosimilars on the market that will launch competitively in 2023 (settled with Abbvie), but it seems like any way you cut it, this should be a huge opportunity for Avid, probably in early 2023 or late 2022 when CHRS starts to build inventory in advance of a launch.  In the interim I’m sure there will be other manufacturing runs to prepare. I believe this is being largely ignored and/or analysts have not yet figured this out. As a hypothetical, a few numbers below:

Although Avid analysts haven’t noticed, several CHRS analysts believe this will be a several hundred million revenue product for CHRS, and relatively quickly.  The Company has executed well on its existing product in the market, which bodes well for launch of Humira in a few years. CHRS at a recent conference believes the Humira biosimilar opportunity could be up to $1bn in annual revenue.  Assuming 20% COGS for the product, which they’ve alluded to publicly, that would be over $100mm in incremental EBITDA to Avid.  Even lower cases are still enormous for Avid.  $50mm of incremental EBITDA at even 15x is over $13/share. It is hard to see how this won’t be meaningful and CHRS is expected to file its BLA in early 2020.  I think the filing and ultimately approval could be catalysts for Avid as it will be clear who they intend to use for manufacturing. As discussed below, I don’t even think CHRS will actually impact results as much as it will valuation…

Projections/Valuation

It is hard to model this precisely on an annual basis as the business will be lumpy.  But, for reasons outlined above regarding both the industry tailwinds and company specific factors, I believe Avid can compound revenue in excess of 20% for the next several years, BEFORE Coherus even impacts results.  The rough algorithm is that these types of businesses can earn 30-35% EBITDA margins when fully optimized (capacity full), and a few years ago Avid was earning nearly 50% gross margins when it only had the Franklin facility.  The steady growth of the business should yield nearly $40mm of EBITDA in a few years and these businesses have traded in the public markets at high teens EBITDA multiples or even greater, with acquisition multiples in the 20s in some cases.  As time goes on, and with Avid as essentially the only pure-play CDMO, I believe the Company will demand a premium valuation in the market.  If you believe the market is a forward earnings discounting mechanism, what price will investors be willing to pay when they see they prospect of $50+mm of INCREMENTAL EBITDA from Coherus that will begin ramping in 2023?  I suspect it will be a large multiple and I believe it will be justified. Having spoken to industry experts familiar with the CMC Biologics deal at ~23x EBITDA, a large reason for the valuation was that buyers all saw the tremendous growth ahead.  Ultimately, I believe Avid will be a $1bn+ business as EBITDA approaches $40mm, and meaningfully higher when investors begin to discount revenue to Coherus. Various biologics/CDMO M&A comps are below. If anything, multiples appear to be increasing in the space.

I believe the Board “gets it” and expect that Avid will ultimately be put up for sale in a few years.  The Board is well-qualified and very well networked in the industry. I think it is well understood that smaller companies like this tend not to get full value in public markets, and a few board members have history building and selling companies or have been involved in M&A transactions.

·         Joseph Carleone, PhD – Chairman – CEO of American Pacific Co, sold APFC to PE

·         Rick Hancock – interim CEO – sold Althea, a biologics CDMO

·         Mark Bamforth –CEO of Brammer Bio – sold to Thermo Fisher

·         Patrick Walsh –CEO of Avista Pharma – sold to Cambrex

·         Greg Sargen – CFO of Cambrex – sold to PE

·         Catherine Mackey, PhD – previously part of many businesses that were acquired in her tenure

CEO Departure/Current Management

The old CEO, Roger Lias, seems to have been let go/“resigned” in May 2019.  He had been hand-picked by the previous regime, so it is hard to feel terribly about him leaving.  My suspicion is that the current Board gave him some room and time to work, but ultimately were disappointed with his ability to win business fast enough.  I think that’s actually a positive sign. This is a hot industry with a lot of tailwinds. I think the bar is pretty high and this is a Board that demands success, or at the very least, participating in the industry tailwinds like everyone else.  In the interim, Rick Hancock has taken over as CEO. He has experience in the CDMO space, is well respected and networked within the industry, and is bringing in other capable leaders. Business development is being run by Tracy Kinjerski who previously had a stop at CMC Biologics (sold for ~22-25x EBITDA…).  I think she is very motivated to grow this business and prove that she can lead the business development effort before whatever her next gig will ultimately be. The CFO Dan Hart is good in my opinion and tends to lean a little conservative when it comes to commentary and forecasting is my impression. They also recently hired somebody to lead operations who had previously been with the Company years ago.  I view it as a positive that he would come back to Avid based on the outlook he sees today.

Conclusion 

Overall, I believe CDMO is a compelling long-term investment where investors will make multiples of money over time.  The Company has an advantaged asset base in a growing industry, with an enormous opportunity coming from Coherus in the future.  Even without Coherus, as revenue continues to grow and EBITDA grows significantly faster, I believe Avid will continue to move higher as EBITDA potential becomes more widely understood.

Risks

·         This is currently a single site company in California.  Any time you have a one-location manufacturing company, there are risks.  With that said, this facility has actually withstood the largest earthquake ever in California

·         Some kind of regulatory or FDA issue.  They have a long history of passing inspections flawlessly and have not received any kind of warning in many years.  This is actually one of Avid’s advantages

Catalyst

·         Continued operational execution and EBITDA growth

·         Coherus BLA filing early next year

·         Build-out of Myford 2 facility signaling growth expectations

·         Eventual sale to a strategic or PE sponsor