CTLT - Laughing Water Capital - Avid Bioservices: Recession Resistant Cash Flows And ~200% Upside

Summary

• Avid Bioservices is primed to more than double capacity over the next few quarters.
• Perception should change as Avid fills its new capacity and develops into a free cash flow machine.
• It would not surprise me to see fast growing, recession resistant cash flows valued at 20x, suggesting ~200% upside is possible.

The following segment was excerpted from this fund letter .

Avid Bioservices ( CDMO )

Avid, our large molecule, small batch, domestic Contract Drug Manufacturing Organization, should be familiar as CDMO was a meaningful position in the portfolio for several years before I reduced it late in 2021. Following a steep decline in price, I re-purchased shares earlier this year, and for a few months I looked brilliant as shares quickly rallied. However, more recently shares retreated once again. The decline was sparked by cautious comments out of Sartorius AG ( SRT.GR ), a provider of picks and shovels to the biologic CDMO industry, and the decline was made worse by a guidance cut by Catalent ( CTLT ), a larger CDMO with a focus on biologics. Avid Bio was thrown out with the bathwater, and when CDMO reported that backlog “only” grew 23% in fiscal Q2’23, shares fell further despite the fact that CDMO actually raised guidance.

In my view, this recent sell off is just noise.

Reading past the headlines from SRT.GR and CTLT reveals that weakness at both of these companies is mostly tied to the rolling off of Covid vaccine manufacturing, centered in Europe, and/or related to divisions other than biologics. Of course, CDMO does not have European exposure, has zero Covid business, and is not exposed to other verticals such as OTC health supplements that are more directly tied to consumer spending.

As for CDMO’s “disappointing” backlog growth, over the years that we have owned CDMO backlog has been consistently lumpy on a quarterly basis, and the Company has consistently outperformed over longer periods of time. Management took pains to note that a few days difference in timing can result in big swings to backlog, and further noted that in the past when new capacity came online, backlog jumped higher almost in lockstep.

I am reading tea leaves here, but with an additional $100M of capacity coming online in calendar Q1’23 (vs fiscal ’23 guidance of $150M in revenue), it is at least curious that management would remind investors that in the past capacity expansion has led directly to jumps in backlog. An additional ~$150M of capacity should come online in the summer of 2023. Moving past tea leaves and on to facts, the Company also noted that Process Development revenues grew 74% YoY and 37% sequentially.

In my view, while backlog should not be completely ignored, the real leading indicator in this business is Process Development. Process Development is essentially when a customer comes and says, 'lets run some super small batches to make sure we have the process down, and when we know that the process is sound, we will start to run bigger batches.' In fact, according to management, Process Development revenue is typically ~15% of the total amount a customer will spend with CDMO, which again suggests that CDMO’s new capacity will be filled rather quickly.

Regardless of quarterly lumpiness, earnings power at CDMO is highly likely to improve in the intermediate term. As mentioned above, revenue capacity should be somewhere around $400M by summer of 2023. This increased capacity is intended to meet huge secular tailwinds as drug development is increasingly focused on large molecules, with more than 5,500 biologics awaiting FDA approval at present. Further confidence can be gained by recognizing that historically industry capacity has not been added on spec. Rather, capacity is typically added when existing and potential customers ask for it based on their own pipelines. Examining the pipelines of CDMO’s existing customers such as Halozyme ( HALO ) seems to suggest that this fact pattern has been playing out at CDMO.

To be clear, I cannot tell you with any certainty how long it will take to fill CDMO’s new capacity. While I believe they have a distinct competitive advantage due to their impressive and long-standing regulatory track record, they are not the only industry participant adding capacity. Additionally, it is possible or perhaps even likely that a more difficult fundraising environment will slow the cadence of work from development stage biopharma companies. However, when this capacity is filled CDMO should be able to generate somewhere around $120M in steady state FCF, versus a current market cap of ~$850M.

As the Company grows into its new footprint, perception should re-rate dramatically higher as the Company will be more predictable, have wider margins, and generate cash rather than consume cash. Further, the Company will maintain tremendous strategic optionality. They could choose to expand further organically, they could become an acquiror, they would be an attractive target for larger players, or they could return capital to shareholders. This optionality will likely lead to a higher multiple for CDMO, but if we assume 20x steady state FCF is conservatively the right multiple for a fast growing, recession resilient business, then shares would trade ~200% higher than they do at present. Whether it takes 3 years or 5 years to reach that point, we should be happy either way. If I am wrong, and CDMO falls short of filling their pending capacity additions, the margin of safety is wide enough that we should still do ok.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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