Consort Medical — Update 19 December 2016

Consort’s disclosed pipeline (Exhibit 1) now has 16 respiratory, nasal, ocular and autoinjector projects 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.

Consort’s business is subject to sensitivities common to both medical device and drug manufacturing companies. In particular, it has a relatively high, albeit diversifying, customer concentration: the top five customers represented 50% of group revenues in H117. This is mitigated by long-term contracts and the ongoing focus on diversifying both its product and customer bases. Moreover, there are risks pertaining to product development and commercialisation, ie clinical or regulatory failure or delays, new product uptake and supply chain rationalisation, delivery on business development and successful implementation of its growth strategy. Post the June 2017 UK referendum vote, the impact of FX fluctuations has become more apparent. In terms of FX risk, a 1c weakening of €/£ rate reduces revenues by £0.8m and operating profit by £0.1m.

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 compare Consort’s earnings multiples against a broad peer group of UK and international peers (Exhibit 2). Consort’s business model is unique in the context of the healthcare sector. Consequently, its peers include UK healthcare companies, 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.

We believe that EV/EBITDA is the most appropriate parameter for a peer group comparison given the differences in capital structures between the constituents of our comparator group. With the international and UK peer groups trading at 15.5x and 13.3x 2017e EV/EBITDA, respectively, we note that Consort Medical trades at a discount on calendarised multiples. Consort’s 2016-18e EPS CAGR is below the average of both the UK and international peer groups, however both groups contain a notable outlier; hence we consider calendarised 12.0x FY17e EV/EBITDA to be justified. That derives an implied average valuation for the current Consort operations of 1,105p per share.

We then consider a risk-adjusted NPV of the business pipeline. For this pipeline, we forecast known projects, which based on Consort guidance have a 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% and also roll forward our model to reflect the passage of time.

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 value the Bespak project pipeline at 254p/share (previously 220p/share) at a 60% probability of success for non-DEV610 programmes and at 316p/share (previously 273p/share) at 80% probability. Adding this to our peer group valuation of 1,105p/share gives a valuation range of 1,359p to 1,421p per share.

We have also performed an overall DCF-based valuation, including the financial impact of the product pipeline, as a reality check. We employ a three-phase DCF, using our forecasts for free cash flows from our model from FY17 to FY22 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 2032, with a terminal value applied after that (using a 2% growth rate). We consider the risk profiles of Aesica and Bespak’s underlying businesses to be similar and have used a 10% discount rate and assumed tax rate of 18%. This approach suggests Consort Medical is worth 1,260p/share (previously 1,248p).

Consort’s H117 interims (for the six-month period to 31 October 2017) continue to demonstrate delivery on its growth and margin expansion strategy. Underlying revenue growth (constant currency) was 2.0%, although FX boosted reported revenues to £144.9m (+6.9%; H116: £135.5m). Bespak revenues grew 4.3% to £58.9m (H116: £56.5m) supported by growth in both product sales and service revenues, while more modest underlying growth of 0.5% at Aesica was enhanced by the pound weakening vs the euro, translating into 8.8% reported revenue growth to £86.0m (H116: £79.1m).

The continued impact of operating leverage and active cost management has supported further improvement in operating profit and margins despite increased investment in Innovation. H117 operating profit (before special items related to restructuring and acquisitions) increased to £18.9m (H116: £16.5m; +8.5% on a constant currency basis) with an EBIT margin of 13.0% (vs 12.1% in H116). On a divisional basis (Exhibit 4), margin improvement at Bespak was +30bp (to 20.7%) and +160bp at Aesica (to 7.8%). Management remain comfortable with guidance of ultimately achieving a double-digit margin at Aesica. EBITDA margin (also before special items) expanded to 17.4% from 15.9% on the back of 11.9% underlying EBITDA growth to £25.2m (H116: £21.5m). Pre-tax profit (before special items) increased to £16.6m (from £14.1m), with a 5% increase in the interim dividend to 7.09p/share. Consort’s dividend policy is to pay dividends with cover 2-3x basic EPS.

Cash generated from operations was £10.1m, with capex of £6.2m. EU approval and launch of INJ570 (UCB’s Cimzia Autoclicks auto-injector) reduced the effective tax rate (before special items) to 16.1% for the period as historic R&D losses related to The Medical House are now recognised as a tax asset. At-end October 2016, net debt stood at £106.8m, an increase on the £97m net debt position at end-FY16; capex and FX on cash and borrowings were contributors to this increase.

On the back of the strong H1, we upgrade forecasts and now expect group revenues of £290.2m (previously £281.5m) for FY17 and £305.9m (formerly £298.7m) in FY18. For FY17 we expect Bespak to contribute £122.5m (FY18: £129.8m) to revenues with £167.7m from Aesica (FY18: £176.1m). We forecast group operating profit (before special items) to increase to £38.5m and £40.9m for FY17 and FY18; at the divisional level, we expect Bespak operating profit (again before special items) of £25.1m in Fy17 and £26.0m in FY18, with Aesica generating operating profit of £13.4m (FY17) and £15.0m (FY18). Our expectation is for normalised pre-tax profit of £34.8m for FY17e and £37.2m for FY18e, and fully diluted EPS of 58.0p for FY17e and 62.1p for FY18e. Operational cash flow will remain strong, however, due to investment in Innovation and growth opportunities in both divisions capex will also be high in the next couple of years. Given that H117 capex was below expectations and that management is guiding towards a high level of spend in H217, we have shifted £2m of capex into FY18, now forecasting capex of £23m in FY17 and £27m in FY18. Thereafter, we model annual capex of £17-18m. Adjusting our working capital assumptions to account for the pound weakening against the euro, we expect net debt at end-FY17 of £105.9m and £107.6m 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 3.0x. Net debt/EBITDA as reported at end-October 2016 stood at 1.9x. Consort has total committed debt facilities of £171.2m, of which £47.1m is undrawn, leaving the company with financial resources for potential bolt-on acquisitions or opportunistic product and/or technology acquisitions as appropriate.