OptionCare: Backdoor Biotech Play
by Alan J. Brochstein, CFA
AB Analytical Services
Many investors know that biotech companies participate in an industry with abundant opportunities ahead, but they find it challenging to invest. For every Genentech (DNA), Amgen (AMGN), Celgene (CELG) or Gilead (GILD), there are scores of private and public companies that fail. The industry as a whole has lost money. Not surprisingly, 65% of all domestic biotech stocks with market caps in excess of $50mm trade below $10 per share – not exactly a sign of a robust investment universe. Most of us are incapable of confidently predicting which companies engaged in the lottery will actually win, yet many continue to play the game. What is the prudent investor to do?
I believe that there are many ways to participate in the growth of biotech in general without taking too much company-specific risk. Besides investing in a basket of stocks (perhaps through an ETF), there are some very interesting companies that are leveraged to the growth in biotech. I wrote in April about one of those companies, Covance (CVD), which is a contract research organization. I like that one in particular due to the breadth of its product offering and its very high share in doing the lab work for trials (scalable relative to actually running clinical trials), but there are several others. The CROs are leveraged to biotech because almost all of these companies lack the infrastructure to do clinical trials themselves. In fact, even when they are quite mature, they maintain their outsourcing relationship (as AMGN has done with CVD). The trials tend to be more complex as well. Another type of “backdoor” play is Millipore (MIL), which is deeply involved in the manufacturing processes. Of course, there are the sellers of lab equipment and reagents as well. One type of company with which the reader might not be familiar, though, is the in-home infusion provider. The one that I like is OptionCare (OPTN), based in the Chicago area.
OPTN participates in two businesses, both of which are linked to the biotech industry. The Specialty Pharmacy Distribution business, which delivers injectables and other drugs (for cancer, MS, RSV, and many other treatments like Xolair for asthma and growth hormone injections) to the patient directly or to the doctor out of two facilities, accounted for 60% of sales last year, while the Infusion business made up almost all of the remaining sales (small ancillary businesses like respiratory therapy and durable medical equipment). The Specialty Pharma distribution industry has seen a lot of consolidation in recent years, with Express Scripts (ESRX) buying Priority Health and Medco (MHS) purchasing Accredo Health. Of course, CVS (CVS) also recently bought the largest Specialty Pharmacy distributor, Caremark. The Infusion business, which is much less on the radar screen of Wall Street, is extremely fragmented, though Apria (AHG) has good share. According to OPTN, the industry is 1/3 national players, 1/3 independents and 1/3 hospital-based. OPTN primarily provides services in the home, but it does maintain some ambulatory centers and goes into doctor’s offices or clinics as well. Infusion is necessary for total parenteral nutrition (intravenous treatment for patients with chronic digestive problems), anti-infective therapy, pain management, enteral nutrition and chemotherapy. What is most exciting about this industry is that many of the new biotech drugs are being developed outside of oncology. As such, the doctors aren’t set up to give patients these timely infusions. A great example is Tysabri (for MS). Additionally, as cancer becomes even more chronic rather than fatal, there simply won’t be enough space within the doctor’s office to provide ongoing treatments.
So, OPTN is positioned in right in the middle of two great trends, with some overlap as they are able to go into the home for infusion or delivery of specialty drugs or have patients come into their ambulatory infusion centers for both traditional infusion as well as administration of non-infused specialty drugs. For those interested, Medicare/Medicaid makes up only 20% of sales (though Medicaid jumped in the most recent quarter and the combined was 25%). The growth strategy of the firm appears to be industry growth, internal expansion and acquisitions.
OPTN recently has been breaking out of a consolidation:
On the technical front, it is worth noting that the company has a convertible bond that becomes “triggered” if the stock closes above 14.34 for just two more days (20 of the last 30 days of a quarter will have been achieved). I believe that the convert has created an overhang of sorts, with the stock struggling for two years now to break through the trigger. Most of the shares are already included in the share count. More on this point, later. What I found extremely interesting is the hedge-fund community’s recent buying interest along with the position size of their three largest holders. FMR, Wellington and Lord Abbett owned a combined 30% of the company. During Q1, Magnetar, Pequot and SAC each bought initial positions of about 2% of the company. For the life of me, I can’t figure out if this is somehow related to convertible arbitrage, but thus far, I don’t see how that is the case. The CEO owns 12% of the company, while the Chairman of the Board and founder, John Kapoor, owns about 10% ($118mm).
Dr. Kapoor’s other holdings as an insider currently include over $60mm of Sciele (SCRX), though he has sold 2/3, $7mm of Neologic (NEOL), where he was also Chairman until 2004 (still a director) and has lost a small fortune (for most), $168mm of Akorn (AKRX), which is quite interesting as SAC and Pequot are the largest shareholders there and FMR just established a position, and $14mm of Introgen (INGN) – quite an interesting guy who has done well for himself since emigrating from India in the late 60s. In all, there is not a lot of stock out there if more “growth” investors like Pequot decide to become involved.
As one can see from the chart below, valuation has been rather constant for several years now. In 2001, all of the Specialty Pharma Distribution stocks were drawing intense investor interest as the dot-coms melted and the promise of biotech had strong appeal. The group was marred by a shortage in IVIG that began in 2004, a factor that definitely impacted OPTN.
Looking at the financials, I do note one issue that sticks out like a sore thumb – low margins. This is one of the areas I intend to discuss with management (which I have yet to hear back from after an email and a call). While the company has never had impressive margins, they have been depressed somewhat by the IVIG issue. Synagis has also been an issue. There may be some issues with respect to the BCBS of Michigan contract start as well. This could be an opportunity as the company continues to build scale. Revenue growth has been 24% over the past 5 years, but EPS growth has been only 10%. Part of the drop is in share-count expansion, but margin deterioration has accounted for about 1/2, as RPS has been about 18%. As one can see in the chart below, analysts are projecting a slight rebound:
The balance sheet appears to have some debt, but it is effectively equity. The bonds will convert to a combination of cash and stock, with the company no longer paying the 2.25% interest as holders convert but having to probably pay higher interest costs. The company has a credit line to handle some of the redemptions. In any event, as the bonds are converted, there will be a debt reduction to some degree and an increase in equity without dilution. Inventories and AR have slowed after above-revenue growth in 2005 (AR) and 2006 (both) – something to watch.
I recently added the name to my concentrated portfolio. While I am still missing some information that would make me more confident in the company’s prospects, I am encouraged by a number of factors. I like the recent new deep-pocketed buyers and the highly concentrated list of holders (5 entities with over 50% of the stock), the valuation, the take-out potential due to scarcity value, the industry’s prospects, some good news recently out of Medicare regarding potential expansion of the home infusion benefit, a recent big win with BCBS of Michigan that expanded their national payer client list (validation of the company’s value proposition) and reduced some the concentration risk of BCBS of Florida, and the technical trend. I am concerned with the low margins, the trends in AR and Inventories, lack of familiarity with the management team that recently cancelled a conference presentation with no explanation, and a legacy “franchising” operation that impacts financial statements. I expect that my conversations with management will allay some of these concerns. I currently see strong support in the 14.50 area, resistance at the recent all-time high of about 16 and the potential to reach 18 (20X 2008) over the next six months.
I fervently believe that investors will better begin to understand the growth potential for home infusion as a cost-saver to the healthcare system as infusion demands increase due to new biotech therapies. For both lines of business, the value proposition is the same: compliance and proper treatment reduce expensive in-hospital stays for the chronically ill.
Disclosure: Long OPTN and CVD
AB Analytical Services is a regular contributor to BioHealth Investor.com
_____________________
AB Analytical Services
Many investors know that biotech companies participate in an industry with abundant opportunities ahead, but they find it challenging to invest. For every Genentech (DNA), Amgen (AMGN), Celgene (CELG) or Gilead (GILD), there are scores of private and public companies that fail. The industry as a whole has lost money. Not surprisingly, 65% of all domestic biotech stocks with market caps in excess of $50mm trade below $10 per share – not exactly a sign of a robust investment universe. Most of us are incapable of confidently predicting which companies engaged in the lottery will actually win, yet many continue to play the game. What is the prudent investor to do?
I believe that there are many ways to participate in the growth of biotech in general without taking too much company-specific risk. Besides investing in a basket of stocks (perhaps through an ETF), there are some very interesting companies that are leveraged to the growth in biotech. I wrote in April about one of those companies, Covance (CVD), which is a contract research organization. I like that one in particular due to the breadth of its product offering and its very high share in doing the lab work for trials (scalable relative to actually running clinical trials), but there are several others. The CROs are leveraged to biotech because almost all of these companies lack the infrastructure to do clinical trials themselves. In fact, even when they are quite mature, they maintain their outsourcing relationship (as AMGN has done with CVD). The trials tend to be more complex as well. Another type of “backdoor” play is Millipore (MIL), which is deeply involved in the manufacturing processes. Of course, there are the sellers of lab equipment and reagents as well. One type of company with which the reader might not be familiar, though, is the in-home infusion provider. The one that I like is OptionCare (OPTN), based in the Chicago area.
OPTN participates in two businesses, both of which are linked to the biotech industry. The Specialty Pharmacy Distribution business, which delivers injectables and other drugs (for cancer, MS, RSV, and many other treatments like Xolair for asthma and growth hormone injections) to the patient directly or to the doctor out of two facilities, accounted for 60% of sales last year, while the Infusion business made up almost all of the remaining sales (small ancillary businesses like respiratory therapy and durable medical equipment). The Specialty Pharma distribution industry has seen a lot of consolidation in recent years, with Express Scripts (ESRX) buying Priority Health and Medco (MHS) purchasing Accredo Health. Of course, CVS (CVS) also recently bought the largest Specialty Pharmacy distributor, Caremark. The Infusion business, which is much less on the radar screen of Wall Street, is extremely fragmented, though Apria (AHG) has good share. According to OPTN, the industry is 1/3 national players, 1/3 independents and 1/3 hospital-based. OPTN primarily provides services in the home, but it does maintain some ambulatory centers and goes into doctor’s offices or clinics as well. Infusion is necessary for total parenteral nutrition (intravenous treatment for patients with chronic digestive problems), anti-infective therapy, pain management, enteral nutrition and chemotherapy. What is most exciting about this industry is that many of the new biotech drugs are being developed outside of oncology. As such, the doctors aren’t set up to give patients these timely infusions. A great example is Tysabri (for MS). Additionally, as cancer becomes even more chronic rather than fatal, there simply won’t be enough space within the doctor’s office to provide ongoing treatments.
So, OPTN is positioned in right in the middle of two great trends, with some overlap as they are able to go into the home for infusion or delivery of specialty drugs or have patients come into their ambulatory infusion centers for both traditional infusion as well as administration of non-infused specialty drugs. For those interested, Medicare/Medicaid makes up only 20% of sales (though Medicaid jumped in the most recent quarter and the combined was 25%). The growth strategy of the firm appears to be industry growth, internal expansion and acquisitions.
OPTN recently has been breaking out of a consolidation:
On the technical front, it is worth noting that the company has a convertible bond that becomes “triggered” if the stock closes above 14.34 for just two more days (20 of the last 30 days of a quarter will have been achieved). I believe that the convert has created an overhang of sorts, with the stock struggling for two years now to break through the trigger. Most of the shares are already included in the share count. More on this point, later. What I found extremely interesting is the hedge-fund community’s recent buying interest along with the position size of their three largest holders. FMR, Wellington and Lord Abbett owned a combined 30% of the company. During Q1, Magnetar, Pequot and SAC each bought initial positions of about 2% of the company. For the life of me, I can’t figure out if this is somehow related to convertible arbitrage, but thus far, I don’t see how that is the case. The CEO owns 12% of the company, while the Chairman of the Board and founder, John Kapoor, owns about 10% ($118mm).
Dr. Kapoor’s other holdings as an insider currently include over $60mm of Sciele (SCRX), though he has sold 2/3, $7mm of Neologic (NEOL), where he was also Chairman until 2004 (still a director) and has lost a small fortune (for most), $168mm of Akorn (AKRX), which is quite interesting as SAC and Pequot are the largest shareholders there and FMR just established a position, and $14mm of Introgen (INGN) – quite an interesting guy who has done well for himself since emigrating from India in the late 60s. In all, there is not a lot of stock out there if more “growth” investors like Pequot decide to become involved.
As one can see from the chart below, valuation has been rather constant for several years now. In 2001, all of the Specialty Pharma Distribution stocks were drawing intense investor interest as the dot-coms melted and the promise of biotech had strong appeal. The group was marred by a shortage in IVIG that began in 2004, a factor that definitely impacted OPTN.
Looking at the financials, I do note one issue that sticks out like a sore thumb – low margins. This is one of the areas I intend to discuss with management (which I have yet to hear back from after an email and a call). While the company has never had impressive margins, they have been depressed somewhat by the IVIG issue. Synagis has also been an issue. There may be some issues with respect to the BCBS of Michigan contract start as well. This could be an opportunity as the company continues to build scale. Revenue growth has been 24% over the past 5 years, but EPS growth has been only 10%. Part of the drop is in share-count expansion, but margin deterioration has accounted for about 1/2, as RPS has been about 18%. As one can see in the chart below, analysts are projecting a slight rebound:
The balance sheet appears to have some debt, but it is effectively equity. The bonds will convert to a combination of cash and stock, with the company no longer paying the 2.25% interest as holders convert but having to probably pay higher interest costs. The company has a credit line to handle some of the redemptions. In any event, as the bonds are converted, there will be a debt reduction to some degree and an increase in equity without dilution. Inventories and AR have slowed after above-revenue growth in 2005 (AR) and 2006 (both) – something to watch.
I recently added the name to my concentrated portfolio. While I am still missing some information that would make me more confident in the company’s prospects, I am encouraged by a number of factors. I like the recent new deep-pocketed buyers and the highly concentrated list of holders (5 entities with over 50% of the stock), the valuation, the take-out potential due to scarcity value, the industry’s prospects, some good news recently out of Medicare regarding potential expansion of the home infusion benefit, a recent big win with BCBS of Michigan that expanded their national payer client list (validation of the company’s value proposition) and reduced some the concentration risk of BCBS of Florida, and the technical trend. I am concerned with the low margins, the trends in AR and Inventories, lack of familiarity with the management team that recently cancelled a conference presentation with no explanation, and a legacy “franchising” operation that impacts financial statements. I expect that my conversations with management will allay some of these concerns. I currently see strong support in the 14.50 area, resistance at the recent all-time high of about 16 and the potential to reach 18 (20X 2008) over the next six months.
I fervently believe that investors will better begin to understand the growth potential for home infusion as a cost-saver to the healthcare system as infusion demands increase due to new biotech therapies. For both lines of business, the value proposition is the same: compliance and proper treatment reduce expensive in-hospital stays for the chronically ill.
Disclosure: Long OPTN and CVD
AB Analytical Services is a regular contributor to BioHealth Investor.com
_____________________
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