Description

Enzymotec  is an attractive risk return opportunity at current trading level as the Company is making its way out of the headwinds and getting back on track for smooth sailing. Enzymotec is an Israeli based company formed in 1998 and IPO’d in the US in September 2013 at $14.00. The stock soon doubled in the next quarter as growth investors priced in aggressive expectations and the stock traded at unrealistic multiples. In early 2014, the Company hit couple of rough patches (Q2 sales down 40% yoy and badly missed analyst expectations) due couple of unforeseeable industry shifts (including new regulatory policies for nutrition industry in China and general weakness in the Omega-3 market due to new research discrediting the supplement). After the 40% drop in Q2 2014, revenues have been slowly recovering. The Company has a great management team and the technical know-how to weather any short-term headwinds and come back strongly. With multiple avenues to grow revenues and earnings, the stock price should potentially recover and touch its previous highs.

Business overview, market opportunity and considerations:

Enzymotec develops and manufactures lipid based nutrition supplements and medical foods. The company operates in two segments: Nutrition and Vaya Pharma, both segments offer range of products based on lipid expertise.

1.       Nutrition Segment: This segment currently generates most of the revenues. The two most popular products in the segment are InFat (ingredient for infant formula) and Krill oil (dietary supplement).

-          InFat is a clinically-proven fat ingredient for infant formula that more closely resembles the composition and properties of human breast milk fat. InFat accounts to approx. 25% of the total revenues, 30% of which are attributable to sales in China through Biostime, a leading local provider of infant nutrition product is the biggest customer. The ingredient is sold through a 50% JV called AL, with AarhusKarlshamn AB (AAK). Pursuant to the JV agreement, the Company supplies the enzymes used to manufacture InFat, and AAK manufactures the final InFat product. Sales in China have faced a lot of headwinds since early 2014, including new regulatory changes with respect to products of infant formula and investigations and in to alleged price fixing by infant nutrition companies including Biostime. Additionally, Biostime has been losing market share with China’s rapid increase in ecommerce purchase of infant nutrients (currently approx. 30% vs. 0% in 2013) as a wide variety of products have become available online. Enzymotec has been able to tackle these issues to a certain extent with the development of new ingredients and supply for new brands.

-          K-REAL is a krill oil-based omega-3 ingredient that is developed and manufactured by the Company and accounts for about 40% of the total revenues. While fish oil is the go to supplement for Omega-3, most people are not familiar with Krill oil, which is a much more superior Omega-3 supplement. The global market for Omega-3 supplement is approx. $3.5bln (growing at approx. 7% CAGR). Krill oil market is approx. $188mm in 2015, double the 2010 market according to research by Frost & Sullivan. Though krill oil is still the main Omega-3 supplement product, the Company is also expanding into the much bigger fish oil based Omega-3 supplement market. The Omega-3 supplement market was negatively impacted in 2014 by the negative PR campaign against the product as some studies reported that the supplements can increase the risk of prostate cancer, while other studies showed that they do not. The negative publicity along with increasing supplier capacity in anticipation of growing markets culminated in pricing pressure and decline in revenues. Recent studies have shown that the supplement does not increase the chances of prostate cancer and according to recent research estimates that market is expected to grow at a CAGR of 15%+ through 2021 to reach $7.5 billion.

2.       VAYA Pharma: Company offers portfolio of lipid based branded medical foods to be used under medical supervision either by oral intake or tube feed for cardiovascular and neurological conditions. Medical food is a non-FDA approved product administered under a doctor’s supervision from ingredients generally recognized as safe (GRAS status). Current products include Vayarin (for Attention Deficit Hyperactivity Disorder or ADHD), Vayacog (for early memory impairment), and Vayarol (for high triglyceride levels). The Vaya product was first launched in 2011 in the US. Contribution from the Vaya segement is currently less than 15% to the total revenues but this is the growth engine for the Company. Expected revenue for 2015 is around $8mm, though gross margins are high (80% range) and the segment breaks even (before R&D expense) at current revenue levels. Vayarin (65% of Vaya sales) has received most of the management’s current focus given its commercial prospects.  Vayacog and Vayarol make up for the remaining 25% and 10% of the Vaya sales, respectively. Unlike the infant nutrient ingredients, the Company sells the Vaya products directly to the customers through its sales reps and has recently started distributing the products through its online pharmacy (approx. 20% of sales). The Company currently has 33 sales reps in 17 states versus 20reps in 5 states last year. Currently, most of the sales reps are new and are getting trained on the product and so these reps are not yet actively marketing the Vaya product.

Investment Highlights:

         i.            Vaya pharma is the growth segment and has the potential to boost revenues and earnings for the next couple of years:

o   Currently, the Company has 33 sales reps across 17 states. Most of these reps are new to the platform and in training. The reps will soon start actively marketing the product and increase the geographical coverage. Additionally, with more sales reps onboard, the Company can focus on marketing Vayarol and Vayacog products. 

o   Additionally, the Company has recently started its online pharmacy distribution channel for direct to customer sales. Online pharmacy distribution is getting great traction, contributing to approximately 20% of the segment’s sales. Online pharmacy will enable geographical expansion within and outside US.

o   The market opportunity for the Vaya products is significant. ADHD market in the US alone is approx. $6bn and there are currently no good non-Rx ADHD alternatives. Global market for dementia or Alzheimer’s is approx. $5bn (9.5% CAGR) and according to Alzheimer’s Association there are 5.3mm people in the US formally diagnosed and more people with memory impairment. 

       ii.            Sales growth of Omega-3 supplement products is expected to be back on track with recent data demonstrating that the supplement does not increase the risk of prostate cancer. The overcapacity issue should also resolve quickly as the demand increases and the industry sees more consolidation

      iii.            InFat segment is set to get back on growth track. The Company is currently looking at vertical integration. The Company is offsetting the headwinds from the reduced sales in e-commerce with new products for other infant nutrition manufacturers. Additionally, the infant nutrition market is expected to grow faster than previously expected with China now dropping its one-child policy.

     iv.            Stock is attractively valued with the stock currently trading at approx. 16.5x 2015E EBITDA and 10.5x 2016 street expected EBITDA. Revenues and EBITDA has room to expand with the above mentioned investment highlights playing out. Company has no debt and is able to finance its growth with free cash flow. The Company has been very prudent with capital deployment with less than $40mm in cumulative investments since 1998 to develop and commercial all its products. Additionally, the management team is highly capable and has strong expertise in lipid based solutions.

Risk: The major near term risk is the litigation risk with the Company currently being involved in two lawsuits

         i.            Neptune Lawsuit: Neptune, one of the major krill oil competitor, in 2011 filed a lawsuit against the Company claiming patent infringement. USPTO recently determined that 26 out of 28 Neptune's claims are unpatentable with the remaining two still being decided. If the outcome is in favor of Neptune, Enzymotec might end up paying royalty payment, but the chances of that seem low. The final hearing on the two patents might be resolved in the H1 2016.

       ii.            AAK Arbitration: Company’s JV partner for InFat, submitted a claim for arbitration with regards to the Company’s disclosure in connection with its IPO. According to its claims, the Company violated certain non-disclosure obligations related to the JV agreement.

Catalyst

upcoming positive quarterly results showing growth in Nutrition and Vaya segment; lawsuits outcome in favor of Enzymotec.