Evotec — Upgraded on healthy cash flows post acquisition

Besides the Celgene collaboration, Evotec continued to forge new partnerships on top of reaching another preclinical milestone by delivering a fifth preclinical candidate in endometriosis programme run in partnership with Bayer (one candidate in Phase I). In our view, among the most notable developments over the past several months was LAB282, a newly established venture with Oxford University and Oxford Sciences Innovation (OSI). OSI will contribute some €14m over the initial three years, while the translational projects will be sourced from Oxford University. LAB282 aims to advance assets through preclinical proof-of-concept and potentially create spin outs. In addition to execution of the research, Evotec also retained the option to participate in future equity financing rounds. In addition, Evotec made two new equity investments: in Eternygen’s (metabolic diseases, novel target) €8m series A round backed by a consortium; and Fibrocor Therapeutics’ (fibrosis) launch, with C$2.8m backed together with MaRS Innovation. All these deals are recent examples of Evotec’s continued search for innovative forms of partnering with the goal to leverage its drug discovery expertise.

In December 2016, Evotec finalised the acquisition of Cyprotex, a UK-listed ADME-Tox (absorption, distribution, metabolism, excretion, toxicology) and DMPK (drug metabolism and pharmacokinetics) specialist, with cash outlay of £55.7m for shares and repayment of all debt. The offer price of £1.60 per Cyprotex share was a 9.4% premium to the volume weighted average price of the 30 trading days on AIM prior to the offer.

Cyprotex is a niche player and one of the largest contract research organisations specialising in ADME-Tox and DMPK. It has clients in a variety of industries including pharmaceuticals, chemicals, agrochemicals and cosmetics. During a conference call, Evotec hinted that it will continue to work with clients from other industries beyond pharmaceuticals, which will diversify its existing client base. In our view, besides potential synergies, the acquisition expands Evotec’s specialist offering, but importantly also adds new clients. Headquartered in the UK and founded in 1999, Cyprotex has 136 employees with rising numbers of clients and partnerships (Exhibit 2). Cyprotex’s sales increased 18% y-o-y in 2014 and 35% y-o-y in 2015, with the positive growth trend set to continue in 2016. The underlying EBITDA margin was 22% in 2015 and Evotec expects the deal to be accretive to EBITDA in 2017.

Evotec announced a new drug discovery and development collaboration with Celgene on 15 December 2016 to identify disease-modifying therapeutics for neurodegenerative diseases, with the initial focus on amyotrophic lateral sclerosis, Alzheimer's disease, Parkinson's disease and a few others. The deal involves Evotec’s proprietary iPSC platform, which Evotec developed over the past five years. Celgene received exclusive options to in-license compounds after Evotec carries out preclinical work with its iPSC platform in the areas covered by the agreement using its own compound library, but Celgene could also test its compounds. In return, Evotec received $45m as an upfront payment with another $250m in potential milestone payments and low double-digit royalties for each programme that Celgene may in-license. The initial term of the collaboration is five years. Although in the neurodegenerative disease area Celgene has an exclusive option to in license the identified compounds, Evotec mentioned that this platform will be expanded into other disease areas, therefore enabling more partnerships in the future.

iPSCs differ from embryonic stem cells. iPSC were genetically modified to ‘regress’ from fully differentiated cells, like skin cells, to younger stages where they regain the ability to multiply and differentiate into any type of cell. This overcomes several major issues related to human embryonic stem cells, such as ethical hurdles and sourcing. iPSC technology was discovered 10 years ago and was expected to revolutionise medicine with new cell therapies and boost regenerative medicine. However, major safety issues, such as iPSC developing into tumours, meant that clinical development was challenging. Instead iPSC revolutionised the research industry by allowing researchers to model diseases, enhance drug screening and look into patient stratification even before the compound reached the clinical stage, eg ‘clinical trial in a dish’.1 The importance of the Celgene/Evotec deal is that it confirms the scale of Evotec’s iPSC platform, which to our knowledge is among the pioneers of the drug discovery industry.

Evotec’s Q316 revenues grew 35.9% y-o-y to €45.2m and well surpassed our expectations. This was primarily driven by upfront, milestone or other licence-related payments from third parties, which totalled to €8.7m (vs €3.4m in Q216 and €1.1m a year ago) and can partially be explained by the milestone payment from Bayer booked in Q316 after the initiation of the Phase I trial in endometriosis. Excluding milestones, upfront and licence payments, the Q316 sales from the core drug discovery services business came in at €36.5m, slightly ahead of our expected €35.1m.

The Q316 gross margin of 45.1% (vs 35.6% in Q216 and 31.3% a year ago) was positively affected by significant milestone payments. Adjusted gross margin of 32.1% was still ahead of our expected 27.4%. R&D expenses of €3.8m were lower than our forecast of €5.0m, as well as reported SG&A of €6.0m versus our estimate of €6.8m. Evotec’s Q316 operating profit was further increased by net other income of €1.4m (mainly R&D tax credits) and came in at €12.0m versus our estimate of €1.5m.

We have made only small changes to our top line estimate for 2016, while the forecast for 2017 was increased by the revenues from the Cyprotex business. Our long-term estimates were mostly affected by the increase in long-term margins, as Evotec reported better-than-expected gross and operating profit margins. Our adjusted EBIDTA estimate for 2016 has been significantly revised upwards and we now expect it to more than quadruple year-on-year.

Evotec guided that it expects €18-20m in revenues from the Cyprotex business in 2017, which looks conservative compared to historical €18.6m in FY15 and €10.4m in H116 (using the same exchange rate of €1.19/£ at the closure of the deal) and a CAGR of 21% between 2013 and 2016 (using two times H116 for FY16 sales). We find the conservative stance reasonable given the integration period; hence in our model we include revenues of €19m in 2017 and subsequently assume c 10% growth gradually slowing to 5% by 2025. Cyprotex’s gross margin averaged an impressive 78% over 2013-15, compared to Evotec’s 30% (using revenues excluding milestone payments); we use a 75% margin for this business going forward. Cyprotex’s operating costs (excluding a goodwill impairment one-off in 2014) averaged c 73% of the total revenues over 2013-15 compared to just 25% estimated for Evotec in 2016 (using revenues excluding milestone payments). We expect synergies in running the combined businesses and assume that Evotec will be able to bring the operating costs for the Cyprotex business down to c 60%.

Out of the total amount of £55.7m (€66.3m at €1.19/£) paid by Evotec, Cyprotex’s equity purchase price was £41.8m (€49.7m) while the remainder was used to repay the seller’s debt. The upfront from Celgene will be received on closure of the collaboration deal, but for accounting purposes will be deferred over a five-year period and will be reflected as income to the EVT Innovate business segment. Including the cash of €90.3m received after Novo’s investment, we calculate that Evotec should have accumulated a solid net cash position of €187m (estimated end-Q416 net cash less acquisition costs plus Celgene’s upfront plus Novo’s investment).

The estimate revision and the inclusion of the Cyprotex business have resulted in changes to our forecasts, as shown in Exhibit 3.

We value Evotec at €1.2bn or €7.9/share, up from €620.3m or c €4.7/share previously. This is based on the revision of our estimates, the inclusion of the Cyprotex business and Novo’s investment, the addition of the upfront payment from Celgene and rolling our model forward.

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 35% achievable within the next 10 years and maintenance capex of around €8-9m. In our R&D pipeline valuation, we include the most advanced clinical- and preclinical-stage products, for which we keep our assumptions unchanged as described in our previous reports. Evotec’s shareholders enjoyed a strong share price rally this year, which we expect will be further supported by healthy cash flows and a maturing preclinical pipeline.