Catalent - An Easy 10% Upside Story

| About: Catalent (CTLT)
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Summary

CTLT had a decent finish for FY16.

After almost a year of working through the Beinheim issue and sustained FX drag, the stock is largely out of the woods in my view.

My refreshed price target for CTLT is $28 based on two valuation methods discussed below, suggesting 10% upside.

Yet, the target can be easily exceeded if CTLT executes on its “expanded” M&A deal pipeline.

Decent Finish to FY16

Catalent (NYSE:CTLT) had a decent finish to FY16 ended on 06/30/2016. 4Q revenue of $532m was 6% solidly above consensus, although adjusted EPS of $0.52 was one penny shy of Street consensus.

After almost a year of working through the Beinheim issue and sustained FX drag, the stock is largely out of the woods in my view. My refreshed price target for CTLT is $28 based on two valuation methods discussed below, suggesting 10% upside. Yet, the target can be easily exceeded if CTLT executes on its "expanded" M&A deal pipeline.

A Substantiated Growth Story with a Conservative Margin Guidance

Management sounded more confident during its latest earnings call on growth drivers. Although Beinheim still occupied some airtime, investors are starting to move beyond this issue and focus on fundamentals. And the fundamentals of CTLT are looking brighter than ever.

To start with, FY17 guidance is well within CTLT's long-term growth range, with identified drivers to grow EBITDA faster than the top line. Its higher margin businesses (e.g. manufacturing, packaging, biologics) are mostly outgrowing lower margin ones (e.g. consumer health and distribution), moving the business in the right direction. Importantly, management noted that there is "no margin pressure" within each category, demonstrating healthy market dynamics and reflecting CTLT's superior offering. In addition, for FY17, management also expects higher utilization across biologics, and the DDS segment.

As a result, I believe the guided EBITDA margin of 22.5% is quite conservative, compared to the 21.7% achieved in FY16. So in my model, I project revenue/EBITDA to be $1,960m/$450m, reflecting a higher margin of 23% in FY17.

M&A Execution Should Bring Additional Upside

Investors should be reminded that the contract manufacturing industry remains a highly fragmented one. Only a few companies claim over 5% market share - CTLT included - while the top five still control way less than one-half of the market.

Yet, the industry is a textbook example of economy of scale. To begin with, it's economics 101. For most pharmas and biotech companies, it does not make sense to maintain a global manufacturing network of sub-scale factories while they can get the products made in CMOs' expansive factories for a fraction of the cost.

In addition, as the manufacturing process requires increasingly more expertise for complex molecules such as biologics, pharmas are increasingly keen to outsource their manufacturing capability. Catalent, currently the leader in biologics manufacturing, is bound to ride the tide in years to come.

The increasing demand from customers also should drive CMO industry consolidation, for obvious reasons of economy of scale. CTLT's peer Patheon (NYSE:PTHN) has been executing on multiple M&A deals in the last two years. CTLT management also sounds quite bullish on M&A execution in FY17.

So the M&A boost to the story is not a matter of if, but a matter of when.

And yes there is Beinheim…

No longer the elephant in the room, Beinheim still occupied some airtime during the 4Q earnings call. Unfortunately, management did not provide much granular discussion on this topic besides saying that FY17 has fully incorporated Beinheim's impact. I just want to reiterate the nature of the Beinheim incident - it was an isolated, ill-conceived act by a dissatisfied ex-employee.

Valuation

With much of the noise behind it, CTLT should finally trade on fundamentals. A forward EV/EBITDA multiple of 10.9x and a forward P/E of 17.8x are such understatements of CTLT's growth in the years to come. Using more appropriate multiples (12x forward EBITDA and 20x forward EPS), I arrived at a target price of over $28 per share. That suggests more than 10% upside, just based on fundamentals.

With a kiss of near-certain M&A in FY17, that target can easily move into the low $30s. There you have it - 19% price appreciation.

Disclosure: I am/we are long CTLT.

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.