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The following segment was excerpted from this fund letter.
How Cheap is Cheap Enough?
Consider the case of Avid Bioservices (NASDAQ:CDMO), a large molecule, small batch Contract Drug Manufacturing Organization that will be familiar to all but our newest partners, as we owned shares from 1H 2018 until all but exiting our position in the low $30s in Q4 of 2021. Since that time, shares have declined precipitously as the company is both a “growth” stock and in the S&P Biotech ETF (XBI), which has declined ~36% YTD to quarter end. However, in my view Avid Bio is a baby with the bathwater, and we once again made Avid Bioservices a large position during the quarter.
First, unlike most “growth” stocks, Avid Bioservices is not a “disruptor.” You don’t have to make any blind assumptions about total addressable market (TAM), customer acquisition costs (CAC), or churn. There is very little risk of “garbage in, garbage out” when modeling Avid’s future. Rather, Avid’s assumed growth is tied to building additional manufacturing capacity. In my view, it is a much easier task to understand the dynamics of building an additional manufacturing facility than it is to understand the dynamics of alleged TAM, potential CAC, and unknown churn.
Second, unlike most biotech stocks, Avid is a real business, not a binary bet on whether or not a drug will meet its hoped-for end state. Lastly, and most importantly, Avid Bio has one characteristic that staunchly separates it from other high flying growth stocks and biotech stocks that have been punished by the market: it is set to gush cash in the not-too-distant future.
|
Future Revenue Capacity |
$370,000 |
|
|
EBITDA margin @ scale EBITDA @ scale |
33% |
36% |
|
$122,100 |
$133,200 |
|
|
– Interest |
– |
– |
|
– Tax |
– |
– |
|
– Maint. CapEx @ 3.25% Free Cash Flow |
12,025 |
12,025 |
|
$110,075 |
$121,175 |
The company is in the process of expanding its manufacturing footprint, having announced plans to have revenue generating capacity of $370M within the next ~12 months, vs. revenues of $119.6M in fiscal 2022 (YE April 30). This expansion is fully funded, and at that scale the company has guided to “low to mid 30%” EBITDA margins, which appears reasonable if not conservative based on commentary from competitors. From there, interest payments should be zero assuming outstanding convertible debt is equitized, and with nearly $700M of NOLs, it will be at least a few years before the company is paying meaningful taxes.
Lastly, once the facilities are built out, they are relatively capital light, and maintenance cap-ex should be 3-3.5% of revenue. Thus, at the prices we were buying our shares, CDMO was perhaps 3 or 4 years away from trading at 7x-8x steady state free cash flow.
To be clear, as always things can go wrong here. It is not impossible to believe that construction of the new facilities might run into speed bumps due to supply chain issues, or cost overruns. Further, there is no guarantee that the company will be able to fill this new capacity.
However, it is rare to see purely speculative capacity expansion in CDMO world, despite the fact that at present demand far outstrips supply, and I think the odds that Avid Bio has customers lined up for the lion’s share of this new capacity are very good. After all, on their March earnings call the company noted that current 12-month backlog is larger than current capacity, and they have also noted that they have been asked to respond to Requests for Proposals (RFPs) from potential customers, even before their new facilities have been constructed.
In CDMO land, quite frequently when there is an increase in capacity, it is in response to existing customers and potential customers approaching an existing CDMO (such as Avid Bio), and asking them to build additional capacity in anticipation of their own future needs. This is because pharmaceutical companies are reluctant to partner with de novo CDMOs that do not have long-established and reliable FDA regulatory track records.
In brief, when a pharmaceutical company partners with a CDMO, the CDMO becomes part of the FDA approval process for the drug. If the CDMO does not run smoothly, the drug will have trouble gaining FDA approval. For many small pharmaceutical companies, avoiding delay is of critical importance as they are often burning cash ahead of FDA approval.
Further, the relationship between the customer and the CDMO does not weaken after FDA approval. If the pharmaceutical company wants to switch to a different manufacturing partner, the drug as manufactured at the new facility must go through FDA approval again; switching costs are high.
Thus, choosing the right CDMO partner is of critical importance. As a result, despite barriers to entry in this business being largely tied to capital and thus low, barriers to success are quite high. Quite simply, it takes ~30 years to establish a ~30-year track record of regulatory success similar to the one that Avid boasts, and without that long track record, the decision maker at a customer is taking an unnecessary risk. Just as decades ago “no one got fired for going with IBM,” in CDMO land no one gets fired for going with a CDMO partner that has a well-established FDA track record… but they might if they go with an upstart.
It bears mentioning that this is not just a theory. There is plenty of evidence that demonstrates that CDMO assets trade hands at many multiples of replacement cost, because capital alone cannot establish a successful CDMO – it takes time and a clean track record.
All of this might sound interesting, but what about a recession?!?
CDMOs are largely recession proof businesses. Patients still need their drugs regardless of what is happening in the real economy. This of course says nothing about what multiple the market might put on Avid Bioservices 3-4 years from now, and it is conceivable or perhaps even likely that in a recessionary environment Avid Bio would be awarded a multiple below what it would deserve in more normal times.
However, if the company ~triples revenue and sees free cash flow go from a negative number reflective of current investment to something well north of $100M over the next 3-4 years, I feel confident that fundamental business improvement will far outweigh the impact of any market-wide multiple contraction.
If the world is “normal” in 3 or 4 years, I think it is reasonable to say that recession proof free cash flow deserves a 20-25x multiple, which implies a stock price of somewhere in the $31-$43 range, or a CAGR of 27%-53% over that 3 or 4 year period assuming all else equal. Of course, I would not be surprised to see a higher multiple for Avid Bio given the tremendous strategic flexibility the company will maintain at that time.
For example, with no debt and recession proof revenues and cash flow, the company could comfortably lever the balance sheet by 3x, which would allow them to repurchase almost half of the equity if the stock does not move considerably higher between now and then. They could also continue to grow organically, or become a buyer of smaller orphaned CDMO assets, or they would be an attractive target for a bigger CDMO player.
If the world is still panicked by inflation and recession 3-4 years from now, and market multiples have contracted severely, I think we would still be pleased with the result of this investment. At a multiple of 15x my estimate of FCF, which seems punitive for fast growing, recession proof free cash flow with strategic flexibility, shares would trade hands at $25, or a 20%-28% CAGR from our purchase price, assuming all else equal.
But what about inflation?!?
CDMOs are well positioned to pass on inflationary cost pressures to their customers. The actual manufacturing of a drug represents a small portion of the total cost of drug development, switching costs are very high, maintenance capex needs are low, materials costs are contractually passed on to customers, and at present manufacturing capacity in the industry is tight.
I want to stress again that things can go wrong with our investment in Avid Bioservices; there is no such thing as a perfect investment. In particular, the obvious risk here is that industry capacity expansion becomes less rational than it has been historically. To be clear other industry participants are also adding capacity, although much of this expansion has been international, and focused on larger scale (20,000+ liter) capacity drug substance, while Avid plays in the smaller scale (2,000 liter and smaller) arena, and I believe domestic capacity is highly valued due to supply chain concerns.
Avid also has a concentrated customer base, although capacity expansion should dilute this potential problem, and their largest customer Halozyme Therapeutics (HALO) is guiding to more than double revenues over the next few years, which is likely a big reason that Avid Bio is expanding. Still, I think the odds for success here are very favorable, and as I see it, the potential problems with this investment have little to do with inflation, interest rates, or the economy, as long as one can remain focused on the business.
In fact, there is an argument that higher inflation and interest rates and a weaker economy could actually strengthen Avid Bioservices’ competitive position. After all, if the big risk here is that the industry abandons its historic discipline and binges on speculative capacity expansion which could weigh on margins, it seems that reduced access to capital for development stage pharmaceutical companies would reduce the demand for speculative capacity expansion. Additionally, appetite for deploying speculative risk capital into building de novo facilities should decline during periods of tighter money supply and higher cost to build new capacity.
Further, while I feel confident that the pieces are in place for this business to be in a much better place in 3-4 years than it is today, I have no idea what will happen to the stock in the near term. If the broad markets continue to decline, there is no reason that Avid Bio’s stock cannot decline as well. Of particular note, while Avid estimates that only ~5% of their backlog is tied to Covid treatments, the industry may get spooked as Covid treatment related demand rolls off. Further, as new capacity comes online, capacity utilization – and thus margins – will quite naturally dip as it will take time to fill this capacity.
But with the future, normalized, success of this business being tied mostly to their ability to successfully kit out a new building and customers continuing to choose CDMO partners with outstanding regulatory track records rather than unknown upstarts, I think the odds for success here are very favorable.
Should we not have bought shares at ~$12 that I think have a fairly clear path to ~$40 because they might go to $10, or $9 or $8 first? If they did go to $8, all else equal the potential 3-year CAGR as I see it would be ~75%: clearly that would be ridiculously attractive. But should we pass on the potential for a ~50% 3-year CAGR – also ridiculously attractive – that I think has a good chance of happening because we *might* be able to get a 75% CAGR?
The point is that I think it would be a mistake to let the desire for a perfect investment opportunity become the enemy of a very good investment opportunity. It would also be a mistake to fret about inflation, and interest rates, and near-term stock market volatility, rather than to simply believe that if a business can notably improve its earnings power over the next few years, as long we don’t overpay going in, we will be well rewarded despite some market swings in the interim.
There is an enormous amount of evidence to suggest that we are more likely to generate acceptable investment returns over longer periods of time if we simply ride those swings, rather than fool ourselves into believing that we will be able to perfectly time our exits and re-entries in order to avoid the swings.
Avid Bioservices is just one example of the type of business – and the type of investment – that we own. Each of our businesses and investments is different, but each of them is similar in that they all have a unique path in front of them that should allow them to thrive in the intermediate term, and generate acceptable investment returns over that period, regardless of what happens in the near term.
Not all of them will work as envisioned. The only certainty is that I am wrong about something somewhere. But despite some inevitable mistakes on my end, and despite near term price action that may be uncomfortable, I think we will be rewarded with time. As always, patience is the key.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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