2023-10-03 20:45:01 ET
Summary
- Repligen Corporation's stock continues to track lower within its longer-term downtrend.
- Shares trade at 88x forward earnings, Q2 numbers were flat, and FY'23 guidance has been narrowed due to flat momentum.
- The company's economic value is low, and its end markets are undergoing change in the life sciences industry.
Investment summary
Since my last Repligen Corporation (RGEN) publication , the stock has continued to track lower and continues within its longer-term downtrend (Figure 1). The latest investment updates do little, if anything, to change the company's neutral view.
Shares still trade at 88x forward earnings, Q2 numbers were relatively flat, and management has narrowed its FY'23 guidance range on the back of flat momentum this YTD. Added to that, the company's economic value is low, measured as a function of the profits generated on its business investments. RGEN's end markets are undergoing rapid change as well. According to its latest filing:
"As the overall market for biologics continues to grow and expand, our customers – primarily large biopharmaceutical companies and contract development and manufacturing organizations and other life sciences companies (integrators) – face critical production cost, capacity, quality and time pressures. Built to address these concerns, our products help set new standards for the way biologics are manufactured."
Each of these factors will be discussed in greater detail here today. Net-net, the asking multiples to buy RGEN today are beyond my limits, and combined with the thin business returns, I reiterate RGEN as a hold.
Figure 1. RGEN 2-year price trend
Critical investment facts underlining hold thesis
1. Life Sciences market considerations + trends
There are multiple crosscurrents currently impacting the outlook of the global life sciences industry. The global market was valued at $144Bn in 2022, with high growth expectations of CAGR of 10.8% into 2030.
Multiple factors are expected to contribute to this growth:
- Growth of gene and cell therapies, along with breakthroughs in diagnostics.
- Shifting R&D focus to reflect these trends, along with the use of technology.
- Linking both points above, digitalization and integration of artificial intelligence ("AI") to all points along the value chain.
Concerning point (3), automation and AI integration looks to be one key growth lever for the life sciences industry going forward. With reference to manufacturing and supply chains, in its 2022 report on the industry, KPMG asserts that life science companies are increasingly linking up with external providers of raw materials and in production rather than vertically integrating these components. This may be beneficial to RGEN going forward. It also found that the industry is moving its supply chains to segmentation and parallelization. The focus is moving towards digitalization, and that includes the Internet of Things ("IOT"), AI, and other uses of technology to make supply chains "more agile and more sustainable in the future":
There are massive strategic shifts going on within life sciences due to the impact of digitalisation. There’s increasing personalisation of medicines and therapies as life sciences companies explore how medical, clinical, and production data can be used to improve treatment and care. Different manufacturing and supply chain strategies will be needed depending on the volume and level of personalisation.
Certain production strategies, such as for high-volume medicine pill production, will be volume driven and require large streamlined facilities; other strategies, such as for personalised large-molecule therapies, which are more individualistic to patients, will lead to smaller production facilities located in hospitals.
— Caroline Rivett, Life Sciences Leader, KPMG, UK
Figure 2. Note: Figure A shows the current barriers to the life-sciences industry. Figure B illustrates the advantages of AI integration.
Source: Trends in the life sciences industry, 2022, KPMG, see: pp.11 "Manufacturing & Supply Chain"
Figure 2 outlines the current barriers to entry into the industry and where KPMG foresees AI and the like being of benefit. This is supported by research from Deloitte (2023), who surveyed life sciences companies on their planned investments over the coming 5 years, as noted in Figure 3. As you can see, the capital allocation plans are towards automation and AI. How this relates to RGEN is critical. It implies that companies that aren't offering AI or automation in their own processes may be overlooked by those who are. A quick search of RGEN's latest 10-Q and earnings call shows no mention of AI or automation. That's not to say its offerings aren't critical. But, it's something to think about for future industry positioning, and who will attract the capital flows in the coming years.
Figure 3. Survey of capital allocation plans over the next 5 years from Life Sciences companies.
Source: 2023 Global Life Sciences Outlook, Deloitte
2. RGEN's latest numbers
It's worth first noting that RGEN appointed Jason Garland as its new CFO as of last week. Garland came over from Integer Holdings ( ITGR ). It will be interesting to see what value Garland can bring from here.
As for the quarter, RGEN came off a difficult comps period in Q2 FY'23, given the high percentages of COVID-19 revenues in the previous 2 years. It put up Q2 revenues of $159mm, down 13% sequentially and 23% YoY. H1 FY'23 revenue was $342mm, marking a 17% drop compared to H1 of the previous year. The core business revenues were down by ~3% on core EBITDA of $37mm. Critically, gross profit was down ~34% YoY to c.$80mm, with margin compression of 8.5 percentage points from Q2 last year. Given the flat momentum, management "derisk[ed]" FY'23 top-line forecasts, calling for $635mm—$665mm in sales, implying a base business decline of 5%—9% and a total revenue decrease of 17%—21% on FY'22.
As to the divisional breakdown:
- COVID-related revenue in Q2 was negligible, with RGEN booking slightly >$1mm, in contrast to $36mm in '22.
- Cell and gene therapy orders increased by 4%, with revenues up 7% from Q1 this year.
- Product revenue in Q2 and H1 decreased by 23.3% and 17.4% to $159mm and $341.7mm, respectively. This was all due to reduced revenue from its COVID-19 programs.
- I'd also add the book-to-bill ratio for its base business was 0.82 for the quarter and 0.88 for the first half. You want a ratio of >1, to say more orders were received than shipped during the period, so this tells me demand is down. Orders for cell and gene therapy increased by 4% as mentioned. Still, management said there was a sharp "drop off in demand from pharma, which includes biotech, along with a slowdown in orders at the CDMO level after two-quarters of modest gains".
Product mix and shift are one of the core value drivers of any business's sales growth. RGEN has been shifting its mix for the last 7 years. It had moved the focus on direct product sales, targeting the pharmaceutical industry and contract manufacturers ("CDMOs") over this time. Looking at how this has played out since H1 FY'22:
(i). In 2022 : For Q2, direct sales made up 89.2% of product revenue. For H1, it was 88.1% of product revenue.
(ii). In 2023: 84.7% of Q2 product revenues were direct sales, 84.4% in H1.
One of the potential issues I've identified with the direct sales model in RGEN's case is the fact that orders/sales are impacted by scale and timing impacts. This means revenues booked can be very lumpy. Predictability, or lack thereof, is therefore a factor to be considered in all RGEN's modeling.
3. Economic value and valuation
It's useful to see what's baked into RGEN's current market value to make inferences and comparisons.
Firstly, the stock sells at over 88x forward earnings , 13x forward sales, and 81x forward EBIT for a market value of $8.87Bn. Consensus expects $647mm in revenues this year, stretching up to $1.86Bn by FY'28. This calls for 23.5% CAGR in sales over the coming 5 years. Earnings are tipped to grow from $1.08/share to $3.40/share into FY'26, equally as high growth.
Hence RGEN sells at 4.77x its 5-year sales projections (8,870/1,860 = 4.77x) at its current market value. If this pulls through, the company is priced to 2.73x its top line over the coming 5 years to trade fairly at current multiples (13/4.77 = 2.73x). Considering its TTM revenues of $729.3mm, the Street's estimates aren't too far off (729x2.73 = $1.98Bn).
But you'll pay $88 for every $1 of future earnings growth, to capture ~23.5% sales growth alongside a potentially solid bottom line. If market values are a set of discounted expectations, why has RGEN's share price underperformed lately?
In my view, for 2 reasons:
- Sales growth to date has required heavy investment of capital to achieve, (despite a lower growth rate than current forecasts). What this says for forward sales growth is telling.
- As a percentage of capital employed to run the business, the earnings rate has been below the cash reinvested to grow.
(1). Capital-intensive growth
Figure 4 outlines RGEN's value drivers for the last 3 years. Sales have compounded at 7% each TTM period, with stable operating margins averaging 28%. But to maintain its competitive position, each new $1 in sales required $0.93 investment across NWC and fixed capital, $1.63 when factoring all the company's acquisitions. In other words, each $1 in sales growth reduced FCF by $0.93, $1.63 with acquisitions. That doesn't leave a whole lot of cash left to spin off to shareholders at the end of each year.
Moreover, consider the capital investment requirements to hit the consensus numbers from earlier. Should it maintain these current trends, a 23% sales growth rate would demand additional investments of $156–$358mm per quarter, producing FCF of $57–$130mm each rolling TTM period (this excludes any M&A assumptions).
BIG Insights
(2). Low returns on invested capital
The rate of earnings produced on RGEN's capital investments is noted in Figure 5 below (it is split into 2 charts). As you can see, ~$39/share of capital invested in the business produced $2.56/share in trailing NOPAT in Q2, just 6.6% return on investment. This is low in my opinion (we look for 12% as a threshold margin). Post-tax margins and capital velocity are low, 19.6% and 0.34x in Q2 respectively (TTM values). This explains a number of things:
- RGEN's growth since 2020 hasn't been accretive to shareholder value, as the returns on capital required to grow have been below the hurdle rate.
- The company's competitive strategy lacks cost differentiation or production advantages.
- RGEN likely isn't the most efficient compounder of capital as we speak, potentially leading to reduced expectations and ultimately a lower market value.
- Combined, the thin returns on capital means more FCF has to be reinvested to grow RGEN's business, leaving less distributable cash to shareholders. If the value of a firm is the present value of the cash you can draw from it over a time horizon, this is telling.
Each of these factors explains why RGEN's market value has compressed in recent times in my opinion. The market is looking for the best stewards of capital and wants high returns on the investments a firm makes.
Consequently, the asking multiples of 88x forward earnings and 82x forward EBIT are simply too rich for me. The returns on capital aren't there, plus, RGEN's ability to compound sales + earnings whilst maintaining attractive FCFs is questionable. Plus, the company's ROE of 7.3% drops to just 1.7% for the investor being asked to pay 4.3x book value as I write.
I don't have a fair value for RGEN at this stage, as the asking multiples are too high for me even to consider any investment towards the company. The question of opportunity cost immediately presents itself, and there are more selective opportunities available. This in itself warrants a neutral view.
Discussion summary
In short, there are multiple economic headwinds RGEN must overcome in order to attract a buy rating in my opinion. This starts with the economics of the business, which shows RGEN as a low-margin, low-capital turnover entity. The gulf between these low business returns and the high valuations is another neutralizing factor. To pay $88 for every $1 of future earnings without the business returns underneath this doesn't stack up in my investment cortex. The question of opportunity cost immediately arises here. In that vein, reiterate RGEN as a hold.
For further details see:
Repligen: Current Market Values Well Supported, Valuations Are Not, Reiterate Hold