The NovaMed acquisition is a mistake and will be a drag on valuation. Worst of all, it sticks SciClone on the path of mediocrity.
Reni Benjamin upped his 12 month target price from $8 to $10 per share, but you don’t need the NovaMed deal or look into maybe figures for 2014 to get there. Based on Benjamin’s 2011 net income estimate of $25.6 million, all of which will come from Zadaxin sales and SciClone’s current business, and 50 million diluted shares (without doing the NovaMed deal), you get fully diluted 2011 EPS of $0.51, a 19% increase over 2010 EPS. Applying the comparables’ 16.4 P/E for 2011 earnings, just like Benjamin does, you get a target price of $8.36 per share. So how do you get to $10?
The NovaMed deal obligates SciClone to give the NovaMed owners up to more than $67 million in cash ($24.7 million at closing and up to $43 million two years from now). According to Benjamin’s projections, NovaMed operations, which will be run separate from Zadaxin sales in China, will generate only $2 million of net income over the entire period and likely generate no cash. So, to make the no-buy vs. NovaMed-buy an apples-to-apples comparison, we should look at SciClone distributing up to $67 million in cash to current SciClone stockholders or $1.40 per actually outstanding share. They’ve got it for NovaMed, why not for the current SCLN stockholders? Add that to $8.36 gives you $9.76 per share – without the NovaMed buy. Okay, close enough to $10 and without the risks of whether or not NovaMed will become profitable and when, whether this merits the permanent 15% dilution to EPS and ownership, and whether Lotter, the CEO of NovaMed and now CEO of SciClone China, would be any better at driving Zadaxin sales in the future.
Adding NovaMed as a separate operating unit in China does nothing you would hope to get by making a smart purchase for SciClone China. The Zadaxin sales force does not get another product to sell. For them it’s still just Zadaxin and someday perhaps DC Bead and Rapidfilm. Instead of NovaMed, if SciClone purchased some currently marketed products that would fit well with the abilities of its current sales force (requiring only a very modest increase in sales & marketing expense and essentially no increase in G&A) there would be an immediate increase in revenues, earnings, EPS and SCLN stock price. For the up to $105 million price tag of NovaMed, SciClone could have afforded to pay premium prices for good, strong product lines that would continue many years into the future. Furthermore, if and when the Chinese government reduces the maximum price for thymosins including Zadaxin, the purchased strong product lines would become the future for SciClone China. The worst thing about the NovaMed deal is that it sucked the buying power out of SciClone, and thereby continues SciClone’s dependence on Zadaxin pricing, and destroys the opportunity to transform the Zadaxin sales force into a real pharmaceutical powerhouse in China.
where do I start...it doesn't seem like we are headed for Palookaville...maybe you better check your numbers again...I think the trained sales team that we now have will open a whole new avenue of revenue...much more attractive to do business with...a growing China business since 1996...soon to have a sales force of 1000 strong...and 18 drugs to sell at present...I can't wait to see what the real numbers will be in the coming quarters...how long will it take to raise guidance?
agree with the current optimism. my prior posts suggested this acquisition and fcpa investigation will take a year to shake out. export sales to china is a long lead time business, likely q2 sales are already in the distributor's warehouse. if there will be an impact from fcpa practices or internal china stuff it should not surface until q3 or later. enjoy the ride
to provide some institutional history to the last comment, zadaxin was not a failed fda drug. it failed a poorly run and poorly designed trial that was done by another company. taking advantage of that is how the old sciclone mgmt got the us rights to the drug. sciclone mgmt ran trials in taiwan and china for hbv and that is how the drug was registered in china (china has over 100 million people with hbv so it was a very good idea) and all the other hbv countries. hcv was a second us zadaxin effort years later and it failed. but neither time was zadaxin actually submitted to the fda for approval. point being that sciclone then had as much pharma expertise as anybody in china. but things change and mgmt changed and now, having coasted for almost a decade, to get back china know how sciclone is trying to buy it. probably would have done better buying a 100% china company, but if there are some us fcpa issues with sciclone there certainly would be some with a 100% china operation trying to operate to us standards as fcpa only applies to us companies. china, japan, europe all operate without fcpa concerns. if novamed is really acting as a rent a sales force for other companies and takes a fee for service, i am concerned about what expertise they really might have. as i wrote before, we will all know in a year or so.
My posts have been very infrequent, but sometimes helpful. I believe I was the only poster to point out that the H1N1 trial interim data was slipping away and that success was unlikely. I wasn't guessing, just studied the data and information provided and came up with the most probable result. Likewise, I should not put a time on the event of price controls on thymosin, just that as a generic it is certainly a candidate and with Zadaxin priced at 3-4x the competition, Zadaxin is most vulnerable. Consequently, the market is most likely to attach a significant discount to Zadaxin profits that could be reduced very suddenly and by a great amount with the imposing of a price ceiling in the likely event that it comes about.
I agree with all you say about the China market and branded generics. Having the rights to the products is what is important and it isn't clear what proprietary position NovaMed has. It looks from Benjamin's figures that NovaMed revenue is almost all from marketing fees which barely covers NovaMed expenses. Notice that there is no cost of goods sold line for NovaMed in the projections. That's because the real owners of the product, Sanofi or whoever, books the sales revenue and NovaMed just gets to book the marketing fee it receives from the product's owner. 25% sales gains for pharmaceuticals is pretty typical at this point in the China market. But NovaMed just gets a gain in marketing fees. Sales commissions to the 450 sales people and other selling expenses eat up the great majority of such fees. NovaMed is in a fundamentally low margin business. In addition, because the China pharmaceutical market is booming, there is intense competition to hire and retain sales people which further squeezes NovaMed's ability to turn a profit. You and I are saying the same thing - SciClone needs more products of its own to sell in China - high margin products like Zadaxin. To get them they will have to pay for them. It isn't clear that the NovaMed deal brings any such products to SciClone, and now SciClone has $100 million less to buy these needed products.
But doesn’t NovaMed give SciClone 18 new products and 450 sales people? The sales people, yes, the products, no. According to its website NovaMed is essentially a contract sales organization, a CSO, also known as ‘rent-a-sales-force’. NovaMed markets the products for some pharmaceutical companies for a fee. Typically, when a product gets to some meaningful sales figure, a pharmaceutical company terminates a CSO’s contract and takes back the product. There are tales of CSOs who found themselves with hundreds of empty-handed sales people when the pharmaceutical company decided to take back the product. Consequently, CSOs are a low margin business and not highly valued, typically at one times revenue (the marketing fees). SciClone says that pro forma, NovaMed revenue for 2011 will be about $40 million, so the $37.1 million value of the SCLN stock given in the purchase, 8.3 million shares, by itself should have been the total purchase price for NovaMed.
So what else does SciClone get for the $24.7 million cash it handed over plus up to $43 million more in two years? SciClone says that there are some higher margin products in the NovaMed portfolio and that NovaMed has been acquiring actual rights to some products, too. Well, first of all, acquiring rights to interesting products for China is supposed to be one of Blobel’s objectives. What’s he saying, that NovaMed beat him out in competing for products at $1 to $2 million per shot for a few products? Is this why SciClone has to pay $67 million in cash – to get the products SciClone was supposed to be hunting for?
So far, “only” $24.7 million in cash has been handed over to NovaMed’s owners. The remaining $43 million is based on so-called ‘earn outs’. Earn outs are often used in acquisitions for the acquired company to demonstrate that it is worth and will receive the final purchase price. If the acquired operations or products perform to certain agreed levels, the seller earns more than the down payment price. However, the way the earn outs for NovaMed are structured, it looks like Blobel and Titus weren’t in the room when they were written. There are two problems with the earn outs: 1. They are pretty much lay ups and most of the money will be “earned”; and, 2. They provide incentives for actions that could be counter-productive or even damaging to the company.
interesting debate and one that twelve months from now will resolve soon enough. clearly this was a great deal for novamed's investors and mgmt. novamed's 18 or so products and claimed vast geographic distribution capability are not reflective of a good business model in china. just some facts to help: ims states that the average sales rep in china brings in 1.5 million yuan ($347,145)per year. sciclone's reps with only one product do a bit better. novamed's 450 reps bring in about $70,000 each. novamed's 18 products average less than $2 million each. the costs of sales and distribution in china grow exponentially as distribution moves away from the inner cities. zadaxin is a high priced specialty hospital product. novameds products are low cost generics. as the press release said there are no synergies planned so the frequent mention of 680 sales reps means nothing and it is not likely that the quality of the novamed sales people will be able to be trained to sell an immune system and oncology drug. pharma sales forces in china are measured in terms of thousands, not hundreds. not sure what sciclone was thinking, it is very clear what novamed was thinking. the anticipated new combined new p&l, balance sheet and cashflow is what is hurting the stock. still sciclone has the cash to fund all this for a while. good luck to all.
One earn out, for about $10 million, encourages growing NovaMed legacy products to a combined total of more than $94 million during fiscal years 2011 and 2012. Since NovaMed revenue is growing at 25% (like every other pharmaceutical business in China) this isn’t much of a stretch. We should note that NovaMed, according to Benjamin’s projections, will earn only $2 million on those sales, so $10 million for $2 million isn’t a great trade. And why provide a major incentive to grow the legacy (low margin) products? Shouldn’t SciClone want to focus on high-value opportunities instead?
The second earn out is even stranger. It provides about $20 million to NovaMed if SciClone China combined 2011-2012 EBITDA is greater than $92 million. If you work with Benjamin’s projections, taking into account that China is 95% or more of SciClone’s gross profit, etc., and some realistic assumptions of China R&D and G&A, you can get to SciClone China EBITDA of about $50 million in 2011 alone. Remember, NovaMed’s operations are projected to contribute no more than 2-3% to EBITDA in 2011-2012. So NovaMed owners are on track to get $20 million in early 2013 because SciClone is on track to deliver the profits from Zadaxin! (I’m assuming that Lotter’s CEOship isn’t critical to continuing for the next 20 months the several strong years of Zadaxin sales performance). Let’s put it this way. Zadaxin sales alone will generate a total of $60 million in net income for SciClone in 2011-2012. At the end of 2012, SciClone effectively is obligated to make a special one time distribution of $20 million, a third of net income, but only to the old NovaMed owners and regardless of whether they still hold any SciClone stock! I guess you could say this is an incentive for Lotter not to damage the profitability of Zadaxin in China. But that’s like giving the fox the key to the hen house and paying him a reward for maintaining egg production. Paying big rewards for short term performance goals can be counter productive and damaging to long term operations. We have seen how this turns out and it often isn’t very pretty. Managers do whatever they can to raise short-term sales and clamp down on expenses – replace high cost workers with cheaper, less expensive ones, and screw down R&D or other expenditures that don’t translate into profits within a few months. The manager earns the bonus and the company has lost its talent and become less competitive going forward.
There’s a third earn out component of $10 million relating to signing new product distribution agreements (more rent-a sales-force stuff?). No details are provided in SciClone’s 8-K filing. Lotter of NovaMed will be CEO of SciClone China and on the board of SciClone. You can count on him to strive hard to ensure that NovaMed’s owners receive the SciClone-blessed earn outs. Lotter is a co-founder of NovaMed and most likely had an ownership position of 10% or more. So Lotter can make probably several millions of dollars in the earn outs by concentrating on growing the low-margin legacy products, not screwing up the Zadaxin sales operation, and adding some maybe just ho-hum distribution deals. Unfortunately, it appears that the kind of deals that could transform SciClone in China is not part of the incentives, especially if there is a cost that hits the EBITDA calculation.