Current Price: $2.1
Target Price: $3.25
Upside: 50%+
Expiration Date: Q2’23
This idea was shared by Jordan.
Enzo Biochem announced on March 16th that they entered into an agreement to sell their Clinical Laboratory Services segment to LabCorp (LH) for ~$146m. This sale transforms the financial profile of the business as the company is currently a going concern, and the CLS segment was responsible for the vast majority of the cash burn. The remaining portion of the business is the company’s “Products” segment, which the company also refers to as its “Life Sciences” business. Even if the products segment was worth $0, the $146m coming from LabCorp is worth ~$2.94 / share versus the stock today at $2.10.
There are two gating factors that need to take place for the transaction to close, shareholder vote and HSR review, both of which I expect to pass easily.
Remain Co: Enzo Life Sciences / Products Segment
The remaining business, Enzo Life Sciences, “manufactures, develops and markets products and tools for clinical research, drug development, and bioscience research customers worldwide”. Barring 2020 and the impact of the pandemic, this business does ~$30m of revenue annually and is close to breakeven. According to management, it belongs to a $10bn TAM that is growing in the upper single digits. As highlighted on the last earnings call, ENZ has just begun to launch new products that will allow them to further penetrate higher growth areas of the market. Additionally, management is reducing the cost structure of the business, which will improve margins; they recently consolidated the geographical footprint of the products segment to a single location. Management was clear on the last call that the business will grow, and they will generate higher gross margins and operating leverage over the fixed cost infrastructure: “These efficiencies and cost improvements, coupled with a fixed cost leverage from expected volume growth, combined with higher margin new products provide us with the opportunity to expand margins, while growing the business leading to better profitability.”
The recent earnings release on 3/20/23 shows that the sale of the Clinical Labs division does not conclude strategic alternatives for the business. According to the release, “the transaction positions Enzo to consider strategies to maximize the potential and value of the company’s remaining assets, including the Enzo Life Sciences segment.” I would not be surprised if this segment was also divested as a part of the strategic alternatives process.
Shareholder Vote
Enzo’s history provides some context for why I think a 50% majority will be relatively easy to reach. There has been significant activism in ENZ’s history. Key players include Roumell Asset Management (RAM), led by James C. Roumell, and Harbert Discovery Co-Investment Fund, led by Kenan Lucas. A partial history of the activist efforts of Harbert and RAM funds from 2019 and 2020 is detailed in an activist investor presentation easily found in RAM’s 13D filing on December 30th, 2020. Additionally, management and the board’s prior sins were detailed by RAM in the same investor presentation on slide nine and in numerous investor letters from both RAM and Harbert. These sins include significant underperformance relative to ENZ’s peers, poor governance, related party transactions and undisclosed related party transactions, excessive compensation, and an entrenched board that essentially ignored shareholders’ requests when they voted against the reelection of Dr. Elazar Rabbani to the Board of Directors. Refer to these shareholder letters for more details: Harbert Discovery Fund letter 10/27/21, RAM letter 5/5/21, RAM letter 1/14/21. As part of their efforts and as documented in the letters, both activists requested that the board hire a financial advisor to evaluate strategic alternatives. Almost four years later, shareholders are finally seeing some value created. These two parties alone represent almost 15% of shares outstanding. Additionally, officers and directors of the company have agreed to vote the shares they beneficially own, which represents 11% of shares outstanding according to the 8K filed on 3/16/23. Lastly, if the transaction does not close, ENZ shareholders are left with a going concern and a stock that was trading at ~$1.11 prior to the deal announcement; shareholders should want this sale to take place. Importantly, within the Asset Purchase Agreement, there is an “Aggregate Ticking Fee.” The ticking fee requires that after the Shareholder Approval Date, Labcorp is required to pay ENZ $75k / day up to $7m until the transaction is closed or terminated. ENZ has a very significant incentive to expedite the shareholder vote to further support the balance sheet.
HSR Review
To evaluate whether the sale harms the competition, we need to know what the CLS segment is and why Labcorp wants it. The Clinical Laboratory Services segment includes a CLIA (Clinical Laboratory Improvement Amendments of 1988) certified lab based in Farmingdale, NY, which also includes “a network of over 30 patient service centers throughout NY, NJ, and Connecticut” as well as “two free-standing “STAT” or rapid response laboratories in New York City and Connecticut, an in-house logistics department, and an information technology department” (ENZ 10-K FY’22). The value of the asset to LabCorp is mostly geographic and was clearly highlighted by Bill Haas (VP of Labcorp Diagnostic’s Northeast Division) in the transaction press release: the acquisition of Enzo’s CLIA lab allows Labcorp to “bolster [their] commitment to the New York Tristate healthcare communities.”
Why does this transaction not harm competition? There are 322,312 CLIA labs registered with the CDC; of those, 14,050 registered CLIA labs are in NY. However, CLIA labs that have a Certificate of Compliance (like ENZ’s CLIA lab in Farmingdale, NY) can conduct moderate and/or high-complexity testing. There are 16,652 CLIA labs registered with the CDC that have a Certificate of Compliance. In New York, there are 1,424. As a part of Enzo’s network, Enzo has 2 Independent Clinical Labs that have a Certificate of Compliance. Labcorp also has 2. It seems obvious that this acquisition does not harm competition in the US broadly or in NY specifically.
Taxes
Although we don’t know the book value of the CLS segment, we do know that ENZ had Federal NOLs of ~$96.7m and state and local NOLs of $38.1m on 7/31/22. Additionally, operating losses have continued subsequent to the last 10K. Moreover, ENZ did provide one clue to estimate the book value of the Clinical Laboratory Services segment. According to the 10K, Enzo’s own estimate of fair value of the “reporting unit exceeded the carrying amount of the reporting unit by approximately $55m.” With this clue, we can estimate the book value of the CLS segment with significant assumptions. We believe that the assumptions we are making are extremely conservative. The 10K highlights that ENZ’s goodwill balance is held in the Clinical Labs reporting unit. Therefore, the company, when evaluating impairment, assesses the fair value of the reporting unit and compares it to the carrying value to determine if goodwill is impaired. ENZ’s process is a bit unusual. ENZ computes the fair value of the Clinical Labs reporting unit by “determining the multiple of enterprise value to revenues for a peer group of clinical reference labs, discount[ing] that multiple, and [applying] it to [their] reporting unit’s annualized revenues.” With significant assumptions, we can replicate this process. We are not 100% certain who the company considers their peer group or the discount rate they use; however, we can make some assumptions and sensitize them. Regarding the peer group, ENZ’s 12/2/21 proxy lists the following as ENZ’s peers: “Harvard Bioscience Inc., Invitae Corp., Meridian Bioscience Inc., Myriad Genetics Inc., Nanostring Technologies Inc., Natera Inc. and Pacific Biosciences of California Inc.” Using the CDC’s website, we can ascertain that only Invitae, Myriad Genetics, and Natera have CLIA labs. At the time of ENZ’s 10K, those three companies were trading at ~2.9x EV/annualized revenue. Although ENZ had annual revenue of $74.4m in FY’22, Q4 revenue annualized was only $49.5m. If we apply a 20% discount to the EV/Revenue Multiple, we compute a “Fair Value” of ~$116.6m. If this “fair value” was $55m above carrying value, it would imply a carrying value of $61.6m. Therefore, the $146m Labcorp transaction would create an implied gain of $84.4m. If we use a larger discount, the gain becomes larger. Importantly, we assume that the NY State Corporate Income Tax is 8.85% for purposes of this analysis. We are not tax experts, but this is at the upper end of the base rates they provide. Below is a table that shows our work and provides a sensitivity analysis for changes in the discount rate. For purposes of valuation, we will assume a 20% discount rate and ~$4.1m of taxes.
Liquidity
Because the balance sheet is thin, on 3/10/23, the company signed a commitment letter that gives them access to an $8M revolver at SOFR + 5.5%. In addition to the ticking fees, which will help, the company can use the revolver to get them to the transaction close.
Valuation
Our valuation takes a sum of the parts approach. The two parts are the balance sheet at the time of close and the products segment. We have provided a sensitivity analysis below that flexes our assumptions around the number of months to close the transaction and the EV/Revenue multiple for the Products Segment. Regarding cash burn, our assumption is that cash burn is roughly consistent with the ~$7m / quarter currently happening, and our base case is that the transaction closes in June. Regarding the Product Segment, there are numerous publicly traded Life Sciences companies that sell instruments and various consumables including reagents and kits, including QGEN, QTRX, CTKB, CERS, TBIO, and BIO. This larger comp set has multiples that range from .8x ’23 Revenue to 5.38x ’23 Revenue. The smaller-scale companies are QTRX, CERS, and TBIO. QTRX has significant consumables mix, significant cash burn, and slow growth, and it trades at 1.37x ’23 Revenue. CERS, similarly, is a slower-growing (at least relative to ’23 consensus expectations) significantly unprofitable company that trades at 2.75x ’23 Revenue. TBIO, is a high-growth cash incinerator with a diverse mix of revenue streams that trades at .8x ’23 Revenue. For our base case, we assume 1.0x revenue. Adding up the sum of the parts, the pro forma net cash position, inclusive of five months of cash burn (for a June ’23 Close) and an assumption for taxes, implies $2.64 / share in net cash, combined with $.60 from the product segment gives us a price target of $3.24 or 54% upside from today’s close at $2.10.
Disclosure
Our firm currently holds a long position in this security which can currently be considered a long-term holding. Our research is completely independent and based on public information, our proprietary research, and our analysis of that information. While Author has tried to present facts it believes are accurate, Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in ENZ. Reader agrees to hold harmless and hereby waives any causes of action against author related to the note above. As with all investments, caveat emptor.
Sharing a few questions/answers Jordan and me have exchanged via email.
Balance Sheet liabilities
Me: What are your thoughts regarding the other items on the balance sheet, including $43m in liabilities? Are any of these assets/liabilities getting transferred together with the CLS sale? How will the balance sheet look like after CLS sale?
Jordan: Everything tied to the “assigned contracts” is getting assumed, everything not is being excluded. Assigned contracts means each Assigned Real Property Lease and each contract. I think this is simply everything tied to CLS. It’s hard to parse out what specifically belongs to which segment. The majority of the liabilities are leases. I’m assuming that the mortgage debt stays with the company. Additionally, <30% of all the leased sq. ft. is used by the Life Sciences / Products segment. Additionally, if you want to count the AP and AL, you should also take into account the AR and Inventories. Obviously, we don’t know how much belongs to which segment, but I take comfort in the fact that NWC is positive.
Corporate Overheads
Me: Corporate overheads seem to amount to $12-$15m a year. If capitalized in SOTP framework, these would explain a large part of the difference between your target price and the market price. If the company sells the Product segment, then corporate overheads kind of become irrelevant.
Jordan: Good question. Three fold answer: First, I think the company will probably sell the product segment, but I obviously don’t know that; Second, my underwriting is based on a revenue multiple for the consolidated business going forward, and I think that’s justified by comps, so in my opinion, I am including corporate opex in my valuation math; Third, I think the pro forma corporate burn is <$10M annually, additionally the $2.7M of cash corporate opex included $877K of legal spend, some of which is tied to this transaction and some of which is tied to arbitration with two former executives… the arbitration for this is in June and July of 2023. After the legal spend and some reduction in shared services for the divestiture of the CLS segment, I think that burn will be less than $8M annually.
Governance
Me: Given the questions above as well as not that inspiring management’s track record so far, don’t you think this company will continue to trade at a large discount to cash even after the CLS sale closes successfully? Has governance improved anyhow over the last 4 years? Do activists have teeth in this situation and can force management to distribute excess cash instead of paying it out themselves through salaries and etc?
Jordan: Yes. Management completely turned over. New CEO and new CFO. The current CEO came in November of 2021, and the activists made sure he had the ability to operate as a CEO without oppression from the Board, and they actually put him on the board. The bad actor is Elazar Rabbani, he is the company’s founder, Chair, and CEO. He was stripped of Chair and CEO roles and is currently a director. Additionally, Bradley Radoff was put on the board by activists. Radoff is an activist, and he specializes in governance. Radoff was at Citadel and Thirdpoint.
Thanks for the idea, clearly articulated thesis and seems really attractive
How do you think about the patents they have and do you think there is any monetization value there going forward?
If this deal breaks, isn’t the company’s insolvent / will need huge equity issue?
This is definitely a risk, although I think its very small as LH is a serious buyer. But if the deal were to break, you’re probably correct and ENZ would need to raise cash.
What is the bear case here? Simply that the deal might not close? Probability of that seems very remote IMO and I struggle to see the downside otherwise. I am just trying to figure out why such a large spread continues to persist here given what seems such an obvious asymmetric risk/reward. Perhaps just going unnoticed by the market given the tiny market cap? I would appreciate a sanity check if I am missing something.
Large downside though right?
If the transaction fails, the downside would be large – this might account for a portion of a discount to net cash. Then you have large corporate overheads as well as a lack of clarity of what will management do with the received cash or with the remaining business. These points are most probably responsible for the rest of the discount.
Once the deal closes, what will the company do with the cash?
It is not clear yet what they plan to do with the cash. That is one of the key reasons for why the stock trades at such a discount to pro-forma cash on the balance sheet. Hopefully, the presence of multiple activists and Bradley Radoff sitting on the board will keep management away from any egregious capital allocation decisions.
Quick update on ENZ. The company has officially signed an $8m credit facility agreement with Gemino Healthcare. The credit facility should be enough to satisfy ENZ’s liquidity needs at least until the sale completion.
https://www.bamsec.com/filing/121390023027554/1?cik=316253
Proxy Filed this morning. There were a few surprises, but I wanted to give a preliminary update for the sum of the parts here.
Pro Forma cash of $141.7 is inclusive of deal fees. The taxable gain is $98M. This is not the actual after-tax gain because it doesn’t include the NOLs. This is very clear on page 29 of the proxy. On the Federal side, they have NOLs to offset the entire taxable gain. On the state NOL side, they had $38M of NOLs at the time of the 10-K last year… they have only burned money since then. At NY state income taxes, I don’t see how they would pay more than $6M in taxes.
The most surprising thing to me was how small the pro forma adjustment to the lease liabilities was. Reached out to the company this morning to try and better understand.
SOTP table https://www.specialsituationinvestments.com/wp-content/uploads/2023/04/ENZ.png
Jordan, thanks for the update. From your sensitivity analysis looks like the risk of losing capital even at current share price levels is very low.
Ransomware attack 8K. Bad timing. Company has a disaster recovery plan and systems are coming back online. Unfortunate timing.
Definitely unfortunate timing. I can’t think of any precedents that have broken public M&A transactions, at worst a small cut to price. Based on the language in the 8K it is difficult to tell whether it would qualify as a MAE.
If they have any decent IT service, ransomware attacks should only mean being offline for a day or so. Recovery from such attacks is very routine.
Some additional info from the proxy. As suggested by Jordan in the write-up, the discussions regarding the sale of the Life Sciences (products) segment were ongoing, but then the sale of the lab segment got prioritized. Excerpts from the proxy (ELS= Enzo Life Sciences):
“Between October 2022 and December 2022, at the direction of our board of directors, Jefferies contacted a total of 105 potential buyers, consisting of 59 potential strategic parties and 46 financial sponsors that could be interested in acquiring the ECL and ELS business segments.”
“On January 12, 2023, at a meeting of our Board, management updated our board of directors with respect to its efforts in the Sale Process, and Jefferies updated our Board regarding the efforts specifically to sell assets of ECL, as directed and prioritized by our Board”
Shareholders’ meeting is set for May 22nd. I expect this to pass easily. ENZ currently trades slightly below $2.55/share estimated net cash (as per Jordan’s most recent comment). Estimating the remainco valuation at 1.5x EV/revenue multiple, the price target lands at a $3.72/share, implying 50% potential upside. No updates on the ransomware attack so far.
Jordan’s updated valuation table below.
https://www.specialsituationinvestments.com/wp-content/uploads/2023/04/ENZ.png
We recently spoke with management, and unfortunately the tax language in the proxy was confusing to me and other shareholders I spoke with. The wording read that “The actual after-tax gain will be a different amount.” I thought that the reasoning for that was the very next sentence that says, “Management expects to utilize substantially all of the Company’s historical tax attributes to offset a substantial portion of its taxable income arising from the Asset Sale.” After talking with management, apparently the table in the proxy incorporates the NOLs. Additionally, they have to pay city taxes in NYC. All in, I think the tax impact is closer to $17.3M vs. the $6M I had in my original underwriting. Certainly a bummer on the tax side.
Essentially, that means that the Net Cash / Share is $2.28 not $2.55. Feel free to make your own assumption for what the product segment business can do in revenue and what multiple you want to apply to it.
Any idea why they filed a shelf today with B Riley? It seems pretty odd.
Do I understand this correctly – ENZ intends to raise more cash than its whole market cap? $150m from a mix of securities (mix of stock, prefs, warrants, etc.) and $30m equity. So it seems management intends to go on an acquisition spree here and probably shareholders will see no proceeds returned from the Laboratory segment sale either? If that’s the case, my suspicions of the shady founder Rabanni still running the show here have probably been correct.
Overall, this changes the thesis completely, but why is the stock not moving? Does the market think that the fact management thinks they will be able to raise such amounts is positive?
Jordan, are you still holding?
Respectfully, that’s not how a shelf works. If you have a $150M mixed shelf, it doesn’t mean you are going to raise $150M. Companies put a shelf in place to make sure they have authorized and issuable securities that they can issue when needed. it is bad, from a fiduciary perspective, to not have a shelf available. I’m not sure if their prior one expired. I think that they have the shelf and the ATM out of an abundance of caution. If the deal didn’t go through they would need cash. Best to ask the company.
We effectively and materially moved on after we got a more full understanding of the taxes. As you can see in the 4/26 post, the net cash / share is roughly $2.28 if the deal closes. There is still upside from the product side, but we were content with the trade not knowing how the rest will play out.
Understood. Thank you for sharing!
Following Jordan’s comment above, I am removing ENZ from the list of active portfolio ideas. With reduced expectations of pro-forma net cash, and a lack of clarity if management will pursue the sale of the remaining products business, the case no longer offers an attractive risk/reward.