Description

Pablo Legorreta’s Royalty Pharma, a person and business that I have admired for many years, is going public.  He’s built Royalty Pharma into a cf powerhouse, buying royalty interests in late stage or approved/marketed pharmaceuticals or biotech products, and holding them for the long term.  He’s positioned the company as the leading R&D partner to the Pharma industry, having cumulatively deployed over $18B of cash to acquire royalties, representing over 50% of all biopharma royalty transactions.

Now he’s going to IPO.  He finances the biz with bank debt of $5.9B paying L+150, takes in monthly income from the royalties, and pays a quarterly dividend (the last one annualized amounts to a ~3.4% dividend yield) on a $16.6B all-in post offering mkt cap which will be based on 595.3m shares out.  Cash post offering will be $2.6B, for a $20B EV.

Royalty interests include some blockbuster drugs such as Januvia (diabetes), Remicade (arthritis), Humira (arthritis), Tysabri (MS), Neupogen/Neulasta (cancer), and dozens of others across a broad range of therapeutic classes.  All-in there are royalties on more than 45 biopharmaceuticals, with 22 of those each generating end market sales of over $1B in 2019.  It’s an extraordinary track record of picking blockbuster drugs.

They also have additional potential returns from equity in pharma companies they receive when purchasing royalties.

It’s high quality and stable cash flows at royalty gross margins, with significant market share and cost of capital advantages, plus the quarterly dividends.  And, there is growth from a variety of drivers, including harnessing the marketing/sales efforts of their pharma partners, the generally increasing use of pharma on an aging baby boomer population, and greater numbers of royalties per new drug being aided by research collaboration and complexity.  In addition, technological advances are widening their market with new treatment modalities (cell therapy, antisense, RNA, gene therapy, etc.).  Global prescription pharma sales are expected to grow at a 7% CAGR to $1.2 trillion in 2024, despite nearly $100 billion in cumulative sales lost to patent expiry.

While it may seem crazy for biopharma development companies to give up future revenue to royalty interests, it is actually a highly effective way to fund the high cost of development because it allows the company to retain full control over pipeline assets.  This is important relative to the highly dilutive funding alternatives available to pre-approved sits, and the many strings attached from bringing in a larger pharma co to help with costs.

This unique company should trade at least in line with consumer product or non-commodity royalty businesses at a multiple of 20 something x cf.  And, I can envision a large supply of new buyers for this royalty category emerging from the forlorn holders of energy centric royalty trusts, upcoming index inclusions, and those who appreciate a low capex, cash generative business model.  

Price range is $25-28 per share for a 70m share offering (80.5m with the greenshoe), for a max offering size of $2.254B with ~$550m from selling shareholders and $1.7B to the company.  Post offering shares outstanding will be 350.83m class A, plus 244.5m class B, for a market cap of $16.6B at the top of the range.  In Feb 2020, PE firm General Atlantic acquired a minority stake with terms undisclosed.

JPM is left lead, with a broad selection of 12 of the usual suspects as joint leads and co-managers, so street coverage will be wide and deep.  It is set to price next Monday, on June 15th (moved up from June 16th).  For equity cap valuations in this writeup, I’m using the top of range $28, but I’ll guess it likely goes at $27-ish.

Management has reserved 5% of the offered shares, approximately 4m shares, for their own purchase. These shares will be subject to 180 day lockup, so this will reduce the amount of freely traded shares in the IPO (presumably to about ~76.4m).

There are also 244.5m class B shares, subject to lockup and then exchangeable one-for-one into Class A shares, which are going to the “Continuing Investor Partnerships”… [and if lofty in six months I may look into an unlock short trade… But in this case I’d be boxed, since I like the long term prospects of this business].  The B holders get 18% of the pre-IPO business, which will shrink over time as new acquisitions are made in which they will not participate, as expiries occur, and they are excluded from the quarterly dividends.  

On Friday June 5th, they paid a quarterly dividend of $140.8m.  Annualized this would be $563m or a 3.4% div yld to the top of the price range.  Knock 18% off of this, and recalc the balance for A shares only and you’ll get 4.7%.  The filing noted an initial 15c per share quarterly dividend estimate, which would be $0.60 or 2.1% div yld, but I think that’s a starting point.  Either way, it’s a low payout ratio, starting at 25% that can be increased over time.

Last year they earned $1.176B of net income which is ~$1.97 per share on the fully diluted A+Bs.  At a 25x multiple that’s $49 per share.  Yes, there were equity/warrant gains in there which will be variable, and they have occasional milestone payments, but given the div yield capacity, the broad group of growing royalties, and a quality management team, I’m seeing value in the offering.  And, the A/B structure will give the street some extra firepower since taking 18% off the $1.176B but using the 350.83m A shares they would actually report EPS of $2.74 per A share.  That’s 9.7x the top of range (even if a bit of an illusion).

I’ve had the pleasure of meeting the CEO, Pablo Legorreta, a few times over the years.  He was a Lazard banker in the Paris office before starting the company in 1996, and in addition to all indications of him being a fine human being, he has an interesting bio.  He’s been a YPO member, sits on the boards of Rockefeller & Brown Universities, the Hospital for Special Surgery, the Pasteur Foundation, the Open Medical Institute, and the Park Avenue Armory.  Plus, he founded a non-profit, Alianza Medica para al Salud, which provides educational scholarships to Mexican and Latin American doctors and healthcare providers to study abroad.  He has a degree in industrial engineering from Universidad Iberoamericana in Mexico City.  And, he recently became a founding member of Mount Sinai’s new Institute for Heath Equity Research, which is newly created as a response to health inequities made apparent by COVID-19.

Here’s some snippets of note:

The debt distribution is nicely spaced for the next five years, and, in time, will likely be distributed out further.  Their low cost of capital is a strong competitive advantage, and their plentiful access to capital combined with flexible deal structuring allows them to provide partners with a high degree of transaction certainty. Debt coverage is healthy at over 7.5x adj ebitda/net interest.  And, their debt is investment grade rated with stable outlook…  and only to get better post offering which will put them in a leading position for new deals.  This shows when the debt is due:

Revenues look quite stable, but make note of the provisioning changes which are driven by adoption of new accounting rules for credit losses on financial instruments amounting to a $192.7m gain at Jan 1 that is reflected in Non-current financial royalty assets, and flows through to the Provision for changes in expected cash flows:

With breakout of royalties, leading to over $2B of Adj EBITDA in each of the last four years (2016-2019, ex the proforma accounting). And, with low div payout ratio, indicating much higher dividend capacity… I think their plan is larger future distributions:

Royalty Expiry and Renewal:  One thorny part, as indicated in red above, is upcoming expiry of their royalties for their HIV (2021) and Januvia (2022) segments.  The rest is long dated, averaging 15 years+.  Just below the red marks are Xtandi (2027-2028) and Promacta (2025-2027).  The rest last well into the 2030s or are perpetual, and they’ve stated, “Management estimates that the most material patents provide protection through 2037.”  So they will have a ~$400m revenue headwind in stages for the next two years, and an additional ~$200m in 2025-2028.  Not great, but nowhere near fatal and it’s an ongoing part of this business/industry.  Plus there are offsets from the fast growing drugs, and (continuing down the list) Tazverik & Crysvita which were acquired in Q4 2019, don’t generate cash receipts until 2020.  And, there will likely be additional offsets from new approvals (Approvals in 2020: Tazverik in Jan, Nurtec in Feb, Trodelvy in April) and or new royalty acquisitions, which they are in an excellent financial position to find.  

FWIW, a quick web search on Tazverik shows analysts at Clarivate estimating $103m of initial 2020 sales and $617m of sales by 2024.  For Crysvita, they paid $320m for a 10% royalty on European sales, and it’s owner estimates ~$125-140m in sales this year excluding EU royalty revenue, up from $86-88m last year.  

When it comes to offsetting new with old, I am relying on management to continue handling this with aplomb, and I don’t think they are going public to escape expiries… If so, there would be heavy insider selling, not buying. The public structure will give them an additional currency for acquisition and greater dealmaking flexibility.

Though the A & B share structure is clean, the B’s, going to legacy investor partnerships, are entitled to 18% of the pre-IPO royalties per the Org structure.  Offsetting this, they don’t get the div (so initially a higher A’s only yld) but I’m assuming they’ll all convert as expiries start hitting, and or if they make some large acquisitions:

Shareholder info:  B holders are keeping their shares along with the 18% of pre-IPO royalties, and selling from A holders is quite light (10m of 70m offered, ex greenshoe) with management retaining and planning to increase:

There are some far above the curve stats at Royalty Pharma.  For example, with only 35 people they generate over $51m of revenue per employee.  

Another is their effectiveness in acquisitions of development stage royalties: “From 2012 through the first quarter of 2020, we acquired royalties on development-stage product candidates for a total transaction value of $6.1 billion of cash. Products underlying $5.6 billion of these acquisitions have already been approved, leaving us with $0.2 billion of total cash transaction value associated with products that are still in development.”

So, nearly 97% of all the capital deployed to pre-approval situations over 8+ years is now productive.  And this augments the $7B of royalties acquired between 2012 and 2019 on already approved products.  

A final snippet is they use conservative estimates when acquiring.  They note several sits that have far exceeded their sales estimates, so I’ll include this from the filing [underlining is mine]: “Of the 22 therapies in our portfolio that each have 2019 end-market sales of more than $1 billion, approximately half of those therapies were acquired since the end of 2011. Based on our portfolio as of June 2013, we estimated that we would generate royalty receipts of $0.3 billion in 2019. However, through successful new royalty acquisitions and outperformance of existing products, we were able to generate royalty receipts of $2.3 billion and Adjusted Cash Receipts of $2.1 billion in 2019.”

You can find many other interesting bits in their filing, so here is a link to the S-1.  

Anyhoo, I like this and am putting in for the offering.  As usual, I expect to get cut way back… but I’ll hope to grab a position worth in the after-market.

And, a final note from Uncle Sam, that there is some tax funkiness where they use an “Up-C” structure which allows US taxables to pay upon exiting the investment, though divs would be normally taxed along the way. 

Catalyst

Catalysts:

Street coverage and index inclusions

Periodic announcements on pipeline and new investments

Collapsing of the Bs into As

Cranking out cash flows and increasing dividends

Risks:

Regulatory changes to pharma pricing and political scapegoating of pharma companies

Approval risks in pipeline, especially on royalties acquired with debt

Interest rate and forex risk

Patent duration and or term of royalties