EBS - Emergent BioSolutions Is Clearly Risky But The Reward Could Be Substantial

2023-08-23 09:22:46 ET

Summary

• Emergent BioSolutions is facing equity issuance and significant debt covenants in Q1 2024, but at its core, this is a robust pharma supplier to the U.S. government.
• The underlying value of the business is likely in excess of the price, even taking account of probable dilution, and debt covenants can likely be met on 2023 guidance.
• If the company can deliver on expectations over the coming months and into 2024, then returns for equity holders could be substantial, with $35/share possible.

I want to love Emergent BioSolutions (EBS), at its core, it's a great business with impressive pharma assets. However, for now, there's risk that debt covenants may eliminate the equity value of the business. EBS is extremely likely to sell further equity causing dilution. I was hoping for more from the company's Q2 numbers, but guidance came down. Still, though there is clear risk in the name, there's a price for everything and the current price of EBS may be attractive on a risk/reward basis, though the risk of losing money is real and this is a position that should be sized appropriately and closely monitored for news flow. If the business can make it through this difficult period, then a price of $35/share is potentially achievable.

Bad News

EBS has sold off and virtually maxed out its revolver leading to tense negotiations with the secured lending group led by Wells Fargo earlier this year. Debt covenants will resume in April 2024 after a recently agreed waiver. The company is now on its second round of cost cuts, management has changed and as a government provider, product sales are at best lumpy, but potentially declining. In Q2 guidance was cut by the interim CEO.

The Major Problems

In my view, EBS has three problems in rough order of importance:

1. Their CDMO (Contract Development and Manufacturing Organization) business was great during the pandemic. Lots of companies needed to sign-up capacity for vaccine production, and EBS was one of the few companies that had the facilities to produce at scale. They signed up Janssen and AstraZeneca among others. However, CDMO revenue has fallen back to around pre-pandemic levels and their cost base is still inflated, plus certain of their CDMO assets were criticized in FDA inspections. Now this segment of the business is bleeding cash as they have inflated costs and very little revenue, investments to address issues found by the FDA did not help. They have done two rounds of cost cuts at this point, but the segment is still losing money. It seems the right actions are being taken and the business is no longer a strategic focus, for now, but still, there's a way to go until costs are right-sized in the CDMO segment.

2. Acquisition of TEMBEXA, this business was a clear strategic fit, but the deal arguably came at the wrong time, contributing to already rising debt levels.

3. Government purchases are lumpy. This means that equity investors looking for steady quarterly revenues don't always see it from EBS. Also, ironically, the pandemic may have adjusted the government's focus slightly from the risks of anthrax and smallpox, where EBS does very well in terms of providing medical countermeasures, to other risks that the pandemic surfaced (vaccine delivery innovation, protective equipment, influenza, coronavirus countermeasures etc.). I believe their core business is fine as other biological threats such as anthrax and smallpox remain, but ironically, the pandemic didn't necessarily help.

Robust Core Business

Nonetheless, EBS is a strategically important pharmaceutical supplier to the U.S. government, which is trading at a substantial discount to ongoing fair value (debt issues notwithstanding).

Then this core business is complemented by a multi-site CDMO for producing pharmaceutical products for others or internally, rights to NARCAN nasal spray used for opioid reversal with an Over the Counter (OTC) launch in process, as well as some international contracts and milestone payments related to a recent disposal potentially coming in 2026 or so.

Debt Troubles

As of Q2 2023, which maps to the calendar quarter, EBS has $815M of net debt and is forecasting $50-$100M of EBITDA for the calendar year 2023 implying 8.2x to 16.3x leverage for 2023 if guidance falls within management's estimated range. Not pretty. In contrast, debt covenants, after recent negotiations to currently waive them, require 4.5x leverage for the quarter ended March 2024 and 2.25x debt service coverage. That might seem like a pipe dream on management's current guidance, but remember Q1 2023 was a terrible quarter and will roll off before the covenant test occurs. That makes hitting the leverage target much easier.

Lastly the company, per debt covenants, must raise $75M of equity or unsecured debt by April 30, 2024. Currently the company has a $150M ATM in place and has sold just under $10M of equity as of Q2 reporting, so further share sales, and therefore more equity dilution, could come soon (if not already).

If that weren't enough, add to that the resignation and untimely death of the Executive Chairman and co-founder of the company in 2022, and the CEO retired effective immediately as of June 2023 leaving a management consultant and board member as interim CEO. The company received two unfavorable FDA site inspections of their CDMO facilities and lucrative Covid contracts for their CDMO facilities rolling off and you can see why the market has concerns here.

But the core business is likely robust, underpinned by decade-long government contracts. Whether equity investors get to see the returns from that business is an open question.

Medical Countermeasures

EBS has developed, partnered or acquired rights to many crucial countermeasures that the U.S. population and military potentially faces such as anthrax and smallpox. The U.S. maintains a Strategic National Stockpile of these countermeasures so that potential threats, such as bioterrorism and other risks leading to accident or intentional releases, can be rapidly countered with vaccines and antivirals on hand, with some of these forward-deployed close to urban centers. This is, in part, based on the BioShield Act passed by Congress in 2004 and subsequent legislation. This was in response to the 9/11 terrorist attack of 2001. Whereas with Covid-19 there was a rush to develop a vaccine, with anthrax and smallpox, were an event to occur the U.S. maintains a stockpile of existing vaccines and therapies, so then it's more a question of distribution than manufacture should an emergency occur. EBS is a primary supplier.

This creates an attractive business, in order to maintain a stockpile of hundreds of millions of vaccines and meet military needs, the Department of Health and other government organizations will typically make relatively regular purchases from EBS often underpinned by multi-year contracts. This keeps the stockpile up to date as older vaccines expire or become outdated, such as a vaccine exceeding its shelf-life or a two-dose vaccine being replaced by a single-dose vaccine.

This ongoing engagement also ensures that the U.S. maintains a robust domestic supply chain for development of important countermeasures. For example, during COVID-19 EBS was able to partner with AstraZeneca, Jansen (then Johnson & Johnson) and others through their CDMO services to enable those firms to scale-up production of their vaccines. EBS's primary products are countermeasures are anthrax and smallpox, which are the largest elements of the Strategic National Stockpile's budget but EBS also has countermeasures for botulism, ebola and nerve and chemical agents.

High Leverage

How did debt become so high? There are two main reasons. In September 2022, EBS paid an initial milestone of $238M to acquire a smallpox antiviral (Tembexa) and during 2022, the CDMO business saw Covid-19 vaccine production contracts roll-off leading to a $150M annual loss as costs remained while revenue fell off. Losses continue, but EBS has recently taken two rounds of restructuring to attempt to right-size the business.

As an aside, the growth in debt from their 10-K is almost comic.

In addition, government procurement is somewhat unpredictable and an expected purchase of smallpox vaccine in 2022, did not occur, though purchases have resumed to some degree in 2023. Of note, government procurement here may be a mess, the Government Accountability Office released a report in October 2022, criticizing the procurement processes of the strategic national stockpile. This may imply that the apparent missed purchase was potentially due to poor administrative processes rather than any change of direction for the national stockpile.

Also, it's worth noting that although the revolver and term loan holders have increased the effective interest rate to 11% and imposed restrictive covenants, the company also has $450M of unsecured debt costing under 4% due 2028, so assuming the company can get its revolver balance back to reasonable levels, then debt levels and interest payments become more manageable and less onerous fairly quickly.

CDMO Issues

The CDMO issues focused on two of EBS' facilities. In one there was a mix up with AstraZeneca and Jansen vaccines that was clearly unacceptable, and likely a result of the rapid scale up of vaccine production during Covid.

A second issue occurred more recently, where the FDA found primarily that one of EBS's sites had excessive wear on metal trays used in the production process, due in part to a sub-standard inspection process for the trays, leading to some evidence of metal contamination in the products. Given the trust placed in CDMOs there is of course zero tolerance for errors here, but the issue is fixable and being addressed by EBS. Also, where external demand for CDMO production is lacking, EBS is able to repurpose some of the CDMO assets for internal product production.

Management is in flux with the death of the Executive Chairman and co-founder in 2022 and the recent resignation of the CEO in June 2023. However, this is a relatively straightforward business to run, underpinned by government contracts and the interim CEO has announced plans to take out further costs.

Stock Overhang?

Of note, the executive chairman who died in 2022, previously held 9.7% of the equity. Though it is unclear how his estate has been managed as of the latest proxy there were no 5% holders (beyond BlackRock, State Street and Vanguard) and so it's possible that liquidating the former executive chairman's material equity holding has created an overhang for the stock over the past 12 months in addition to operational issues. Plus of course, the likely sale of stock over the coming months via the ATM does not help.

OTC Narcan

EBS will launch OTC Narcan very shortly. This nasal spray can counter the effects of an opioid overdose and may be an important channel to help address the American opioid epidemic, which does not seem to be improving. EBS is, in some sense, meeting the needs of the government here, who are actively seeking to broaden the availability of inexpensive NARCAN and so this initiative in addition to being profitable may help underscore the relationship between EBS and the U.S. government in addressing medical threats.

Covenant Targets

The company needs to produce, on my estimates, approximately $150M of EBITDA from Q2 2023 to Q1 2024 in order to avoid tripping debt covenants (I'm also assuming that debt comes down by $75M from share issuance and $75M from internal cashflow assuming 50% EBITDA conversion to FCF). Note that covenant target is not based on the calendar year, but effectively omits Q1 2023, which is helpful as Q1 2023 was a terrible quarter for EBS.

Here's what EBITDA for the purposes of covenants could look like.

That results in adjusted EBITDA of $202M to $252M.

This may be achievable assuming the government purchases of medical countermeasures continue, the launch of OTC NARCAN is somewhat successful and restructuring of the CDMO takes out costs to right-size the business closer to pre-Covid levels. It's relatively rare to see a quality pharmaceutical business deal with debt covenant issues and it seems these issues could be resolved by EBS. That's because pharma businesses during good times can throw off cash for debt paydown.

Blue Sky Valuation - $35/share

In subsequent years, EBS should be able to control costs at its CDMO business resulting in $250M of annual EBITDA (similar to pre-pandemic levels) and reduce debt to $500M or less through proceeds from internal cashflow and the planned equity raise. On a 12x EV/EBITDA multiple, which appears reasonable for a high-quality pharma business, that's $2.5B of equity value. Of course, a share sale is likely, which could increase the share count to perhaps 70M (from 50M today), but that would still produce a value per share of $35/share, representing a potential multi-bagger from the current price.

Summary Valuation

The below scenarios give a weighted average outcome of just over $22/share. Though there is a material chance of loss.

Basically, I have to say I don't think that the company will trip debt covenants unless something changes. Though I do think equity issuance will bring down the valuation from previous highs. For reference, the stock traded at $50 pre-pandemic and over $100 at times during the pandemic in 2020 and 2021.

But I do think at the current price of around $4/share concerns are overdone unless we do get more bad news with Q3 and Q4 results. Essentially, the business trades at around 4x EV/EBITDA today.

Backing To The Current Price

Now let's try and create the current price as a going concern. Let's assume debt stays at around $800M and assume they raise $75M issuing shares at $4/share for a share count of 69M (from 50M today). Then at the current price of $4.50/share that's an EV of $1,111M, given that normalized pharma multiples are around 12x in the U.S. today, that suggests normalized EBITDA of $92M or so.

There's a nice summary of historic metrics here , but aside from the current results caused by heavy CDMO losses, the closest I can get to that normalized number is 2018 when EBITDA was $152M, or 65% higher than what the market is implicitly estimating. Plus at most levels of estimated EBITDA for the business they should be able to start paying down debt materially over the coming quarters, hence corresponding increasing the equity value.

Catalysts

A thesis with such a broad spread of outcomes ($35 to $0) can be hard to assess, so here's what I will broadly be looking for to confirm that the business is on a positive trajectory, or conversely if not met, confirm that a $0/share outcome is increasingly probable:

• Q3 results early November 2023 show EBITDA comfortably above $50M and ideally north of $70M with CDMO costs contained and clear positive cashflow used to trim debt
• Q4 results in February 2024 cement the upper end of EBITDA guidance of $50M-$100M for the full year (remember that includes a terrible Q1) and 2024 EBITDA guidance is $200M+, debt comes down compared to Q3. Narcan OTC launch is not a disaster.
• By April 2024, reinstated covenant tests are met and $75M of capital is raised at reasonable average equity prices to avoid massive dilution (i.e. $4/share or higher) there is a clear path to move total net debt below $500M before the end of calendar 2024 based on FCF. 2024 guidance for Anthrax and smallpox countermeasure sales (if provided) are similar to prior years i.e. not less than $400M combined.

Conclusion

EBS is an interesting set up that's worth monitoring for its substantial upside potential. If current guidance can be met, it signals a strong end of 2023 and Q1 2024 is unlikely to be as bad as last year. That should enable the business to avoid debt issues and even pay down expensive revolver debt materially by late 2024. Of course, material equity issuance may weigh on the stock over the coming months, and further operational missteps whether from lack of government purchases or a failed OTC Narcan launch could cause the company to trip equity covenants.

Still, I view the setup as quite favorable at current price levels. If the business can get through the next 6 months, then the CDMO should cease to be a drag on profits, and the value of the medical countermeasures and Narcan businesses should shine through. These are attractive assets and when not over-leveraged are attractive, stable businesses for equity holders with formidable cashflow generation and relatively high predictability. They should command a premium valuation, but debt issues need to be overcome first.

Risks

• I'm not a technical analyst, but the technical setup here is pretty awful and you are catching a falling knife, there are potentially less risky entry points in the future
• The company is very likely to issue shares over the coming months and has already sold shares this year
• Further operational missteps could trip debt covenants
• There may have been a structural change in the government's purchases of medical countermeasures after the pandemic as priorities shift leading to structural decline at EBS
• Costs of the CDMO assets may continue to weigh on profits
• The Narcan OTC launch may be unsuccessful
• Given the setup here there is a risk of a "take under" in that the business is acquired for less than its underlying value and returns to equity holders are prematurely capped

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