Catalent’s Acquisition Of Cook Pharmica Overshadows Earnings

On November 6, Catalent, Inc. (NYSE:CTLT) reported its first-quarter 2018 earnings (the company’s financial reporting year is staggered two quarters from the calendar year) which subsequently sent shares tumbling almost 8% at times to open the week of trading. The focal point of the report was Catalent’s acquisition of Cook Pharmica for $950 million, a privately-held biologics-focused contract development and manufacturing organization. On the quarterly conference call, CEO John Chiminski had the following to say of the acquisition:

The combination of Catalent and Cook Pharmica significantly strengthens our position as a leader in biologics development and manufacturing. Together, we’ll provide customers a single partner to accelerate biologic drug development programs for our customers and bring better treatments to patients worldwide through a comprehensive portfolio of integrated solutions. The acquisition closed on October 23 and the integration is well underway, already creating value for the company, our customers and our shareholders.

The financing behind the transaction was also favorable to CTLT as the payment process included the use of cash, debt markets, and capital markets. The company issued 7.4 million shares of common stock at $39.10 per share, roughly 8.5% lower than the stock price was trading at before the earnings report. The majority of the acquisition was funded by the stock issuance as well as the $450 million, 8-year note offering Catalent completed in October. The remainder, $150 million, will be paid in three $50 million installments each October for the next three years. The use of multiple sources of financing meant that CTLT didn’t have to shell out too much cash upfront.

Impact of Cook Acquisition

It appears that the quarterly performance itself was not what drove CTLT shares down so dramatically after the release, but rather concerns regarding the recent acquisition. The takeover of Cook Pharmica was large enough to affect its capital structure as well as its 2018 guidance so that must be what the market didn’t approve of; however, neither was negatively impacted dramatically. On the earnings call, management provided a long-winded explanation of how the company’s capital structure was affected. In short, Catalent’s leverage ratio now stands at 4.8x instead of the 4.0x it was at before the transaction. Walsh expressed his belief that the cash flow generation of the combined entity will allow management to lower this ratio to around 3.0x within 24 months. Concerns over the higher debt load are certainly understandable; however, the excerpt below from the company’s Q1 2018 earnings presentation should ease those concerns:

As you can see, the company has total debt of $2.1 billion and doesn’t have any major debt maturities approaching for the next five years. With over $500 million expected in EBITDA for 2018 alone (will be discussed next), investors should not be too focused on the leverage risk of Catalent. There is one other aspect of this slide that stands out to me and that is the bullet point underneath “Capital Allocation” on the left hand side. There are four main points covered and debt reduction is mentioned last while the first two are centered around future growth. To me, this indicates that Chiminski and his team couldn’t be less worried about those debt maturities half a decade away. In fact, this implies that the company will be looking to spend more money and potentially increase its leverage again in the coming years. This mentality can be dangerous but with revenue and EBITDA growing at the rates they are, Catalent can afford to be aggressive in its vision.

With regard to FY18 guidance updates, please see the image below, also sourced from the Q1 2018 earnings presentation:

As you can see, the acquisition of Cook Pharmica will be moderately additive to the bottom line this year with a larger boost coming in the form of revenue. Catalent will surely be looking to expand on this revenue growth and integrate its business model so that net income numbers increase over time. One thing investors should note is that this is not a flatlining company that made this huge purchase to ignite growth. A look at the “Prior Guidance” column shows that the company was projecting growth of 6%, 8%, and 9% for revenue, adjusted EBITDA, and adjusted net income, respectively, before Cook was factored in (using the midpoint of prior guidance). This acquisition was also not fully a “net new” addition. The biologics capabilities of Cook will be integrated into the existing company and will subsequently enhance the performance of CTLT’s business while adding additional revenue dollars over the top. Cook Pharmica looks like a prudent addition by Catalent.

Q1 2018

The company started its fiscal year well as year-over-year performance was strong, with revenue and EBITDA each increasing 22% on a constant currency basis (organic growth stood at 14% for revenue and 13% for EBITDA). Additionally, each of the company’s three business segments – Softgel Technologies, Drug Delivery Solutions, and Clinical Supply Services – reported double-digit growth in both revenue and adjusted EBITDA. Adjusted net income per diluted share of $0.25 even managed to increase $0.04/share or 19% from last year, despite 7.4 million more shares outstanding at quarter-end.

Softgel Technologies

The Softgel segment grew revenue 16% and EBITDA 15% year-over-year. These results were also aided by an acquisition that CTLT closed in the third quarter of FY17. Accucaps, a Canada-based developer and manufacturer of over-the-counter, high potency and conventional pharmaceutical softgel products, can claim most of the growth seen in the quarter as organic revenue only increased 2% while organic EBITDA fell 3%. The primary reason for the subpar organic performance was weakness in Europe and Asia Pacific; North American operations performed in line with FY17.

Drug Delivery Solutions (DDS)

DDS had a strong quarter growing revenue 17% and increasing EBITDA 12%, 13% and 10% of which were organic, respectively. The company’s biologics operations are housed in DDS and are a primary growth engine for Catalent with CFO Matthew Walsh outlining on the conference call his belief that biologics has been a focal point and can fuel CTLT’s growth. Walsh had the following to say about the segment:

Recent investments in our biologics business continued to translate into growth during the first quarter and it remains the fastest growing business within Catalent.

We recorded strong revenue and EBITDA growth at our Madison facility, driven by the completion of project milestones and larger clinical programs. The SMARTag technology continues to meet proof-of-concept milestones and customer interest remains strong.

We continue to believe that our biologics business is positioned well to drive future growth as indicated by business development signings with Roche, Moderna Therapeutics, Triphase Accelerator, Therachon AG and Grid Therapeutics.

As John mentioned, the acquisition of Cook Pharmica strengthens our position as a leader in biologics development, analytical services and finished product supply. The combined business will be able to provide integrated solutions from protein expression through commercial supply of biologics in a variety of finished dose forms.

According to Walsh, the acquisition of Cook helped “fill one of the major gaps” in Catalent’s biologics strategy by adding manufacturing capabilities that Catalent previously did not have. Walsh also noted that the addition of Cook will also accelerate the already strong growth of biologics. On a pro forma basis, biologics is now expected to comprise 21% of Catalent’s revenue in 2018, up from 14% in 2017.

Clinical Supply Services (CSS)

Catalent’s last segment, Clinical Supply Services, generated a massive revenue increase of 46% with EBITDA also climbing 58%. This is Catalent’s smallest business segment (about half the revenue of Softel and DDS) but the growth is encouraging, nonetheless. Also, all of this growth was organic. As of quarter-end, CSS had a backlog of $333 million, which is a decrease of 1% sequentially. However, net new business wins of $99 million in quarter represents an 8% increase year-over-year. While M&A activity helped prop up the year-over-year figures, investors can find comfort that CSS has managed even larger growth figures without artificial enhancement.

Conclusion

It appears that Catalent’s stock is being hampered by its acquisition of Cook Pharmica and the impact it will have on the business. The market didn’t have a strong reaction to the acquisition when the deal closed in October, but it did once the impact on 2018 guidance was announced. I believe this selloff is unwarranted. Catalent’s business is growing (growth which will be amplified by Cook in both the short and long term) across all its segments with continued growth expected this year. If management projections are correct and the leverage ratio can be reduced to 3.0x over the next two years, then I view this acquisition as a strong tailwind and CTLT as a Buy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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