Consort Medical — Update 15 August 2016

Consort Medical’s key objectives for FY16 (to end-April 2016) were achieved with a strong operational performance in both the Bespak and Aesica divisions. In line with strategic objectives, Consort delivered organic growth and new development contracts, completed the post-acquisition restructuring and integration of Aesica and secured its first combined drug/device development and manufacturing contract with Precision Ocular. Following the year-end, in July, it was announced that Precision Ocular completed its £15.5m Series A fund-raising from a syndicate that included Consort. Planned use of funds includes development of next-generation ocular drug delivery systems for the administration of cell and gene therapies to the back of the eye.

These steps provide further evidence of Consort’s ongoing business diversification, both horizontally to harness more of the value chain with pharma customers and vertically into other new administration forms beyond its traditional strength in inhalers. Consort’s disclosed pipeline now has 14 respiratory, nasal, ocular and autoinjector programmes in late-stage development or under regulatory review, each of which represents a minimum £3m peak revenue potential, but some up to £25m, based on the company’s assessment. Exhibit 1 provides an overview of the major development programmes. The most recent additions to this pipeline are the Aeropharm (Sandoz) VAL050 pMDI valve and actuator contract and Precision Ocular’s joint Aesica/Bespak project. At its prelims, Consort also provided a status update on two of its key late-stage inhalation programmes: DEV200 and DEV610. Uncertainty remains over the launch of the Voke nicotine inhaler, potentially in the next year, although the revelation that DEV610 is Mylan’s Advair generic with a GDUFA date of 28 March 2017 brings clarity to its launch timeline and sales potential.

Consort Medical’s investment in innovation and the resulting product launches are the key determinants for its organic growth, in our view. As an acquisitive company, Consort is additionally exposed to risks pertaining to integration of acquisitions in a timely and cost-effective way and the execution of its growth strategies.

The company is also subject to various other sensitivities common to drug and device CDMOs, on both the up and down side. In particular these include reliance on large contracts and key customers, product development and regulatory risks, and technology and commercial risks. We provide more detail on these sensitivities in our Outlook report Improved prospects for margin expansion, published in March 2016.

We also note that Consort is sensitive to FX movements, in particular the €/£ rate. Management has indicated that each 1c movement in the FX rate has a £0.6m impact on full year revenue and a £0.1m impact on EBIT. This translational exposure is predominantly related to Aesica’s European business, while Bespak has low exposure to FX movements (€ or US$).

Our valuation of Consort Medical takes into account both the underlying business and the business pipeline, which we evaluate on a risk-adjusted NPV basis. As a sense check, we also evaluate Consort’s earnings multiples against a broad peer group of UK and international peers. Consort’s business model is unique in the context of the healthcare sector. Consequently, its peers include UK healthcare investments, subsidiaries/divisions of wider groups involved in specialist contract development and manufacture for the pharmaceutical industry (eg Catalent), as well as companies involved in medical packaging solutions and drug delivery.

Given the differences in capital structures between the constituents of our comparator group, we believe EV/EBITDA is the most appropriate parameter. With the international and UK peer groups trading at 12.6x and 11.8x 2017e EV/EBITDA, respectively, we note that calendarised Consort Medical trades at a 8.4% and 2.3% discount, respectively. With 2015-17e EPS CAGR below the average of both the UK and international peer groups, we consider calendarised 11.5x FY17e EV/EBITDA to be justified. That derives an implied average valuation for the current Consort Medical operations of 1,130p per share.

For our DCF valuation, we consider the risk profiles of Aesica and Bespak’s underlying businesses to be similar and employ a WACC of 10% of the underlying business. For the business pipeline, we forecast known projects based on the company’s guidance that each of these will have peak revenue potential of at least £3m pa. We forecast an operating margin of only 15% (below Bespak’s 20%), success probabilities of 60-80% and a WACC of 12.5%. For both of these, we have rolled forward our valuation model to FY17.

We believe the development pipeline should meaningfully boost revenues from end CY16 onwards. In view of the undisclosed identity of many of these projects, our valuation may not adequately capture expected revenue growth (particularly if any of these programmes have significant potential, or material new contracts are secured). We have updated our assumptions following latest disclosures related to potential launch timelines of DEV200 (Voke nicotine inhaler) and DEV610 (Mylan’s generic salmeterol/fluticasone DPI). Consequently, we now expect first material commercial revenues in FY18 from both programmes and for the latter (DEV610), we also upgrade our revenue expectations and probability of success to 90% given that the product/partner is now disclosed and it has been filed with the FDA. Incorporating these changes, we value the Bespak project pipeline at 220p/share (down from 240p/share at a 60% probability of success for non-DEV610 programmes) to 273p/share (down from 319p/share at 80% probability). Adding this to our peer group valuation of 1,130p/share gives a valuation range of 1,350p to 1,403p per share.

We have also performed a DCF-based valuation, including the financial impact of the product pipeline, as a reality check. We have employed a three-phase DCF, using our forecasts for free cash flows from our model from FY17 to FY21 to derive the first part of our NPV. The second phase sees the expected growth rates tapering from a high of 10% in 2021 to 3% in 2031, with a terminal value applied after that (using a 2% growth rate). We have used a 10% discount rate and assumed a tax rate of 18%. This approach suggests Consort Medical is worth 1,248p per share (previously 1,289p).

Consort Medical’s FY16 results highlight continuing delivery on its growth strategy, with significant progress being made with margin expansion at both Bespak and Aesica, and a growing diversification of the business and customer base. Full year revenues for FY16, the first year in which Aesica operations were fully consolidated (FY15 included six months of operations), were a record £277m – up 49.8% on FY15. This reflects growth in all Bespak segments (MDI, DPI and other/injectables) to £117.2m (FY15: £105.8m) and a £159.7m Aesica contribution.

Importantly, FY16 operating profit (before special items related to restructuring and acquisitions) grew to £37m (FY15: £25.1m) with margin broadly maintained (13.4% vs 13.6% in FY15), albeit masking +170bp margin improvement at Bespak (to 21.5%) and 210bp at Aesica (to 7.4%). This reflects continuing operating leverage, active cost management and the curtailment of negative/low-margin work at Aesica. EBITDA (also before special items) grew by 45.5% from £33.2m to £48.3m, with margin falling slightly from 18.0% to 17.4%.

Following the Aesica acquisition in November 2014, FY16 represented a full year of utilisation of borrowing facilities, hence net financial costs were higher at £3.3m vs £2.1m. Pre-tax profit (before special items) increased to £32.3m vs £22.7m (up 42.3%). On account of the strong performance, the final dividend was raised 7.5% to 12.56p, above the 5% increase in the interim dividend. Cash generated from operations was £54.1m; with capex of £21.1m (reflecting the final phase of significant investment in capacity expansion for DEV200 and DEV610) and interest and tax of £9.3m, net debt fell slightly from £99.2m at FY15 to £97m at end-FY16.

We broadly maintain our forecasts as outlined in our March 2016 Outlook report. For FY17 and FY18 we forecast group revenues to increase by 1.6% to £281.5m and 6.1% to £298.7m, comprised of Bespak revenues of £118.1m and £127.2m, and £163.4m and £171.6m from Aesica. At the group level, we expect operating profit (before special items) to increase to £37.3m and £40.0m, with Bespak and Aesica operating profit (again before special items) of £24.2m and £25.4m and £13.1m and £14.6m, respectively. We forecast respective normalised pre-tax profit and fully diluted EPS at £33.5m and 55.8p for FY17e and £36.3m and 60.5p for FY18e. Consort does not have an explicit dividend policy, but adapts the dividend payout in relation to its operating cash flow and investment requirements. We forecast DPS to be maintained at 19.3p.

Operating cash flows are expected to remain strong, but continue to highlight that Consort has identified growth opportunities in both divisions, which should sustain capex at a high level of £25m in FY17-18. Thereafter, we expect capex to drop back to £17-18m. On this basis, net debt is forecast to fall to £93m in FY17 and £88m in FY18.

Consort benefits from a £160m long-term credit facility with rates ranging from Libor plus 165-190bp. The key covenants are that interest cover (EBITDA/net finance charge) must exceed 3.0x and leverage (debt/EBITDA) must be less than 3.25x until 30 April 2016 and less than 3.0x thereafter. Net debt/EBITDA as reported at end-April 2016 stood at 1.92x. The headroom in this revolving credit facility (£46.7m is undrawn), coupled with the £65m accordion facility, means there is ample capacity to make suitable bolt-on acquisitions or opportunistic product and/or technology acquisitions as appropriate.