On November 21, 2019, Recro Pharma (REPH) spun off its money losing Acute Care Drug business, in a taxable transaction. This business has historically masked the strong fundamentals of REPH’s remaining CDMO business, explains Rich Howe, editor of Spin-Off Investing.
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The spin-off business is Baudax Bio (BXRX). It is a clinical-stage biopharmaceutical company. Currently, its largest bet is on its IV Meloxicam drug. That drug is currently in the late stages of its FDA trial, as it is petitioning to essentially become an alternative to opiods.
The spin-off is difficult to analyze. It could be a billion dollar company, but it also could be a zero. It’s hard to get an edge on the company.
However, the transaction is more interesting because of what it leaves behind. For years, the excessive costs to develop Meloxicam have masked Recro Pharma’s wonderful CDMO business.
Recro Pharma's remaining CDMO business is defensive, on pace to grow revenue 34% in 2019, and generates a 39% EBITDA margin. Despite robust fundamentals, REPH trades at 8.3x 2020 EBITDA and 16.4x 2020 EPS, a massive discount to peers.
CDMO stands for “Contract Development and Manufacturing Organization”. As the name implies, CDMO companies serve other companies in the pharmaceutical industry on contract basis to provide drug development and drug manufacturing.
In 2018, 48% of revenue came from Teva (TEVA) and 38% of revenue came from Novartis (NVS). These revenue sources are extremely stable as REPH recently signed long term agreements (5 year contract extension with Novartis and 6 year contract extension with Teva).
Further, revenue is sticky. CDMO’s are written into drug applications so pharma companies must resubmit their application to the FDA if they want to switch manufacturers.
Besides the base business with Teva and Novartis, REPH recently increased its focus on growing its CDMO business through business development efforts. The effort has paid off as the company expects to exit 2019 with ~10% of revenue coming from new business.
Business development entails reaching out to smaller pharma and biotech companies to win business providing services that help them formulate and ultimately manufacturer drugs for clinical trials.
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The goal is that these relationships may start small, but will hopefully grow once new drugs are approved and manufacturing needs to ramp up to meet demand.
The CDMO industry is a great industry with a rosy outlook. The industry has been consolidating, driven by interest from strategic and financial sponsors. Recent acquisitions have closed at 16.5x EBITDA.
The chairman of REPH’s board is the managing partner of Engine Capital, an activist hedge fund, focused on maximizing its portfolio returns. I believe a sale of REPH in 2020 is likely, but even if that doesn’t materialize, Recro Pharma is a high quality business that I would want to own for many years.
REPH is an unusually attractive investment as it trades at a low valuation despite strong expected growth of revenue and earnings; secular tailwinds in the CDMO industry; and he potential to be acquired. My price target of $22 implies 42% upside.
(For disclosure, editor Rich Howe is currently long these shares and states that he plans to build a more meaningful position.)
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