Evotec — Update 29 June 2016

Company description: A diversified hybrid business model

Evotec is a German biotechnology company founded in 1993 by a group of eminent German scientists, including the Nobel Laureate Professor Manfred Eigen, and employs c 1,000 people in France, Germany, the UK and US. Evotec provides drug discovery and early stage drug development services to the pharmaceutical industry, has collaborations with academic institutions to advance novel drug discovery programmes and also invests in its own R&D projects. The structure of this business model allows for prudent investing in R&D projects, supported by the stable, high-visibility and profitable service business. Recently Evotec has spun out an internal drug discovery platform into a standalone biotech company, Topas Therapeutics, which was also backed by a consortium of venture capital investors, with Evotec remaining the largest shareholder.

Evotec’s client base is well diversified, with 53% of 2015 revenues coming from top 20 pharma clients, another 30% from mid-sized pharma and biotech and the remaining 17% from foundations, not-for-profit and academic institutions. It has two business divisions: EVT Execute, which provides drug discovery services; and EVT Innovate, which aims to discover novel therapies through its CureX and TargetX initiatives with academic institutions and subsequently to form collaborations with industry partners.

Valuation

Our overall valuation approach is unchanged, including a combination of DCF-based model with rNPV calculations for R&D assets. However, as the preclinical pipeline is maturing, we have made a detailed revision of our valuation of the R&D pipeline, which now includes preclinical stage projects where there is a defined development pathway. Our Evotec valuation is marginally lower at €575m or €4.34/share, from €577m or €4.36/share previously. A lower net cash position and the removal of clinical stage projects were offset by the addition of the preclinical assets and a slightly higher valuation of drug discovery services mostly due to rolling our model forward in time.

Evotec’s risk profile is balanced compared to the risk associated with the biotechnology sector because of its drug discovery alliance strategy. It is undertaking a large number of discovery projects at once, so that the inevitable failure of some programmes should not undermine the business. The company does not take unpartnered assets into clinical development, so it is not exposed to the significant financial risk associated with clinical development, while retaining some of the upside linked with successful clinical development. Evotec’s growth in FY15 was boosted by the Sanofi deal, while our future forecasts are based on organic growth, which will require Evotec to maintain existing and/or attract new collaborations.

With growth continuing into Q116, we have only made minor changes to our 2016 and 2017 forecasts. Evotec finished FY15 strongly, with total revenues growing by 43% year-on-year or 57% if excluding milestones, upfront and licence payments, which is more reflective of the performance of the underlying business. The acceleration in growth in 2015 was primarily because of the Sanofi deal in Q215. For 2016 we expect 25% underlying revenue growth (more than 15% guided) and adjusted EBITDA of €19.2m, an improvement from €8.7m in 2015. Evotec remains in a strong financial position with gross cash of €122m (net cash: €100m) at Q116. Evotec could make more bolt-on acquisitions to develop its expertise further and ensure it remains a technological leader in the field of drug discovery, although no indications have been provided in this direction yet.

Evotec operates a profitable business providing services for partners that outsource drug discovery processes and early stage preclinical development (EVT Execute segment). This provides Evotec with high-visibility revenues and supports its strong balance sheet (end-Q16 cash and short-term investments of €122.5m). As a result, Evotec is able to invest in its innovative discovery and preclinical drug development programmes (EVT Innovate) via collaborations or on a standalone basis. Evotec’s performance shows that such a hybrid business model is sustainable and offers a unique twofold exposure to risk/reward for investors: the low-risk, high-visibility services business is combined with potential upside from riskier R&D projects. Notably, Evotec has limited financial downside risk associated with clinical stage projects, as they all are progressed through licensing agreements with their partners covering the costs. Our investment thesis is built on both positive company-specific and industry trends that point towards healthy cash flows in the future.

The global outsourcing market is estimated to grow at a CAGR of 5-10% between 2015 and 2020 (source: Visiongain). The main macro trends that underpin the drug discovery outsourcing market’s growth are:

Evotec’s core expertise lies in the earliest stages of drug discovery and development (Exhibit 2), allowing its clients to drive innovation efficiently, reduce costs and increase the development speed. The company has become one of the largest service providers in the Western markets with a diverse client base. Since its inception in 1993, Evotec has been involved in more than 250 partnerships, and has developed more than 30 preclinical candidates and 20 clinical candidates. Notably, Evotec’s customers are very diverse and range from large pharma to “virtual” small biotech companies, to not-for-profit organisations and foundations.

Evotec also owns a portfolio of assets (partnered and unpartnered) in different development stages ranging from discovery to clinical. In terms of therapeutic areas, Evotec has developed expertise in diabetes and diabetic complications, pain and inflammation, oncology, infectious diseases and neuroscience. The strategy for the R&D portfolio is to partner the assets early in the discovery or to develop them up to preclinical candidate nomination. Evotec avoids financial risk associated with the later preclinical or clinical development, at which stage the partner takes over via out-licensing agreements.

Although the long-term macro trends in drug discovery services seem favourable to Evotec, over the past few years the industry has experienced a number of changes, such as financial pressures resulting from the “patent cliff”, cost cutting, consolidation, large mergers and optimisation of in-house R&D. Over the past five years Evotec has navigated these changes, emerging as an established service provider with long-term relationships with the customers (Exhibits 4 and 5). The number of alliances (customers) directly correlates with Evotec’s revenues; therefore important indicators to observe are new clients, those that continue working with the company and the quality of customers, ie those that significantly contribute to Evotec’s top line. The total number of alliances increased significantly in 2014 and 2015 reaching 177, of which 67 were new clients. Twenty-one alliances generated more than €1m revenues for Evotec, indicating a trend of an increasing number of quality customers.

The acquisition of Sanofi’s Toulouse facility at no cost in April 2015 was transformational to Evotec’s corporate structure and ability to grow, as the deal alleviated its capacity constraints. On top of this, Evotec acquired a new strategic alliance for drug discovery services outsourcing and the development of innovative assets. The key highlights of the deal are listed below (more detailed discussion is in our last outlook):

On 22 March 2016, Evotec announced a spinout of Topas Therapeutics with a €14m series A funding round co-led by three VC companies: Epidarex Capital, EMBL Ventures and Gimv. Evotec will remain the largest shareholder. While not many details about the technology were released, Topas has a nanoparticle-based platform with potential to deliver multiple projects in autoimmune and inflammatory disorders. The most advanced project is for multiple sclerosis and is expected to progress to Phase I in 2017. Overall, we view this as a novel corporate development solution for Evotec. Since Topas’s technology is a platform and can be used in multiple projects, a standalone company was viewed as a better vehicle for execution, risk sharing and fund-raising efforts. Evotec indicated that more similar deals are possible, but that will be driven by the nature and prospects of a particular technology.

The EVT Execute operations offer a comprehensive range of high-tech services that are performed efficiently and can be reproduced on an industrial scale. These functions can be accessed flexibly and the collaborations between EVT Execute and clients can range from purely fee-for-service contracts to fully integrated drug discovery alliances.

Fee-for-service contracts have a relatively low gross margin and no scope for success milestones and royalties, yet no development risk exposure. This is a stable, long-term, recurring income stream. EVT Execute provides a complete range of preclinical development services to biotech and pharmaceutical companies. The rate of technological change means that much of this market is increasingly commoditised, hence EVT Execute, despite its proven track record and history of repeat business, needs to continuously develop new capabilities to maintain its competitive advantage. Evotec invests c €10m a year developing new services and extending its current offering, which is being significantly enhanced following the deal with Sanofi as it now has a compound management facility in Europe and has tripled the size of the compound library it can offer to clients.

Integrated drug discovery alliances

On the other end of the spectrum of services provided by EVT Execute is an end-to-end solution for companies that want to outsource entire preclinical programmes. Integrated alliances tend to be initiated by a pharmaceutical/biotech company providing a target to Evotec, which then conducts the entire preclinical drug development process. During these contracts, Evotec is responsible for making the decisions between the various phases of drug discovery, improving the efficiency of the process. The new major collaboration with Sanofi across a range of therapeutic areas could serve as a good reference, in our view, for other big pharma companies outsourcing more drug discovery programmes in integrated alliances to Evotec.

Evotec uses a different payment structure with integrated alliances to standard EVT Execute contracts. These tend to be at a lower FTE rate, but there are potentially performance-related payments and royalties payable. This means Evotec shares in the development upside and its interests are better aligned with those of the client, ie the alliance will be more profitable for Evotec if it is successful in carrying out the drug discovery activities.

A notable trend is that more biotech companies are using Evotec for outsourcing entire drug discovery programmes, largely driven by the fact that many biotech companies have been able to raise significant capital in recent years, which can now be spent on R&D activities. Padlock Therapeutics is a recent example of such an integrated partnership with a small biotech company. On 10 March, Evotec announced that it had achieved a key preclinical milestone in the three-year collaboration with Padlock. Evotec provided a full range of drug discovery services to Padlock, which has now been acquired by Bristol-Myers Squibb for $600m in total deal value.

EVT Innovate is leveraging Evotec’s growing expertise in delivering full range, integrated drug discovery services. The strategy here is to create in-house intellectual property via unpartnered or partnered innovative projects and seek partnering agreements in early drug research stages or when the preclinical candidate is selected.

The cornerstones of EVT Innovate are the CureX and TargetX initiatives. These are collaborations with leading academic centres (Exhibit 6) and pharma companies, in which Evotec and its partners work in an integrated manner to enable efficient innovation. The academic groups benefit from the ability to commercialise their research in a capital-efficient manner, without venture capitalists, while still being able to advance their careers by publishing scientific papers (often not possible if academic groups form alliances with pharmaceutical companies).

Evotec’s risk profile is considerably lower than that of most companies in the biotechnology sector because of its drug discovery alliance strategy. It is undertaking a large number of discovery projects at once, so that the inevitable failure of some programmes should not undermine the business. Evotec also spreads the risk associated with the majority of its projects with a partner. The company does not take unpartnered assets into clinical development, so it is not exposed to the significant financial risk associated with clinical development, while retaining some of the upside linked with successful clinical development. Consequently, its value will still be affected by the outcome of preclinical and clinical trials.

Evotec’s growth in FY15 significantly accelerated largely because of the Sanofi deal. The rate of revenue increase subsequently will depend mainly on Evotec’s ability to achieve milestones from existing alliances, form new EVT Integrate alliances and find pharmaceutical partners for its maturing preclinical assets.

We maintain our valuation approach, which includes a DCF model for the services business and separate risk-adjusted NPV models for the R&D programmes. For Evotec’s drug discovery business, we use a DCF model with a cost of capital of 10%, a terminal growth rate of 2.5%, a long-term operating profit margin of c 25% achievable within the next 10 years and maintenance capex of around €10m. For our R&D pipeline valuation, we have made a number of changes to the projects to reflect recent developments and have decided to include preclinical stage projects, while previously we valued only those in the clinic. Evotec’s hybrid business model is focused on early stage research and is maturing with the expanding discovery and preclinical pipeline.

In its 2015 annual report, Evotec described an R&D pipeline with 28 projects (some of which have multiple compounds) ranging from discovery stage to clinical. Exhibit 7 demonstrates the rationale we employed in order to select which projects to include in our valuation. Early stage drug development can be broadly classified into discovery and preclinical stages. As a general rule, we assume that value should be assigned to those preclinical projects that are likely to move to clinical stage if the data from the ongoing studies is supportive. In our view, this corresponds to the preclinical stage when the project is already past the discovery stage, is being tested in in vivo studies and the data package for the initial new drug application is being accumulated.

With this in mind, we now include several of the preclinical stage projects, for which we believe there is enough information to make reasonable assumptions as to the development pathway. Given the substantial risk-adjustment commensurate with the early stage projects, especially in preclinical stage, there will be a natural turnover in the projects with some of them progressing forward, while other ones are terminated due to a variety of reasons. Exhibits 8 and 9 summarise our assumptions and the sum of the parts company valuation.

The main changes compared to our previous valuation are:

For the projects we have used industry standard assumptions. Probabilities to reach the market and timelines were selected according to the stage of the project. Royalty rates are assumed according to the stage of the project where milestone payments were disclosed. If undisclosed, then we increased the royalty rate to capture the milestones as well. We note that all the costs associated with the preclinical development of the assets are accounted for in the DCF valuation, while NPV calculations include only expected royalties and milestone payments from partners, which continue the clinical development (Evotec’s strategy is not to invest in clinical development). As a result, our calculated NPV values represent an upside associated with the assets.

Our Evotec valuation is marginally lower at €575m or €4.34/share, from €577m or €4.36/share previously. The lower net cash position and the removal of clinical stage projects were offset by the addition of the preclinical assets and slightly higher valuation of drug discovery services, mostly due to rolling our model forward in time. We note a significant risk adjustment, which is typical in early preclinical projects. If, for example, all programmes are a success, as per our model, the valuation would be €1.9bn or €14.4/share.

Changes to our estimates are summarised in Exhibit 10. With growth continuing into Q116, we have only fine-tuned our 2016 and 2017 forecasts. Evotec finished FY15 strongly with total revenues growing by 43% year-on-year or 57% if excluding milestones, upfront and licence payments, which is more reflective of the performance of the underlying business. The acceleration in growth is primarily because of the Sanofi deal in Q215, from which Evotec will receive €250m over five years, although the structuring of the deal means that a portion of the revenue (we estimate €86m) with associated costs will be recognised as other income.

Evotec guides more than 15% underlying revenue growth in 2016; our expectation is 25% organic growth to €145m and also 25% total revenue growth to €159m. In line with company guidance, we expect FY16 R&D expenses of €20.7m (approximately €20m according to Evotec). The company guides that adjusted EBITDA should be significantly improved compared to 2015. Our expectation is €19.2m, an improvement from €8.7m in 2015. Our FY16 normalised profit before tax and EPS estimates were mainly affected by the foreign currency exchange loss recorded in Q116. Our estimates imply an adjusted EBITDA margin of c 12% in 2016 vs 6.8% in 2015. We forecast the margin growing to c 14% in 2017. We see a long-term sustainable adjusted EBITDA margin at around 30-35% and a total operating margin of 25-30%.

Evotec remains in a strong financial position with gross cash of €122m (net cash: €100m) at Q116. This means that the company can still make more bolt-on acquisitions to develop its expertise further and ensure that it remains a technological leader in the field of drug discovery, although Evotec has not provided any indications in this direction yet.