Expected Company Sale – Multibagger Upside
This is a high-uncertainty/high-reward setup where the ongoing strategic review might result in the sale of the company at a multiple of today’s price. However, the company is in technical default due to a covenant breach, is non-current on its financials, and has not provided any additional disclosures over the last two months. Investors are left in the dark with no updates of the debt forbearance or the sale process. Hence, LFCR is a bit of a black box today, which is why the opportunity exists. The key known fact is that the company owns a fast-growing and high-quality pharma CDMO business that is apparently coveted by market participants. In a sale scenario, this business could fetch 15x-20x EBITDA multiple resulting in an equity value of $8-$20/share, a significant premium to today’s $5/share market price. 3 pending catalysts are likely to drive LFCR shares upwards – the announcement of a forbearance agreement with the lenders, getting current on the financials, or potentially full company sale.
The current situation has been well covered in a couple of recent hedge fund letters – Laughing Water Capital, Greenhaven Road Capital – as well as in this VIC pitch. I recommend reading through these write-ups as they provide a really good background on the setup. Below is my quick overview of the case together with a number of uncertainties and potential complications that I see here.
LFCR is a contract development and manufacturing services provider (CDMO) for pharma industry, which focuses mostly on the aseptic fill finish sector – filling sterile syringes and vials with clients’ products. This is a very specialized and high-quality business with very sticky clients. Fill finish is a critical step in drug production, where even a minute error can cause microbial contamination posing health risks to the patient. The process has strict FDA requirements and a lengthy reapproval process is needed when a client wants to change its fill/finish provider. Hence, the business is sticky where the switching process can take up to 3 years). It is also the fastest-growing sector of the injectables CDMO industry. The attractiveness of this business is clearly shown in the historical LFCR results – over the last 8 years delivered 15% revenue CAGR and 25% EBITDA CAGR.
The company continues to grow. Back in Oct’22 management issued guidance for FY23 revenues of $124m (+14% YoY) and adjusted EBITDA of $32m (+10% YoY) for the Lifecore segment. This compares to the current EV of $265m. Management is clearly confident this growth is not going away anytime soon and is heavily investing into further expansion. The company aims to double its operational capacity from the current 10m unit fills per year (c. 80% utilized right now) to 22m by FY25 and then double again to 45m by FY28.
So if the business is doing so well, how did we get to a technical default?
Two months ago, the company was hit by a bad combination of delays in product shipments and customer onboarding, which shifted a large chunk of earnings forward and resulted in an earnings miss. The announcement of quarterly results (in mid-March for the quarter ending Nov’22) threw LFCR into a debt covenant breach and a going concern notice. This led to a market panic that for one day crashed the stock price from $5.11/share to $1.67/share. It was noted that the company “is currently in negotiations with the Lenders to seek a forbearance and amendment agreement to remedy the Company’s current and anticipated noncompliance with its covenants”. The same press release included the announcement of strategic alternatives as well as a significant expansion of a relationship with an existing client which agreed to finance $25m of LFCR’s capex. There have been no further updates since.
While the technical default and the going concern might sound scary, the downside appears to be very well protected at current levels even in a bankruptcy scenario. Laughing Water Capital put it well:
“Replacement cost of Lifecore’s assets would be around $400M, and would take 4-5 years, which is attractive vs. the Company’s current enterprise value of approximately $250M. <…> Even when giving no credit for existing cash and/or recent debt payments a rudimentary bankruptcy analysis suggests that equity owners today would survive intact, and with a nice profit. Of course, given that this business is accelerating, not declining, a valuation based on future cash flows would be more appropriate than replacement cost. The point is just to suggest that even in a bankruptcy scenario, equity owners have little to feat other than mark to market risk.”
The current LFCR share price is already at the levels where it was before the ‘going concern’ announcement. However, the market is likely underappreciating a number of recent positive developments.
- Together with the going concern notice, LFCR has also announced a review of strategic review alternatives. The company has retained Morgan Stanley, which has recently advised on the sale of another CDMO (Alcami), to assist with LFCR’s strategic review. Recent precedents suggest that the takeout price could land substantially above today’s trading levels. Currently, the company trades at around 8.5x segment level adj. EBITDA and 2.1x revenues, which look very attractive relative to industry transactions. This article suggests the average EBITDA multiple for CDMO takeouts has been 17x. Several specific examples include Capsugel/Lonza (16x EBITDA) in 2016, Patheon/Thermo Fisher (17x EBITDA) in 2017, Avista/Cambrex (3.9x revenues) in 2018, Alcami/GHO Capital (rumors are the price was 20x EBITDA) and this year’s sale of Baxter’s CDMO business at 6.6x revenues. Although all these CDMO transactions have been much larger, LFCR operates largely in the fill finish sub-sector, which arguably deserves a higher takeout multiple.
- The company has also announced a major commercial relationship expansion with an existing customer. The agreement entails the client making a $10m upfront cash payment for infrastructure preparation and a $15m reimbursement in further capital expenses. This agreement is not only a vote of confidence in LFCR but also suggests material uplift in revenues and EBITDA from this relationship. Laughing Water Capital guesses this expanded relationship would eventually result in 25% uplift in revenues and $10m in incremental EBITDA for LFCR (for a total forward segment EBITDA of $42m).
- Another positive development that has taken place last month is that LFCR has finally transformed into a pure-play CDMO. Until recently, LFCR used to be a bad combination of struggling/low-margin food (pre-made salad and processed avocado) assets and a high-quality/fast-growing CDMO. This made LFCR screen very poorly and completely overshadowed the quality and margin/growth profile of the fill finish operations. In February and April the company finally completed divestments of its food assets, and it’s quite possible that the market is not fully appreciating this transformation yet.
- LFCR has recently completed two common/preferred equity offerings at significantly higher prices. Major company shareholders have participated in both of these. In November’22, the company issued $5m common stock at $7.97/share. In January, it issued $39m of preferreds (7.5% coupon), convertible into common shares at $7/share. LFCR has a rather concentrated ownership with around 44% of shares held by 4 small-cap funds – Wynnefield Capital (16% stake), 22NW Fund (10%), Legion Partners Asset Management (10%), and Cove Street Capital (7.7%). Worth noting that, LFCR position is not particularly large for most of these funds, except maybe Wynnefield (4th largest position), and most of them have also been holding the stock for several years and are sitting on considerable losses.
- Finally, LFCR’s liquidity position is solid. The company is not current on its financials (due to divestments-related accounting restatements) and just looking at the latest available earnings (ending Nov’22) it might seem like LFCR is having major liquidity problems – the available cash at the time was just $6m. However, since then the company has received substantial cash inflows from multiple sources. Since November LFCR raised $39m from preferred issuance, sold the Avocado business for $17.5m in February, and sold the Olive Oil business for $6.23m last month.
Thoughts on the uncertainties involved
The key uncertainty is how to interpret the two months of silence from LFCR and in what form will the company exit the technical default – dilution vs no dilution, liquidity problems or not, the business still on track with the previous guidance or not. I think that lack of disclosures either means the company’s sale discussions are in advanced stages making the forbearance agreement irrelevant, or the lenders are playing hardball and have no intentions of walking away with a minor settlement or a minor forbearance fee. The defaulted loan ($133m) is pretty large relative to the company’s market cap so lenders might be pushing for a material bite of LFCR equity. In the absence of a sale, this potential dilution could offset a large part of the recent positive developments (client expansion, transformation into pure play CDMO, etc.).
Then comes the question of the appropriateness of the 15x-20x EBITDA multiples that have been thrown around for the valuation of the company. It’s fairly difficult to understand how comparable is LFCR business to the previously mentioned industry transactions, most of which involved way larger (multi-billion) and much more diversified private companies. LRFC doesn’t separate its higher-quality fill finish revenues from more generic CDMO service revenues making the comparison even harder. It is not really clear if LFCR can fetch such a high multiple in a sale scenario. Smaller, but seemingly more commoditized/lower-margin peers are trading at far lower multiples. SCTL ($89m market cap) is now valued at 6x forward adj. EBITDA and 1x revenues, while CTLT trades at 10.9x forward adj. EBITDA and 2.2x revenues. Both of these companies appear to have only tiny fill finish businesses and are mostly operating in more commoditized sectors of CDMO. On the other hand, another peer, Avid Bioservices ($950m market cap), trades at a much higher 8.3x TTM revenues. This high multiple is driven by operations in a highly specialized cell and gene therapy space (mammalian cell culture manufacturing) and high growth. Overall, the trading and transaction multiples seem to be all over the place, and without a deeper understanding of the industry nuances and differences between the companies it is difficult to tell which of these peers/transactions are most closely comparable to LFCR.
Another uncertainty is the actual profitability of the business. The $32m forward EBITDA (+$10m from client relationship expansion) is based on management’s FY23 guidance issued in Oct’22. This guidance was withdrawn with the start of the strategic alternatives process. With the company being non-current on its fillings, it is hard to tell if this target is still valid. Also, this figure is for segment-level EBITDA only and excludes corporate overheads. It can be argued that part of these corporate overheads would be eliminated in a sale scenario, but if the company continues as a standalone, one needs to deduct $7m-$8m (as guided by management bac in Oct’22) to arrive at the EBITDA profitability of the whole company.
And finally, there is a question of LFCR management’s competency, which did not inspire confidence even before the current events. The divestments of the food assets have fallen short of investor expectations and have failed to resolve the company’s balance sheet issues. The way management has now thrown the company into technical default causing a 65% share price drop in a single day is mind-boggling. It’s hard to say what exactly happened with those shipment delays and client onboardings, but the fact management has operated with such a tight margin of error and was not able to foresee these issues and pre-negotiate the forbearance doesn’t inspire much confidence. At the very least, any issues and the going concern notice could have been communicated much better if there is no real business effect from it.