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I am based in Montreal, and this is my investment blog. My style is a mix of an early Warren Buffett, Peter Lynch and Philip Fischer. I am on the look-out for companies where the direction of returns on invested capital is headed upwards. They should also have a long runway to reinvest capital, as well as incentivized management.

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Recro Pharma: A Phil Fisher stock at a Ben Graham Price

Updated: Feb 16, 2020

This write-up will be on a small cap, Recro Pharma. The shift in focus from larger caps is because I am finding a lot more value in smaller and more inefficient markets these days. This is not to say that larger companies are overvalued, simply that there is great value yet to be discovered by investors in small caps such as Recro Pharma, which has a 420M$ market capitalization.

Recro Pharma is the remaining corporation of a spinoff completed in November 2019. Recro Pharma is a pharmaceutical services company that operates a contract development and manufacturing (CDMO) business. I almost dismissed the company due to a previous bad experience I had investing in a biotech company which exposed my lack of expertise in analyzing pharma companies’ drug pipelines. But upon a closer look, I found that Recro Pharma has easy-to-understand economics, with stable and highly predictable cash flows.

Recro Pharma spun off its Acute Care business segment into a separate company, Baudax Bio, in November 2019. The segment’s lead product candidate is Meloxicam, a long-acting, preferential inhibitor that possesses analgesic, anti-inflammatory, and antipyretic activities. I did not analyze Baudax because I do not how to underwrite the product’s market potential.

Business Overview

Through its Contract development and manufacturing (CDMO) business, Recro Pharma generates revenues from manufacturing, packaging, research and development and related services for multiple pharmaceutical companies. The agreements that the company has with its commercial partners provide for manufacturing revenues, sales-based royalties and profit-sharing components.

Recro owns and operates a 97 000 square foot, DEA-licensed manufacturing facility in Gainesville, Georgia, inspected by US, EU, Turkish and Brazilian regulatory authorities for compliance with required cGMP standards for continued commercial manufacturing and lease a 24 000 square foot development and high potency facility, also in Gainesville, Georgia. I’ll come back to why regulatory compliance is the source of a competitive advantage for Recro.

The development of the CDMO Industry

Poor lifestyles have increased the numbers of chronic diseases such as autoimmune and heart diseases and diabetes. The high demand for drugs to treat these diseases is driving many pharma and biotech companies to outsource many of the processes in their supply chain to CDMO's.

Companies spend a high share of their capital and profits on research and development to produce better drugs at cheaper costs. But increased competition and shrinking profit margins have forced pharma companies to focus the bulk of their capital and time on drug R&D, instead of manufacturing the formulated drug to stay competitive in the market.

Check out the below image. It shows the development stages of a drug. The entire process can take years and can run in the billions of dollars. And of course, most drugs and molecules of drugs fail early in the process.

This means the greatest factor driving the growth of CDMO's in the pharmaceutical industry is the growing need for state-of-the-art processes and production technologies to formulate and manufacture drugs.

The need for CDMO's is even more prevalent amongst smaller pharmaceutical companies since they can not afford to expand their manufacturing abilities due to financial constraints. That’s why they prefer to outsource some of their processes to CDMO’s.

Basically, CDMO's take parts of the supply chain of pharmaceutical companies which are the most expensive and do it for cheaper.

The development of the CDMO industry is in full bloom and Mordor Intelligence projects that from the current 151 B$, the industry is projected to reach 246 B$ in 2025, for a CAGR of 8%.

Below you can see that Recro Pharma is a one-stop CDMO shop, meaning pharmaceutical companies can use their services across the development spectrum of a drug, which as we will establish later, is a major competitive advantage.

Switching costs inherent to the industry

As pharma companies are outsourcing greater and greater parts of their supply chain to CDMO's, the relationship between pharma companies and CDMO's has evolved to a partnership model, increasing switching costs for pharmaceutical companies.

CDMO's have now become an integral part of the manufacturing of drug substances. Over time, the pharma industry really started to like using CDMO's as it made them more flexible, without having to invest vast amounts in their own manufacturing facilities. It also allows them to start drug-development while drug-substance development is still going on for new drugs. For existing drugs, the CDMO offerings make it easier to tweak and develop new formulations. All of this provides pharma companies with a lot of flexibility.

More specifically to Recro Pharma, since they cover the entire supply chain of drug development, they have an additional layer of competitive advantages. For pharma companies, the attractiveness of relying on an end-to-end CDMO includes having a single reference point for the entire supply chain, avoiding technology transfers and hand-overs between different CDMO's, leading to shorter timelines and greater transparency. All of these factors lead to increasing dependence on the supplier and a subsequent loss of bargaining power.

Since CDMO's must conform to the highest standards for its clients, partnerships between CDMO's and their pharmaceutical partners often go back several years, which increases the dependence on these CDMO's. For example, Recro Pharma’s Gainesville facility has had a relationship with Novartis, one of its biggest partners, for nearly two decades. Recro’s relationship with Teva, the world’s largest generic pharmaceutical company, goes back several years as well. Both these relationships demonstrate Recro’s ability to maintain high quality standards, consistently deliver products on time and meet increasing demand from their customers.

However, the advantages of CDMO's are not just the switching costs inherent to the economics of the industry. There are also significant legal barriers imposed by the FDA that makes switching from one CDMO to another nearly impossible for pharmaceutical companies.

Recro Pharma does develop and manufacture other development stage products. These products for clinical trials and commercial use are subject to regulations. The Food and Drug Administration (FDA) ensures the quality of drug products by monitoring drug manufacturers’ compliance with its current Good Manufacturing Practice (cGMP) regulations. That means FDA assessors and inspectors determine whether the CDMO has the necessary facilities, equipment, ability to manufacture the drug it intends to market.

Furthermore, whenever a pharmaceutical company submits a request to the FDA to produce a drug, the CDMO that will take care of the pharma company’s supply chain has to be included in the FDA request. Is it likely that a pharmaceutical company is going to resubmit an entire FDA application just to change its CDMO? The odds are low because the regulatory barriers are quite heavy.

The nature of the high switching costs in the CDMO industry means the major tendency for pharma companies is to establish long term relationships with CDMO's that last for many years.

Recro Pharma’s growth

Now that we’ve established the exceptional economics of the contract development and manufacturing industry, of which Recro Pharma is a beneficiary, we’re going to go into some specifics about the company.

At year end 2018, Recro Pharma added a second manufacturing facility. The additional capacity was for new product opportunities to enhance development and high potency product service offerings. A highly potent drug evokes a given response at low concentrations, while a drug of lower potency evokes the same response only at higher concentrations. The second manufacturing facility on Recro’s part showed a willingness to offer a broader range of services to its pharmaceutical partners.

Below is a table of the key products developed or manufactured with key commercial partners:

Capital allocation

Before the spin-off of the acute segment, all the free cash flow generated from the lucrative CDMO segment funded research and development for product candidates for acute care segment. Now that Recro Pharma does not need to worry about that money losing segment, all free cash flow can be reinvested into expanded and improved manufacturing capabilities of their CDMO business. More specifically, Recro Pharma has said during earnings calls that their positive cash flow will be used for debt service obligations, working capital and operating activities.

I am a big fan of spin-offs, since both of the spun off corporations and the holding corporations often outperform due to the nature of entrepreneurial power and positive incentives for management in spin-off transactions. Spin-offs often lead to greater focus on certain segment by incentivized management, which more often than not lead to outsized returns for shareholders.

One of the ways Recro Pharma has been able to reorient its focus towards its CDMO business has been through its ramping up of business development efforts. A key hiring was of Heather Sugrue in 2018. She was hired to drive new business and strengthen existing existing client relationships. Previously, Sugrue had spent time at Patheon as well as Ricera Biosciences and MDS Services, all CDMO's. Business development efforts have paid off nicely for the company. Shortly after Sugrue was signed, Recro signed a 6-year extension with Teva for Verapamil as well as a 5-year extensin with Novartis, for Ritalin and Focalin, to be their exclusive supplier. Recro has also mentioned the possibility of signing contracts with existing commercial partners for other drugs.

The Gainesville facility is also only running at a 70% utilization rate on one shift, and there is possibility to run the facility at two shifts, meaning there is great capacity to increase partnerships.

Recro has also mentioned they are reaching out to smaller pharmaceutical companies for their earlier needs with formulations. Some of these newer opportunities may not have huge economic value but are part of projects that in the future can lead to much larger partnerships as development projects continue.

The company’s CDMO segment is dependent on its 4 largest customers for 97% of its revenues (Novartis Pharma AG, Teva Pharmaceutical Industries, Inc., Pernix Therapeutics, Inc., or Pernix, and Lannett Company, Inc.). I think this high level of customer concentration may be a good thing, seeing the quality of these partners.


Before diving into the numbers, I want to mention that I believe it is highly likely that Recro Pharma gets acquired soon. There has been a lot of consolidation in the industry as the CDMO sector has seen a series of larger M&A transactions in an attempt by pharmaceutical companies and CDMO's to expand capacity and enhance capabilities in more complex areas including biologics. Private equity sponsors have also shown great interest in the long-term, stable cash flows inherent to CDMO's – it’s the same reason I invested in the company.

I think the company is motivated to sell itself as well. Going through the proxy statement of the company, I saw a strange compensation package for Recro’s management: they are granted RSU grants with vesting terms of earlier of change-of-control or 1 year. It seems management is heavily incentivized to shop the company.

The Chairman of Recro’s Board of Directors is also the Managing partner of Engine Capital, an activist hedge fund. The fund owns 5% of the company and has pushed for acquisitions at previous companies it purchased stakes in.

Below are the publicly available financials for the CDMO segment of Recro Pharma:

What is particular to CDMO, which I did not find when analyzing other CDMO's, is that Recro owns the patents for some of the drugs it develops and manufactures. Thanks to these patents, Recro receives royalty revenues. These royalty and profit-sharing revenues result in the 45% EBITDA margins, which management has indicated are the highest in the industry.

Below is the development of guidance figures for Full year 2019 management has provided:

Increased guidance has been due to organic growth from existing customers and the success of business development initiatives which has led to new business prospects. Another reason has been thanks to commercial partners implementing new pricing strategies, which have benefited Recro directly due to the profit-sharing nature of their relationship.

I rely on management guidance for valuation since the company has consistently beaten guidance. In only 3 quarters, Recro has already almost reached their 2nd estimate for full year 2019 guidance. So the roughly 50M$ in projected EBITDA for FY2019 will be a key figure for valuation. The latest estimates show a 29% revenue growth compared to FY2018 and a 56% growth in EBITDA.

I did not project cash flows since I don’t know how to estimate the future growth in business for Recro, seeing that they only started operating as a separate CDMO business since November 2019 and new partnerships are only announced once contracts are signed. Instead, a comparables analysis with recently acquired peers and publicly traded CDMOs will be used.

Recro’s stock currently trades at only 8.4x FY2019 projected EBITDA.

The average multiple for comparable companies is 18x EV/EBITDA. At the same multiple, Recro should have an Enterprise value of about 900M$. They also have net debt of about 100M$, giving a market cap of 800M$, which represents roughly 90% of upside from the current 420M$ market cap.

There are a few potential reasons for this disconnect in valuation. Recro was until recently an illiquid microcap (the stock is up over 110% in the past year). There was little analyst coverage and the business was overshadowed by the money-losing acute care segment. Now that that division has been spun-off and Recro is more focused on developing its CDMO business which has already started driving top and bottom-line growth upwards, I am confident the value disconnect will be plugged soon by Mr. Market.

In sum, I liked the great economics of the CDMO industry, which inflict large switching costs on pharmaceutical companies, as well as the new focus of Recro Pharma – a more entrepreneurial orientation which should keep shareholders very happy.

Disclosure: I own shares in Recro Pharma and look forward to either receiving an acquisition offer from a large pharmaceutical company, a larger CDMO or a private equity sponsor. If not, I am comfortable holding this great asset for several years.

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