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The specialist in medical delivery technology, Catalent (CTLT) has been inching higher steadily, as those who are aware about the company’s important role in the availability of a COVID-19 cure have been buying the stock.
While the stock price of better famed peer Emergent BioSolutions (EBS) with three times more followers on Seeking Alpha has also being trending higher, its path has been somewhat more volatile. One of the factors that can explain this volatility is strong following by the retail trading crowd tracking COVID-19 vaccine news.
Figure 1: Comparing stock performance for Catalent and Emergent
Data by YCharts
This has not been the case with Catalent despite the company inking three manufacturing agreements with COVID-19 vaccine developers, including big names like Johnson & Johnson’s (NYSE:JNJ), Moderna (NASDAQ:MRNA) and AstraZeneca (NASDAQ:AZN), to provide fill-finish capabilities.
Fill-finish manufacturing
Fill-finish is a lesser-known but crucial step between development of vaccine by biotechs and its availability for clinical trials in testing centers or, at a later stage, on a more widespread basis in hospitals and points of care for administration to patients. Fill-finishing basically involves putting the vaccines in vials or glass containers under strict hygiene or sterile conditions to prevent contamination.
Biotech companies resort to the likes of Catalent for this critical process, as any contamination would adversely impact efficacy of the vaccine and result in significant economic losses for them.
Now, for investors, an important question is whether Catalent will be able to honor its manufacturing contracts with these big names.
The answer is yes, for both drug substance manufacturing and drug product manufacturing capabilities both in the U.S. and Europe. Facilities include Bloomington for Johnson & Johnson and Moderna, as well as Anagni (Italy) for AstraZeneca, but there are other locations too.
Also, the fact that the company has made strategic investments over the last few years in concert with customers has enabled it to increase capacity for potentially billions of COVID-19 vaccine doses over the next few years.
Additionally, Catalent is working with customers on COVID-19-related antivirals, vaccines, diagnostics and treatments for symptoms. Some concrete figures include forty customers with contracts covering more than fifty COVID-19-related compounds across all four business segments.
Figure 2: Q4-2020 results by business segment
(Source: Company Q2 2020 Earnings Call Presentation)
With the exception of Clinical Supply services where revenue was flat, all other segments witnessed single- to triple-digit net growth.
The reason for Clinical Supply not faring as well as other segments was the pandemic’s disruption of clinical trials where Catalent partnered with biotechs, but the revenue shortfalls were more than offset by tailwinds for the Biologics segment.
In addition to providing manufacturing services for vaccine developers, Catalent is also more directly involved in the COVID-19 vaccine development process itself, as evidenced by both Humanigen’s (OTC:HGEN) antibody therapy and Spicona’s vaccine candidate. In both cases, Catalent’s proprietary GPEx technology are being used.
Another collaboration with Ennaid Therapeutics aims to develop an oral, antiviral treatment for the coronavirus.
As per the executives, they “are currently involved in client discussions regarding over 100 additional opportunities”.
However, the path to turning these windfall opportunities will not be a smooth one, as there are competitors along the way.
The competition
Talking competition in fill-finish, the June upside seen in Emergent stock coincided with the company winning an award from the U.S. government valued at approximately $628 million in a CDMO (contract development and manufacturing organizations) partnership as part of operation Warp Speed. The aim of this “military-style” operation is to provide rapid development and manufacturing services for production of COVID-19 vaccine candidates by 2021 at a minimum.
While not selected as a vaccine manufacturer in operation Warp Speed, Catalent indirectly benefits through its contract agreements with three of the eight engaged vaccine developers.
Figure 3: Vaccine developers engaged in operation Warp Speed
(Source: Wikipedia)
In addition, due to its manufacturing strength, Catalent could benefit from supply contracts with Pfizer (PFE), with which it already has a contract to produce an OTC (over the counter) pain relief product called Advil Liqui-Gels Minis.
The company also has geographical diversification in Europe.
First, there is the Anagni facility in Italy, where two segregated vial lines are dedicated to COVID-19 vaccine candidates for both AstraZeneca and J&J.
Second, there is the planned modernization and expansion plan of the Limoges site in France to create a European Center of Excellence for both clinical biologics formulation development and fill-finish services. This is more of a longer-term development, with project completion anticipated in 2022.
Figure 4: Geographical diversification
(Source: Company Q2 2020 Earnings Call Presentation)
Therefore, despite the competition, there are indications that Catalent will not stop growing anytime soon.
Growth Drivers and Finances
Through its continuous investments in biologics not only in France and Italy but also in the U.S., the company aims to strengthen its position as an industry-leading CDMO.
In addition, the recently acquired cell therapy business in the form of MaSTherCell potentially extends the company’s position in the biotech industry, as it complements existing gene therapy offerings. MasTherCell’s expertise includes both developing and contract manufacturing of chimeric antibody receptor-engineered T-cells. Therefore, there is potential for more vertical integration through this acquisition for cell and gene therapy, which should boost growth in biologics in Europe and, more specifically, in Belgium.
Interestingly, management expects strong long-term revenue from the Biologics segment and aims for it to comprise 50% of total company revenue by 2024, compared to 38% in Q4-2020 (March to June 2020) and 25% in 2019.
While biologics is witnessing strong revenue growth, it is the Softgel and Oral Technologies (“SOT”) segment which accounted for most of the EBITDA increase at 4% compared to Q4-2019.
Diving deeper into the bottom line, growth was driven by higher-margin prescription products in North America and consumer health drugs in Europe, the U.S. and Latin America. Had it not been for elevated operating costs related to COVID-19, including additional bonuses and protective equipment together with adjusted production workflows, margins would have been higher.
Figure 5: Segment EBITDA on a per-quarter basis
(Source: Company Q2 2020 Earnings Call Presentation)
Going forward into the second half of the year (H1-2021 as per Catalent’s reporting), SOT should be adversely impacted by lower demand in consumer health, particularly in cough, cold and over-the-counter pain relief products. This will be offset only to some extent by global demand for COVID-19 therapies and vaccine candidates driving higher levels of demand for both drug product and drug substance manufacturing in the Biologics segment, especially in North America and Europe.
The reason I mentioned “only to some extent” is that the higher costs of raw materials and components for the manufacture of products in the Biologics segment are likely to affect margins. Here, with more than 212 vaccine trials that are currently under development at various phases around the world, the price of raw materials required to produce vaccines is increasing and may add further margin pressures for Catalent as it embarks on the commercial phase.
On the other hand, overall margins should improve in FY-2021 as a result of better expected performance in the remaining two segments. First, the company has witnessed a general increase in demand for respiratory and ophthalmic products in the OSD (Oral and Specialty Delivery) segment. This segment continues to have a strong development pipeline.
Second there is the clinical supply segment, which, after seeing regression in Q4-2020, is expected to resume growth in the second part of the year, and one of the reasons is additional revenues brought by the acquisition of Teva Takeda Pharmaceuticals’ (a joint venture by Teva (TEVA) and Takeda (TAK) with a generics portfolio) clinical packaging facility in Japan.
Figure 6: Revenue progression in millions of dollars
(Source: Seeking Alpha)
I now go deeper into the balance sheet to check evaluate into Catalent’s ability to navigate through its high-growth trajectory with enough cash and a reasonable debt level.
First, fourth-quarter adjusted EBITDA increased 34% to $267.4 million.
Second, cash balance as of June 30 was $953 million, compared to $608 million on March 31 and $345 million at the end of the last fiscal year.
Part of the reason for this increase in cash was an equity offering of $550 million of common stock in June 2020, with part of the net proceeds used to repay the $200 million of outstanding borrowings under the revolving credit facility as well as to fund capital expenses.
This offering and growing adjusted EBITDA contributed to drive the Debt/Equity ratio lower at 0.9 from 1.2 as of March 2020.
Figure 7: Balance sheet with figures in millions of dollars
(Source: Seeking Alpha)
Despite EBITDA growing by 34% as I mentioned above, free cash flow was negative $52.2 million due to increase in CapEx spending and expenses incurred pertaining to additional precautions and supply chain mitigation efforts due to the coronavirus.
Figure 8: Cash flow with figures in millions of dollars
(Source: Seeking Alpha)
Valuation and Key Takeaways
For investors, Catalent is on a growth trajectory, with net revenue, EBITDA and net income expected to grow by 14%, 15% and 18% respectively (considering the mid-point of the guidance range) in fiscal year 2021.
Figure 9: Guidance for FY-2021
(Source: Company Q2 2020 Earnings Call Presentation)
Also, the number of outstanding shares will increase to 179 million, which means an additional equity offering. This increase will represent an additional 8.4% of shares, compared to 13.3% from the previous year’s equity offering.
Also, there will not be any improvement in the free cash flow position, as per CFO Wetteny Joseph:
In fiscal 2021, as a result of our continued expansion plans and risk mitigation efforts for our supply chains, we again expect free cash flow to be much lower than historical levels.”
Therefore, Catalent’s priority is growth, both organic and inorganic (acquisitions), and CapEX expenses should continue to be on the high side, and this despite encountering higher operating costs in managing COVID-19 disruptions.
However, the approach is far from being reckless growth, as the executives only execute on acquisitions as long as they have visibility and target those with return on investment within a 18-24-month time frame.
Still, playing the devil’s advocate, Catalent, while having 31% gross margins, is still less profitable than Emergent or Endo International (ENDP), both providing fill-finish manufacturing services and having profitability above the 40% level. I see Catalent’s profitability growing to that level in 2021-2022 taking into consideration the 18-24-month ROI time frame and the fact that the company currently has to incur higher costs to integrate acquisitions.
Also, for debt-averse investors, the company has set a long-term net leverage ratio target of 3.0x down from 3.5x previously.
With the company looking to be a good bet for patient investors who want to step in early and profit from the COVID-19 market, I now provide an indication for a target price.
In this case, Catalent has a higher valuation multiple of 45x to earnings when compared to Emergent’s 23x, despite the latter being shortlisted for grants as part of Operation Warp Speed.
In addition, Catalent’s past one-month returns have been two times higher.
Figure 10: Comparison with peer
(Source: Seeking Alpha)
Also, Catalent stock price has delivered steady returns, and this matters more for investors instead of the highly volatile path for Emergent stock, which currently appears to be more suitable for traders.
Therefore, the market seems to trust Catalent’s ability to benefit more as a result of its partnership with COVID-19 vaccine developers.
Also, given its higher market capitalization, the pharmaceutical play has more scale to expand fill-finish manufacturing capacity to take advantage of COVID-19-led opportunities.
According to analysts at Yahoo Finance, the target price for Catalent is $102.3, which would mean an 8.5% upside.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing.