EBS - Emergent BioSolutions: Q3 Numbers Leave Work To Be Done

2023-12-18 02:51:34 ET

Summary

• Emergent BioSolutions stock has a call option-like structure to it and trades as an equity stub currently behind a high debt load.
• However, business performance may be improving into the important Q4 period, with results coming in February 2024.
• If historical performance can be regained, then shares are attractively priced at current levels, even assuming material dilution.
• Still, the shares could be worthless if profitability does not materially improve and debt holders are reluctant to waive covenants.

Emergent BioSolutions ( EBS ) is a pharmaceutical supplier primarily to the U.S. government providing anthrax vaccines and other medical countermeasures. They also have an over-the-counter Narcan product for opioid overdose reversal. Lastly, they have a loss-making CDMO business, which did well with Covid vaccine contracts, but now has an oversized cost base. The company is distressed today due to high leverage as operating profits have declined. Still, I find an expected value of 5x the current price, based on a very high chance of equity wipeout against a call option style return if things go well. EBS stock is trading as an equity stub behind a high debt load.

In my view, the key variables to evaluate this stock ( note I last wrote about this stock in August 2023 for further background ) are the following:

• What is the medium-term enterprise value assuming no covenant breach and a return to 'normal' performance?
• What is the probability that the company breaches covenants in early Q2 2024 or otherwise can't regain historic performance?
• What is the likely scope of equity dilution over the next 12 months?

I believe with this framework we can estimate the attractiveness of the stock to investors. As the above framework implies, this is also a risky situation, so we should be looking to achieve a return that provides compensation for the elevated risk.

In summary, there is the potential for material equity upside here if the company can regain historic operating performance without enormous equity dilution. However, with lackluster 2023 results so far, that window is narrowing.

Medium-Term Enterprise Value

Looking back, the company made exceptional CDMO profits during the pandemic as it had vaccine manufacturing resources, which were scarce and highly valued at the time.

Plus they have subsequently sold their travel-vaccine division, though that was roughly break-even as R&D efforts broadly cancelled out profits there. Therefore, with those adjustments historic profits have been the following:

Clearly, historic numbers have been volatile (and note that super-normal pandemic CDMO profits are entirely removed), but the company has shown an ability to generate operating profits assuming it can normalize its CDMO business to break even (not a certainty). With underlying operating income of $48M to $395M on a 10x multiple that suggests the following valuation at current levels of net debt (from Sept 2023).

This shows the opportunity but also the risk for EBS. A return to government medical countermeasure purchases at historic levels and running the CDMO at breakeven (rather than loss-making) could lead to attractive equity returns. However, if the business isn't turned around, maybe the equity is worthless.

Chance Of A Covenant Breach In Q1 2024

The company is required to be under 4.5x leverage (as a simplification for covenant tests), with $779M of net debt that requires EBITDA of over $173M. Guidance for 2023 EBITDA is for -$25M to +$75M as of Q3 2023. That's clearly nowhere close, but Q1 2023 was terrible seeing an unusually high EBITDA loss of -$100M. A normal Q1 could deliver maybe +$25M of EBITDA for a +$125M swing from Q1 2023. Therefore, for the April 2024 covenant test EBITDA could be $100M to $200M on a last 12 months basis. This suggests EBS is likely to trip covenants in early Q2 2024, with perhaps a 75% chance of this occurring.

Equity Dilution

Lastly, the company must raise $65M of debt or equity ($75M less $10M already raised). I assume this will be equity given the current state of affairs. Current pricing suggests that they raise this at around $2/share, so that's 32.5M additional shares for a total share count of 85M.

Resulting Valuation

So putting it all together for the equity to have value the company must be able to return to historic medical countermeasures performance, rightsize the CDMO cost base, and either avoid a covenant breach or have favorable discussions with debtholders.

These are all somewhat related, but first, let's look at the core valuation assuming the company makes it through the covenant tests:

From the analysis above we have an equity value of $1.3B-$3.7B if historic performance can be regained and CDMO runs at break-even. That's an equity valuation of $2.5B now assuming 85M shares out after dilution gets us $29/share . Clearly, that's a massive premium to the current price and there are good reasons why Mr. Market doesn't offer anything close to that price today.

Now let's look at the steps to get there. There's maybe a 25% chance the company can avoid a covenant breach based on strong Q4 and Q1 numbers. This is a tall order, but not impossible.

Next in the 75% scenario where covenants are breached, there's likely a 60% chance debt-holders are friendly and permit another ~12-month waiver and the company rebounds in 2024. However, similar to the last waiver, I assume that if debt holders tolerate another waiver they ask for a $100M equity injection from equity. This would increase the share count another 50M (@$2/share) for a total of 135M shares out or a $19/share equity value. Then in the 40% case, for simplicity, the debt-holders wipe out the equity (clearly, there are lots of interim scenarios here).

Lastly, there's a chance that whatever the debtholders do, the LTM performance is the 'new normal' and the equity is impaired regardless.

Here's what that looks like in a probabilistic sense:

This suggests that the valuation of EBS is more like a call option, with a 48% chance of wipeout and a 52% chance of seeing a positive return. Of course, take these numbers with a heavy margin of error.

If there is a 25% chance of a $29/share value and a 27% chance of $19 then that's a ~$12/share equity value . Though we should also demand a discount to that value for the material risk and uncertainty here. Let's consider the catalysts that are needed to achieve a favorable outcome.

Catalysts

Basically, they need to avoid a covenant breach or deliver sufficiently improving performance that debtholders are less concerned, in broad terms this requires:

• Robust Q4 performance of around $50M+ in EBITDA, which would be the top-end of recently reduced guidance
• Strong Q1 performance of $25M+ EBITDA in what is typically a seasonally soft quarter
• Ability to raise $60M of equity at or above $2/share (this in part requires some strength in the share price, which may be possible if Q4 results in late February 2024 are robust)

Also, though the above appears a challenge, as of a November 2023 announcement the government is procuring $75M of anthrax countermeasures between Q4 2023 and Q1 2024 which is a potential positive and should help margins given roughly 50% gross margins on sales of medical countermeasures.

Other Intermediate Scenarios

In addition to the above analysis, there are various other 'intermediate' scenarios too. Here are some in no particular order, and more for illustrative purposes as a lot of assumptions are required:

• The business is acquired at maybe a 50% premium to the current equity price at $3.50/share. Debt-holders would almost certainly push for this assuming the buyer has a strong balance sheet, but it would cap potential upside for equity holders. An acquisition could come from a business with an interest in the over-the-counter Narcan product or one that wants to expand its pharmaceutical relationship with the U.S. government. The total enterprise value here would be around $1B (most of it debt) so it would be possible for another pharma company to do this transaction.
• A hedge fund (or similar) could come in with a debt/equity package that helps deal with the debt issue but at high equity cost. For example, an investor could offer the company $50M in exchange for 50% of the equity in the business. This would help address near-term debt issues, although high leverage would remain and would likely cap the equity return for investors. This scenario isn't too different from the waiver negotiations with the banks or the company's need to raise equity on the open market, in that a lot of dilution would occur but with a different counterparty.
• The company could sell its CDMO business or its Narcan business. In both cases, there are reasons to keep these with the core medical countermeasures business, generally because the manufacturing processes are similar. Plus, I imagine the business has already looked at selling certain CDMO sites and struggled to get a fair price. Selling the Narcan assets could be interesting, though of course, this business has only recently launched, making it harder for a buyer to gauge medium-term sales, and if it does well others may choose to compete on over-the-counter Narcan. The fact that EBS already sold its travel vaccines assets suggests it has already investigated which assets could be sold without much interest at reasonable prices.

The challenge here is that without a permanent CEO and without a board that has much skin in the game in terms of equity ownership, they may be tempted by an offer that helps to address the high debt, but eliminates or severely reduces the prospect of an equity return.

'Creating' The Current Price

It can also be an insightful exercise to see what the current price implies. The current equity value is $120M behind approximately $800M of net debt. That's an enterprise value of approximately $920M. An average pharma EV/EBITDA multiple is 11x-12x so that would imply that the market sees the company delivering roughly $75M-$85M of EBITDA on a normalized basis. That's the top end of guidance for 2023, but maybe not a stretch for 2024 assuming CDMO losses are contained and government medical countermeasure purchases continue at a steady pace. However, this sort of analysis is less helpful when the company faces material going concern risks, as EBS likely does.

Risks

The risks here are obviously significant. Clearly, the equity valuation is pricing in a high chance of business failure or major dilution. These are very real risks that could cause the equity to be worth zero.

• The company will likely fail its covenant test in April 2024 and the debt-holders may demand additional equity be raised or take ownership of the business.
• Business performance has been weak in the CDMO segment, if costs cannot be controlled, the segment may continue to consume profits from elsewhere in EBS.
• Government procurement of medical countermeasures has been relatively weak in 2023 to date. It's unclear if this is more of a temporary timing issue, or a structure chance to the government's procurement plan. For example, the government may believe it can extend the useful life of its current stock of countermeasures, limiting the need for new purchases.
• OTC Narcan, which the company launched this year is performing well, but is materially lower margin than medical countermeasures, hence growth in Narcan is unlikely to replace any weakness in medical countermeasures.
• The company's management is in flux, the CEO recently departed and the company currently has interim management in place. This could weaken business performance.
• As one positive risk, the company is currently likely in arbitration with Jannsen. Jannsen had an agreement to use EBS for Covid vaccine manufacturing. EBS will argue they weren't paid by Jannsen, in part as Jannsen's Covid vaccine was not as commercially successful as hoped, but that was not EBS' problem. Jannsen will argue for potential problems with EBS' manufacturing process as a reason not to pay EBS. The amount at issue here is about $120M if EBS were to be successful, which appears unlikely, though the details of the case are hard to fully assess. In addition, EBS estimates any payment here to be at least a year away.
• The general environment in fixed income markets will matter too. If interest rates increase or remain at high levels that will be a further drag on EBS, but if rates decline in 2024 that may support the investment to some degree.

Conclusion

EBS is a risky situation. Equity investors could easily see a total wipe out and EBS is basically an equity stub at this point. That said, results should be monitored because positive newsflow here given the call option-like structure of the investment could present attractive returns if things go well. Remember this is a business that sells medical countermeasures to the U.S. government often at 50% gross margins, and overall demand here should be relatively steady.

To get to the current price one must assume very high equity dilution and make what I believe are pessimistic EBITDA assumptions going forward. These assumptions seem punitive and at odds with historic operating results. Equity dilution on the scale the market may be assuming is not planned and operating results in 2024 could well outperform 2023 guidance if history is any guide.

However, I must acknowledge that the window of opportunity for EBS is narrowing and the company must achieve strong Q4 results (expected late February 2024), without this, further share price weakness may make raising additional equity capital challenging and, in addition, mean the business falls well short of the April 2024 covenant. The lack of a permanent CEO is also a concern. Outcomes for equity investors may rest on how negotiations with debt holders go.

Still, the share price may be underpricing positive developments, since a rebound in operating performance in 2024 seems likely. As a result, EBS is, in my view, potentially attractive on a speculative basis, if sized cautiously and monitored carefully. There is a high chance of total equity wipeout, but the upside scenarios are appealing too should Q4 2023 and 2024 trend well.

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