China Cord May Hurt Minority Share Holders

Summary

CSRC passed the inquiry regarding low bid price for China Cord's minority share holders.

HKEX lacks track-records to interfere similar issues.

Watch out for SEC interventions for the last straw.

This is article is published on Seeking Alpha now. Please go to
http://seekingalpha.com/article/3972227-china-cord-may-hurt-minority-share-holders

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Valuation Analysis On Clinical-Stage Biotech

Executive Summary

Aduro Biotech Inc. (NASDAQ:ADRO) is a clinical-stage immunotherapy company and focuses on the discovery, development, and commercialization of treatments for challenging diseases. We analyzed the firm on the assumption of it producing only a single drug, CRS-207, and only applying to pancreatic treatment. We concluded a risk-adjusted price target of $6.70 for this business line.

This is article is published on Seeking Alpha now. Please go to http://seekingalpha.com/article/3971097-valuation-analysis-clinical-stage-biotech

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Section 338(h)(10) Election on Lannett

In this article, I will discuss the tax benefit Lannett ("LCI") will receive from the Kremer Urban ("KUPI") acquisition.

Key Takeaways:
- Section 338(h)(10) can help LCI save tax by stepping up assets
- The NPV calculation shows $87 million cash tax savings
- The "election" may not happen yet

Let's begin.

#1) What is Section 338(h)(10) Election?
First of all, there's an awesome article on this topic from Tony Nitti.

Simply put, here is Section 388(h)(10) magic:
When a corporation purchases the stock of another corporation,  for tax purposes only the buyer is treated as acquiring the target’s assets.  

Or in other words:

A buyer could acquire a target’s stock for legal purposes - thereby keeping the target alive and preserving its non-transferable assets - but acquire the target’s assets for tax purposes, giving the buyer the stepped-up basis in the asset it seeks.

So in LCI's acquisition: LCI acquired KU's stocks -thereby keeping KUPI's contracts and patents - but acquired KU's assets for tax purposes, giving LCI the stepped-up basis in asset.

#2) How to calculate the tax benefit for LCI?
For the LCI-KUPI case, the bulkpart of asset step-up is in the form of  KUPI's intangible assets. There is $659 million net pro forma adjustment in intangible assets, $432 million of which will be amortized in 15 years.

(Source: LCI's 8K on Nov. '15)

So this amortization will hit LCI's bottom line in income statement, but in reality increase it's cash generating capacity.
We can do a simple calculation that discounts this 15-year amortization @8% discount rate, the NPV of tax saving is $87 million.
This number is lower than the management guidance, which expects at least $100 million tax benefit from Section 388(h)(10) election.

#3) Timeline for realization
It's worth mentioning that Buyer and Seller must jointly make the Section 338(h)(10) election no later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.

The acquisition completed on Nov. 2015, but I haven’t heard about the 388 (h)(10) election result yet.
Furthermore, Lannett has agreed to a 50/50 split of the additional tax liabilities UCB will incur associated with the section 338(h)(10) election, up to $35.0 million, and this $35 million has been recorded as liability.

I'm not sure that the $100 million management mentioned is the net number or not.

Related articles:

• Lannett, a mini-version of Valeant?
• The generic pharmaceutical market – what’s the competition landscape for a middle-sized player?
• Will Lannett lose another customer?
• Lannett's C-topical story
• The valuation on Lannett 
• Generic insulin and Chinese partner - another turnaround story of Lannett?
• Controlled substance - Lannett's hidden growth engine
• The Lannett and JSP story

Some thoughts on Lannett

Previously, I have talked about Lannett (NYSE: LCI) from following perspectives:
1. Industry overview: The generic pharmaceutical market overview
2. Previous growth strategy: Lannett, a mini-version of Valeant?
3. Future projections:Will Lannett lose another customer?, Lannett's C-topical story, The Lannett and JSP story, Controlled substance - Lannett's hidden growth engine
4. Valuation: The valuation on Lannett 

After so many moving parts, we currently conclude that LCI is undervalued (bear case valuation at $20 per share).

Investment theses:
- LCI is currently undervalued due to market sentiment
- High-margin, high-barrier controlled substance business has been overlooked by the market
- LCI can generate sufficient cash flow to deleverage, even in severe pricing environment

#1) The big picture
Personally, I don't really like generic pharmaceutical industry. No offense to hardworking and smart management in the industry, but I purely think this industry is a malformation of market inefficiencies and regulation constrains.

If we use some imagination, we can see this whole industry wiped off, if the government mandates brand drug companies lower the drug price after their patent cliff. Then there will be no hassles, no ANDA, no trials in court between brand drug companies and generic ones...

Furthermore, the growth and prosper of personalized drug will reshape current pharmaceutical industry, and I don't see generic pharma with limited R&D investment can survive this reshaping.

What's a future of generic pharmaceutical industry?

If we look at the most regulated industries in the US, like in the photo below:

What patterns do you see?
I see consolidation. Only big players can survive the costly compliance procedures and argue with the government.

We also joked that FDA should a great investment, since the compounded annual growth rate of Prescription Drug application free has been 14.11% for 24 years. In FY 2016, the fee is $2,374,200 for an application with “clinical data” requirement.

LCI is a small and beautiful company, but it will probably get into the consolidation swirl in the near future.

As a result, although LCI is mispriced, I am looking for a trade, instead of a long-term investment.

#2) Time-frame
In the valuation part, I have focused on the bear case valuation. Potential upside catalysts are as followed:
(This graph is outdated after 3Q16 earning call. Need to update)

(Source: complied by the author)

If we look for tools with the most skewed pay-off curve (an instrument that can provide significant upside reward), Long-Term Equity Anticipation Securities ("LEAPs") seem to be good options.

#3) More questions
It's worth mentioning that there has been strong short interest hovering LCI since 2015. The current percentage of share shorted is ~30%.

So far I have considered following reasons for this strong short selling bet:
1. LCI can't handle its transformational acquisition and go bankrupt
2. LCI's business has fraud - e.g. channel stuffing to wholesale distributors and retail drug chains
3. Potential legal issues and product downgrade
4. CEO's health condition (currently age 70)

For (1), I see minimal chance of LCI going bankrupt, since its leverage ratio is 3.8x Net Debt/EBITDA, in line with the pharma industry average.

For (2), while we can cross check with Total Number of Prescriptions (TRx) from IMS, some field researches are still needed.

For (3) and (4), I haven't found material disclosures so far.

More importantly, I still don't understand why LCI didn't walk away from the KUPI deal when there was no break-up fee. It's potentially a fatal red flag.

Controlled substance - Lannett's hidden growth engine

According to management, the controlled substance business is key to the growth of Lannett ("LCI").

In July 2008, the Drug Enforcement Administration ("DEA") granted Cody Labs, a subsidiary that LCI acquired in 2007, a license to directly import concentrated poppy straw for conversion into opioid- based APIs for use in various dosage forms for pain management.

From LCI's 10Q, we read:

"The value of this license comes from the successful development of patentable processes. Cody Labs' expertise in API development and manufacture, allows the Company to perform in a market with high barriers to entry and limited foreign and domestic competition."

Key Takeaways:
- Controlled substances are highly regulated
- LCI's poppy straw importing license and development expertise could be an edge 
- Revenue growth for last 4 years has been decent, but not enough


#1) what are controlled substances?

(Morphine, an example of controlled substances, can be extracted from Opium. Source: The Internet)

Controlled substances have a high potential for abuse which may lead to severe psychological or physical dependence. Thus this market is highly regulated by FDA and DEA. Manufactures/Distributors have to register with DEA on an annual basis.

Furthermore, the controlled substance drugs are protected from foreign competition as long as a source is available in the United States.

#2) What's the prospective in controlled substance business?

Sub-questions: 

a) What's market size of this business?

b) what's the barrier of entry in this business?

From the data above, we found the controlled substance market is $10+ billion in size, with limited players.

If we cross check with other data source, some data suggest the market size for Schedule II APIs is $500~$600 million, while there are five schedules in total. The sales for Hydrocodone/Acetaminophen Combo Market was ~$1.2 billion in 2015.

I haven't got good data on penetration rate yet, but this market has been growing quickly, from only ~$5 billion market size in 2005.

#3) Does LCI have an edge in this industry?

From what we get so far, the controlled instance industry seems a growing playground that haven't been crowded yet.
- Cody Labs has a license to directly import concentrated poppy straw, while only 7 producers has that license
- The management of Cody Labs sounds capable: the president, Mr. Opitz, worked for 20 years with the Bayer group in Germany and Italy in Engineering, Manufacturing, and Product Development, and in the US as SVP Engineering
- The management of LCI has ambitiously expected Controlled Substances will constitute 50% of LCI's revenue in 2019, which will be a great growth booster.

Since 2012, we see a decent growth of this segment in LCI's revenue stream, in spite that the branded drug had some issues with FDA since 2015. However,  the growth was not enough to meet management's ambitions (See Figure above).

To sum up, I believe that controlled substance could be a booster of LCI's top-lines, but we need more information of this niche market. 

Related articles:

• Lannett, a mini-version of Valeant?
• Generic insulin and Chinese partner - another turnaround story of Lannett?
• The generic pharmaceutical market – what’s the competition landscape for a middle-sized player?
• Will Lannett lose another customer? 
• The valuation on Lannett 
• The Lannett and JSP story
• Lannett's C-topical story
• Section 338(h)(10) Election on Lannett

The Lannett and JSP story

One risk related to Lannett (NYSE: LCI) is that over 50% of its revenue (before the Kremers Urban acquisition) comes from one single supplier, Jerome Stevens Pharmaceutical, Inc ("JSP"). In this article I will discuss this partnership and analyze potential risks related to it.

Key Takeaways:

- The banding between JSP and LCI are relatively strong

- Two parties will renegotiate contract in 2019

- We can't rule out the case that JSP will ask a bigger piece of the pie, but the possibility is limited

#1) Why did it begin? 

Levothyroxine ("Levo") Sodium Tablets are used to treat hypothyroidism and other thyroid disorders. It is one of the most prescribed drugs in the United States with over 13 million patients. 

JSP’s Unithroid® was the first FDA approved (August 2000) Levothyroxine Sodium Tablet formulation. Both Synthroid® from Abbott Laboratories’ and Levoxyl® from Monarch Pharmaceutical were approved by the FDA in the following years. 

However, the sales of JSP's Levo products didn't take off. Subsequently JSP filed supplementary application for generic version of Levo .

Since 2002, LCI has been distributing a number of JSP products. And in 2004, LCI and JSP executed a contract that provides LCI with exclusive distribution rights in the United States for the current line of JSP products. The agreement was for a period of ten years.

As a compensation, Lannett granted JSP four million shares of Lannett’s authorized, unissued common stock.

In 2014, these two parties extended a 5-year contract, for which LCI issued 1.5 million shared to JSP and $20.1 non-recurring contract extension cost . LCI also announced If the parties agree to a second five year extension from March 23, 2019 to March 23, 2024, LCI is required to issue to JSP or its designees an additional 1.5 million shares of LCI's common stock.

Furthermore, LCI is required to purchase, in the aggregate, $31 million of products from JSP each year. If LCI does not meet the minimum purchase requirements, JSP’s sole remedy is to terminate the agreement. This translates into ~$150 million annual sales, reasonable at current stage.

#2) How strong is the partnership?

From JSP's website, we found LCI has been distributing most of JSP's products. Moreover, JSP's 5.5 million shares represent ~15% of LCI's outstanding shares.

#3) Is there a possibility that JSP will impact LCI's profit margin in the long-run?

The sub-questions will be:
#a) when they renegotiate the contract in 2019, will JSP eat up the profit margin that LCI is enjoying now?
#b) What's the chance that JSP would abandon LCI and let another distributor to sell its products, or sell its products by itself?

The answer really depends on the negotiation power of management. Since JSP is a family-owned business and they had chosen to get equity from LCI from the beginning, I lean towards a sustainable partnership between these two parties.

To put it simple, JSP is unlikely to squeeze LCI in the year 2019 contract renew. I would put a decent margin for related products in the base case valuation.

Related articles:

• Lannett, a mini-version of Valeant?
• The generic pharmaceutical market – what’s the competition landscape for a middle-sized player?
• Will Lannett lose another customer?
• Lannett's C-topical story
• The valuation on Lannett 
• Generic insulin and Chinese partner - another turnaround story of Lannett?
• Controlled substance - Lannett's hidden growth engine
• Section 338(h)(10) Election on Lannett

The valuation on Lannett

Base on previous discussion, let's focus on the bear case valuation first.

Key Takeaways:
- Stronger financial performance from the cash flow perspective 
- Bear case valuation at $20 per share

My bear case counts in all the negative scenarios that could happen to LCI. Assumptions include:

1. FDA requires LCI to stop marketing C-topical in 2016
2. After JSP renew contract with LCI in 2019, the gross profit margin of related products will drop to 50%
3. Generic segment sales decrease at 9.2% run rate for year 2016-2020
4. Conservative product launches for ANDAs

This projection is ~10% discount of management guidance on $555 million - $565 million revenues in FY2016; projected 50%-55% gross margin is well below 60.5%-61.5% gross margin in the guidance.

Furthermore, due to the step-up in asset from 338(h)(10) tax benefit, amortization of KUPI's product rights and deferred financing cost, we see stronger performance in terms of Free Cash Flow per share.

(KUPI's product rights amortization schedule. Source: LCI's 8K on Nov. '15)

(LCI's deferred financing costs. Source: LCI management presentation on Mar. '16)

I believe a 7x FCF forward multiple (based on 12.8x median P/ LTM FCF for its peers) is appropriate to value LCI in the bear case, which concludes a risk-adjusted valuation of $20 per share.