If you have followed me on SeekingAlpha for the last few years, then you are well aware of the drama surrounding Akorn Pharmaceuticals (AKRX). Although the company has had a checkered past, I believe the company presents an intriguing opportunity for investors with a high level of risk tolerance. Let’s take a look at the company’s past, and its present, to see why I think there is value here.
I first owned the company back in 2014, believing the company was the perfect candidate for an inversion – the hottest trend in the healthcare space at the time – that allowed pharmaceutical and device companies to park IP in foreign entities and significantly lower tax expenses. The company subsequently struggled over the next few years, as generics in general were hit after a wave of price increases finally came to an end.
Akorn struggled with internal controls as well as quality issues, which depressed the stock price for at least a year, before Fresenius Kabi (OTCQX:FSNUY) announced a deal to acquire Akorn for $34 per share. At the time of the deal, I found it best to not sit around waiting for the deal to close, and I was later proven correct by Fresenius terminating the merger, and the Delaware Supreme Court finding that a material adverse event had occurred.
The court case was brutal for Akorn – exposing the company for a lack of internal controls not only in its financial reporting, but also within its R&D facility. Some employees allegedly manipulated testing results that were submitted to the FDA, and the company’s manufacturing facility in Decatur, Illinois was hit with a variety of 483 Warning Letters from the FDA – essentially an official decree that Akorn’s manufacturing standards were not up to snuff.
After the deal broke, shares of Akorn, which had already been tumbling, fell below $3 per share. Making matters worse, the company’s largest shareholder and former Chairman, John Kapoor, was charged with and convicted of Racketeer Influenced and Corrupt Organizations Act charges in association with opioid scandal perpetuated by another of his portfolio holdings, Insys Therapeutics (INSY).
I am not certain I could find a more negative situation if I tried.
New Management Team
Akorn’s previous CEO, Raj Rai, presided over the remarkable comeback and crash of Akorn. Not surprisingly, Rai stepped down, making room for industry veteran Douglass Boothe. Boothe ran Impax’ generic pharmaceutical division before the company merged with Amneal (AMRX). He also served as CEO of Actavis US, the US generic arm of the former Actavis, and GM of Perrigo’s (PRGO) US pharmaceutical business. While I can’t assess his track record, I suspect that Boothe at the very least has the requisite knowledge to understand the business dynamics at Akorn.
In addition to Boothe, Akorn brought in Dandy Dorado-Boladeres who has worked in various quality positions at American Regent, Teva (TEVA), Actavis, Baxter (BAX), and several other pharmaceutical manufacturers. Again, while I do not know Dorado’s capabilities, his resume suggests that he understands best practices within pharmaceutical R&D and manufacturing. This should help bolster some of the areas where Akorn previously was materially weak.
Unlikely to have additional Fresenius liability
Fresenius requested additional damages related to termination of the merger agreement that it had signed for Akorn. The Delaware Court of Chancery denied Fresenius’ request for damages, which at the very least likely eliminates the probability of additional liabilities related to the failed merger.
Product Approvals Coming…But Not in Bunches
Amongst the many issues plaguing Akorn, the direst was with regards to product approvals. The company received an FDA warning letter in January at its Decatur, Illinois injectables plant, and until the warning letter is lifted, the company will not receive any product approvals from that manufacturing site. The warning letter comes on top of the various issues with quality that Fresenius cited during its suit to terminate its merger agreement with Akorn. The generics business is a hits business – the core product portfolio erodes most years, so new products are needed to offset declines from older products.
On the other hand, the company received two new approvals in April from its Amityville, New York plant. One approval is for a generic Flonase (Fluticasone Propionate Nasal Spray) that the company will supply to Innovus Pharmaceuticals (OTCQB:INNV). I am not excited about this approval from a financial returns perspective, but any revenue received from this product would be upside. The OTC generic market tends to be competitive, and Innovus is far from a market leader in the category.
Akorn received a much more exciting approval in the form of Loteprednol Etabonate Ophthalmic Suspension. The competitive landscape is favorable for this product, with innovator Bausch & Lomb (BHC) selling the only product with a market size of $89 million per Akorn. If Akorn can come into the market at a 10% discount and capture 20-30% of the market, I suspect this could lead to incremental EBITDA of $16-20 million.
Looking ahead, I am not particularly bullish about Akorn’s position with the generic injectable space. However, as we can see in the below chart, that should not be a problem. Akorn’s pipeline value is in the ophthalmic category, and the company’s quality issues seem unlikely to prevent approvals in this particular product segment.
Balance Sheet ,Earnings Power, and Valuation – Not Ideal, But Manageable
From my vantage point following the company the past few years, the firm never worried much about its leverage. I believe management assumed a buyout or deleveraging merger was inevitable, and so as the company acquired new assets, the team was happy to pay with debt. As a result, Akorn has racked up roughly $822 million in long-term debt versus a cash balance of $184 million. Naturally, as the stock broke during the Fresenius deal, the debt also traded significantly below par, making Akorn’s creditors nervous.
Because of this anxiety, Akorn entered into a Standstill Agreement with its creditors that will prevent the creditors from declaring an Event of Default or seeking remedies against Akorn. In exchange, Akorn agreed to double the margin on its outstanding loans from 75 basis points to 150 basis points, comply with strict reporting standards, and pay a 1.75% fee on the aggregate principal of debt outstanding.
Undoubtedly, the terms are expensive, but Akorn bought itself some time to see how the business plays out and fix its internal quality issues at Decatur.
I do not love the current leverage ratio – in fact, it implies that Akorn carries net leverage of ~ 7.4-9.0x adjusted EBITDA based on management’s most recent guidance. On the positive side, the generics business can be somewhat unpredictable, and a few product shortages could easily send earnings substantially higher.
Source: AKRX 2018 10-K
As you can see in the above chart, Akorn’s revenue and gross profit often varies by as much as $200-300 million in a given year. 2015 is a slight aberration versus 2014 because it includes the acquisition of Hi-Tech Pharmaceuticals, but the point remains the same – the generics business demonstrates significant earnings volatility. The “Pearson Years” (a reference to former Valeant CEO Mike Pearson who was best known for significantly increasing the price of drugs that lacked competition) are over, but shortages, supply disruptions, and quality issues can plague any given product at a given time, leading to a huge inflection in earnings.
This leads to a compelling point – how do you value a company like this without knowing the timing of the pipeline, potential pipeline molecules, and the competitive landscape of said molecules. The short answer is, it is extremely difficult. I have little idea what Akorn will earn this year, let alone next year. However, I am confident in the dynamics of the industries that Akorn participates in, particularly injectables and ophthalmics. I am relatively confident that Akorn can post $100-200M+ of EBITDA again in the future. I have no idea when that is.
As a result, the investment thesis for Akorn boils down to looking at the current enterprise value against a conservative multiple based on possible cash flow outcomes. Over the past five years, Akorn generated a cumulative $380 million in free cash flow, equal to an average of $76 million per year.
Akorn should be able to generate $70-80 million in annual free cash flow given its current base of business with the occasional directional swings. Given that the company owns some great assets like manufacturing plants, quality know-how (hopefully going forward), approved and in-process ANDAs, and relationships with customers, I think the business could be valued between 15-120x annual free cash flow. This is cheaper than the multiples recently paid for assets in the space including Claris Injectables, Sagent, and Gland – all of which transacted in the 15-20x EBITDA range. This results in an implied valuation of $3.28 - $7.65 – in short, a wide range of outcomes.
That being said, Akorn will also reduce its debt over the next few years, and I think the market will rerate Akorn based on earnings that could tick far above the $71-86 million in EBITDA that the company guided to for FY19.
While the variance of outcomes is quite high, I think the current price could provide a substantial return from current levels. Realistically, the stock could go to $3 or $15 and I would not be surprised either way. However, I think the current trough earnings provides some decent margin of safety for investors with a high level of risk tolerance that would be willing to suffer a 20% decline versus possible upside of 87%.
The most material risk is persistent quality issues at the Decatur plant that produces injectable drugs. I believe Akorn’s recently issued pipeline update suggests that management somewhat agrees, with the value of ANDAs materially tilted towards ophthalmics. I am cautiously optimistic that new quality leads will fix the failing quality standards in the next 12-18 months.
I recently exited at $4.24 after entering at $2.95, but I anticipate entering the stock if it falls back into the mid-$3 range. Akorn’s share price will continue to be volatile, but I believe the situation at present provides some asymmetrical upside.
Disclosure: I am/we are long FSNUY. 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.