Emergent BioSolutions: Deep Value Play With 33% Upside & Military Exposure (NYSE:EBS)


Investment Thesis

We view Emergent BioSolutions (NYSE:EBS) as a strong contender for Covid-19 exposure alongside key exposures to military defence and infectious disease. The company has global niche in biopharmaceuticals, where is holds key differentiators in therapies that protect against public health threats.

Within the portfolio are vaccines and medicines that address a suite of infectious disease segments, including travel-related pathologies and bio-agents. EBS is perhaps most insulated by vaccination production for the bio-threat anthrax. Most importantly, this includes BioThrax, the only FDA approved anthrax vaccine, alongside raxibacumab, a treatment for the same. This gives the company direct exposure to the US federal agency segment, particularly in military defence. The portfolio also includes the drug Narcan, which is the gold standard in reversal or opioid overdose. Also included in the portfolio include the smallpox vaccination ACAM2000, alongside Vivotif and Vaxchora, indicated for vaccination against typhoid fever and cholera, respectively. EBS also has a large contract manufacturing and research development segment, that strengthens the bastion around the company and top-line earnings potential.

We believe the company is well positioned to competently execute current operations whilst leveraging its niche operating model to Covid-19. Contrary to other companies who have reversed guidance this year, EBS have upgraded guidance for 2020 from Q2 earnings. Furthermore, management are of firm belief organic revenue will expand to $2 billion by year 2024, in line with their growth vision over this period. Better than expected contract manufacturing YTD has bolstered this perspective, in our view. Furthermore, EBS were able to mobilise swiftly in developing their own coronavirus treatment candidates, whilst also linking contract development and manufacturing expertise to large biotech players like Johnson & Johnson (JNJ) and AstraZeneca (AZN). Whilst doing so, the company has maintained government service capacity, including key government clients this year. This highlights the strengths in EBS’s exposure to contract manufacturing, and really illustrates the solid positioning of the company’s portfolio in contrast to the coronavirus pandemic.

As such, shareholders have enjoyed around 80% in returns YTD, albeit with downside exposure since early August. Nonetheless, investors have been rewarded adequately for this exposure, with a Sortino ratio over 1 since this period. We believe investors should factor this number in moving forward, as it highlights how the stock holds up during periods of downside volatility.

Fundamentally, the company has demonstrated consistency in growth over the 3-year period to date. Revenues and EBITDA have grown at a CAGR of 124.5% and 600%, respectively. Such tremendous growth volume stems on the back of product sales growth and contract manufacturing, alongside government contract strength over this time period. Margins have remained healthy to date, most recently at 64.8% gross and 30.1% EBITDA on TTM values. We view little margin pressure over the coming periods. The company has several key developments in the pipeline, with additional revenue expansion planned on the back of a small increase in capital expenditures by year 2024, as purported by management. We are cautiously bearish on managements guidance of $2 billion in total revenues by 2024 in our base case, seen below. However, we believe that in the blue-sky scenario, the company will reach closer to this number, contingent on Covid-19 partnership success, amongst other factors.

We anticipate revenue growth of around CAGR 6% by 2024 in the base case, with just over 10% in the blue-sky scenario. We view this alongside CAGR of 23% in FCF over this same period in the base scenario. This represents tremendous value creation for shareholders in our view, and aligns with managements narrative to generate strong returns from developments in the pipeline. FCF has been strong to date, with 4.76% FCF yield, and the company has around $1.76 FCF per share, plus around $2.96 EBITDA per share.

ESB Key Statistics & Author’s Forecasts, base case (Annual):

Data Source: EBS SEC Filings; Author’s Calculations

ESB Key Statistics and Author’s forecasts YoY (Quarterly):

Data Source: EBS SEC Filings; Author’s Calculations

Equally as impressive has been high returns generated on invested capital this year. We were impressed with EBS’s Q2 performance, which saw ROIC reach over 10%, alongside high ROA of 7.11% in this period. This is in addition to the company generating ~$-0.53 for every dollar invested into increasing the asset base. We believe this further underscores the strengths in EBS’s key operating segments, most notably in government contracts and contract manufacturing this year. Key alliances with JNJ ad AZN have undoubtedly propped these figures up, also. This, alongside resilience in the wake of the pandemic, also gives investors insights into EBS’s positioning within the market segment, as a trusted and preferred provider of key services to large players. To illustrate, EBS signed a $135 million tech transfer and capacity reservation agreement back in April with JNJ. Expanding from this, the company then signed the very first Covid-19 commercial supply agreement, again with JNJ, for their Covid-19 vaccination candidate. This is a 5 year arrangement, which will deliver EBS around $480 million over the first 2 years alone.

Data Source: Author’s Calculations

On the charts, returns have progressed within an ascending channel since the selloff in March. From then, support has been consistent until today’s trading, and the stock has bounced away from longer-term support line 2 times. We can see a large breakout at the end of July, right at the date of the 10-Q release, where prices hiked to a high of $137 on the back of the positive news. Since, prices have corrected back towards the support line, where they currently lie, awaiting the next moves. This comes on the back of murky guidance from a Covid vaccine candidate, in our view. Speculators likely will continue to allocate capital pre-emptively in the hopes of a successful candidate, on the back of any whisper.

We believe EBS needs to find its range from here, as there seems to be a battle between the bulls and bears to regain control. Upcoming catalysts include the Q3 earnings report, which may provide the strength needed in order for the stock to regain support. Longer term investors should view the upcoming weeks carefully, to understand the next moves for the stock. Should the earnings be strong, then we are confident that the stock will rebound from support once more, and continue within the channel shown below.

Notice the ascending channel and price correction in August backwards the support floor, on the chart below.

Data Source: Author’s Bloomberg Terminal

We can see that the shares entered into overbought territory past the RSI 70 line during the consolidation that occurred in July/August. This supports our thesis that speculators got ahold of the stock, and drove the underlying price upwards in the hopes of securing a position early on the vaccine news. Investors can read up more on JNJ’s story on this so far, to gain further insight. However, since the correction back towards the support line, we’ve observed the shares remain within healthy RSI ranges of late, where market is currently deciding a range for the stock’s next moves. We can see evidence of this on the charts below, where the correlation in the RSI movement and stock price can be clearly observed.

Data Source: Author’s Bloomberg Terminal

These moves have occurred on the back of volatile momentum, which has fallen off over the last 2 months. We feel this will reduce volatility dramatically, especially if the trend continues its steady climb north. We can see the direct correlation in momentum speed and EBS price returns below, as is often the case in equities. Where we see momentum gain and fall rapidly, we can expect to see price move proportionately to this. For longer-term investors, this information is critical in understanding entry and exit points, or when making decisions about trimming a position. For EBS it seems, in view of this correlation, that investors should look to enter when momentum is gaining and trim positions when momentum has slowed. For those holding EBS in portfolio’s, we advocate to keep a close eye on the RSI and momentum indictors, to assist in reasoning for rebalancing and tactical allocation protocols for the stock.

Data Source: Author’s Bloomberg Terminal

We can also see the above returns YTD on the back of high volatility to the downside. Considering the sharp pullback to today’s trading, this is essential for investors to consider when holding EBS. Fundamentally, much remains unchanged for the company, however, the markets view is equally as important for investors. Although it seems shareholders have been rewarded for exposure to this downside, as mentioned earlier in the article, the magnitude and volume of the downside in returns is a risk that must be priced into the valuation. Further, it is a risk for investors holding EBS in portfolio’s, who would see adjustments to their risk-adjusted returns over the holding period. We would advocate investors consider the level of downside volatility that has been apparent for EBS this year, prior to making an immediate entry. Further evidence of the stock’s next moves will be priced in at the Q3 earnings release, which we look forward to covering for the benefit of all.

Data Source: Trading View EBS

Valuation

We appreciate Q3 earnings are just around the corner, where the valuation will be updated. However, investors can view the snapshot of our DCF modelling below. We have assigned 2 potential models for each scenario: one using the opportunity cost of holding a risk-free treasury plus the index as the proxy for the discount rate; the other using EBS’s WACC calculations for the hurdle rate. Our base case assumptions and inputs for the FCFE valuation are shown below.

Model 1, Opportunity Cost as hurdle rate, Base Case:

Data Source: Author’s Calculations

Model 2, EBS WACC calculations as hurdle rate, Base Case:

Data Source: Author’s Calculations

In either base case, we see a clear value gap to the upside for the intrinsic value of EBS. We’ve manipulated the inputs for the benefit of investors, to gain insight into the range of possible fair values for the stock. In any case, we see value here, where the market has yet to price in many of EBS’s key pipeline developments, including their strong positioning in a seemingly undervalued contract manufacturing segment. With this dislocation in price and market value, we firmly believe that EBS is a value play, where upcoming catalysts will continue to justify the valuation. We also believe that the impressive growth in ROIC and ROA this year justifies the valuation. Therefore, value players should consider entry on current trading, particularly as fundamental risk seems low, and the immediate downside is centered on pricing risk moving beyond Q3.

Data Source: Author’s Calculations

We see similar results analysing multiples and vs comps. The stock trades in a fair range relative to peers, and we have observed key multiples morph over time to today’s measures. EBS currently trades around 21x FCF and has averaged trading at around 74x FCF this quarter, therefore we see the valuation correcting coming into Q4. Furthermore, we view the company at a respectable EV/EBITDA of 12.5x, which has come down nicely over recent periods. Again, this fits the narrative of a value play coming into the remainder of FY2020. The market has sound expectations of the stock heading into Q4, with a P/E of 12.2x, meaning that investors may be looking to news on key developments within the pipeline for evidence of price growth. With P/Sales of $3.92, we also see this as relatively cheap considering the company’s ROIC and ROA and sales momentum YTD.

Data Source: Author’s calculations

Data Source: Author’s Bloomberg Terminal, Author’s Calculations

Therefore, the market may be overlooking the growth potential in EBS stock, considering the dislocation in market price and fair value, in our view. This is further evidenced by respectable multiples vs peers analysis, alongside correction in these multiples over recent times. On this basis, investors may benefit from the lack of exploitation in EBS equity, and may see further upside by exploiting this opportunity themselves. Should the market view the Q3 earnings summary in a positive light, there is certainly room for price correction to fair value, in our view. Considering our DCF modelling, alongside assigning an appropriate multiple to earnings, plus considering our sum-of-the parts and probability framework, we set a price target of $122, just over 28% upside, over the coming 12 months in the base case.

Investors can view the potential price outcomes should the stock continue at current support, on the chart below. We see moderate price appreciation, should the trend continue north over the coming months.

Data Source: Author’s Bloomberg Terminal

Financial Health and Coverage

The company is well capitalised and has strength on the balance sheet. On a short-term solvency basis, the company remains well covered at 2.71x coverage from liquid assets on short-term obligations. There are risks in the event that inventory and capital cannot be liquidated quickly, however, where coverage would drop to 0.92x. Debt facilities make up a decent portion of asset funding, with a debt ratio of 32.98 most recently. This would explain high ROE that has been awarded to equity holders to date, but that figure also reflects the company’s efficient use of provided financing. Debt has been well managed over the recent periods, with long-term debt as a portion of equity decreasing from 85% to 65% YoY, whilst the capital structure has remained largely unchanged. The company committed to a $450 million debt offering earlier this year, a portion of which will be paid to redemption of the existing facility. The notes are due for maturity in 2028. Therefore, the company has no meaningful drains or pulls on liquidity in the near term.

Investors can observe EBS’s capital structure and debt summary below

Data Source: EB SEC Filings; Author’s Calculations

Data Source: EB SEC Filings; Author’s Calculations

Interest expenses remain well covered at ~24x coverage from EBITDA. Strength in the balance sheet is also observed on debt to EBITDA totals of 1.4x-2.1x. Ongoing revenue expansion will undoubtedly provide additional strength to the balance sheet position in periods to come. Therefore, as mentioned, EBS has no meaningful drains or pulls on liquidity at the present time. We believe that management have demonstrated competency over debt management, especially committing to calling the previous notes and refinancing the debt load at the current lower rates. Smart moves. We also see this benefiting pipeline expansion and strategic capital allocation, to which the company has demonstrated they are able to generate sufficient returns over, with efficient use of equity and debt capital.

Data Source: Author’s Calculations

Growth Catalysts & Breakdown

In the short-term, the upcoming Q3 financials release is a potential catalyst to move price. What investors need to understand is performance in each of EBS’s key operating segments, to gain understanding over the full picture of performance and outlook moving forward. To illustrate, EBS has focus areas on 6 distinct segments. These each lie within the “public health threat” domain, and include:

  • Biological, Nuclear, Chemical, radiological and explosives
  • Travel health
  • Emerging infectious disease
  • Emerging health crises
  • Contract development and manufacturing
  • Acute care

Within the portfolio for these segments, the company holds a suite of vaccines, therapies and drug device combination products. In total, there are 10 marketed products within EBS’s portfolio. The most notable of these are Narcan and BioThrax. Narcan will continue to see extensive utilisation and applicability as the US continues to deal in the opioid epidemic. There are alarming overdose statistics arising from the pandemic’s economic fallout, and a historical correlation between recession and society’s increase narcotic uptake has been well established for some time. The active compound in Narcan, naloxone, is a nasal spray that when administered, will reverse opioid overdose that occurs from central nervous system depression. It accounts for around 25% of total sales for EBS, therefore increased uptake by front-line medical personnel will continue to drive sales into 2021 and 2022.

Furthermore, the US government is EBS’s largest client at the current time, which provides stability and predictability in organic revenue growth. The fed firstly provides the company with significant funding volume to develop drug and vaccine candidates. This expands to military to non-federal government entities that incorporate EBS products within safety and threat prevention programming, most notably with the anthrax program and other immunisation protocols. Key positioning amongst and away from this segment ensures ongoing forecasting accuracy, via large contractual placements. For example, the US Government makes up about 60% of total revenue volume under contract manufacturing and supply arrangements, whereas another 30-40% of total revenues are accounted for by commercial and public accounts. These include law enforcement, state health departments, prescription volume from physicians and pharmacies, and also front-line medical personnel services like paramedics and emergency centres. We believe that positioning within these markets provides stability to future revenues, and demonstrates ability to deliver total sales volume to these key accounts. Therefore, as the government’s preferred supplier, and with alliances to state and local agencies, investors can expect growth stability into the coming periods.

The company has also commenced phase 3 trial stages on INSIGHT-013, which is evaluating a hyperimmune immunoglobulin known as COVID-HIG, obtained from patients that have recovered from the virus. The application is set towards those who are currently hospitalised for the virus, and results will be interesting, considering the advancements that have been made. In view of EBS’s contractual strategy with JNJ, this provides investors additional exposure to the Covid-19 vaccination marathon. EBS’s application of the study is exploring populations who are at risk from other methods of exposure, thereby increasing the effectiveness and robustness of the data. Should the company be successful, we would anticipate this to be reflected on the charts.

Risks

On the charts the risks include a sharp pullback below the current level of support, where the stock could struggle to find its range and speculators’ stop-loss orders are set in place. Further, any negative outcomes from works within the pipeline would be reflected on the charts also. There are also operating risks that impact the company. We do believe the contractual segment is a strong point and key differentiator. However, there is risk in high exposure and reliance on the US government for total revenue, through the sale of BioThrax and other biodefence products. Should the government seek another alternative, then around 60% of total revenues would be affected. The value of these contractual agreements cannot be understated, therefore, and are certainly factored into our valuation. What offsets this risk is low product competition within this segment, particularly as BioThrax is the only FDA approved vaccine for anthrax, thus why it is so heavily valued by the US justice department and the federal government total.

There are pipeline and execution risks that exist also, should any failures occur within the developmental pipeline. This presents as a downside risk to investors, who we view are currently awaiting advancements in EBS’s pipeline to make the investment case. Therefore, if the company is unable to continue its biodefence pipeline, then investors are exposed to downside here. The government’s reliance on and subsidisation to EBS partially offsets these risks. However, competition for these large and of course limited contracts is fierce, which creates incremental risk for the company. We see this competition as a risk in the Narcan segment, where other brand names will continue to make the case as the gold-standard. Whilst Narcan remains the preferred brand, pricing power is limited to the control of the segment, which can be disrupted in the presence of additional substitutes and cheaper alternatives.

Conclusion

We view that EBS is well positioned to capture market share and expand on its key differentials that have allowed it to excel to date. Whilst downside volatility has been high on the charts to date, shareholders can take comfort in the safety and value of the contractual power that EBS holds, with large Pharma players, public agencies and of course, the US Government. We believe that the market has overlooked the power of these arrangements with EBS, in search of capital allocation to a vaccine candidate for Covid-19. Thus, we see a large dislocation in intrinsic value to market price, skewed towards the upside. In this view, alongside the stability in revenue prospects over coming years, we view further upside for EBS in the medium to long-term. Therefore, long-term investors with a lower risk appetite, who are seeking long-term capital appreciation with overall stability, are perfect candidates for a EBS holding. Considering the current shape of the yield curve, yield seekers will be happy with the overall picture that EBS presents, also. We foresee further upside in our price target of $122, around 28% upside from today’s trading, on a fair value that represents a large dislocation to market price. We also look forward to coverage following Q3 financials, therefore encourage investors to keep a close eye out for the same in the coming weeks.

Disclosure: I am/we are long EBS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Be the first to comment

Leave a Reply

Your email address will not be published.


*