Consort Medical — Update 15 March 2016

Consort Medical is an international medical devices (Bespak) and contract development and manufacturing company (CDMO, Aesica). Bespak is focused on the development, manufacture and, increasingly, the commercial drug handling of high-margin disposable drug delivery devices. Aesica provides active pharmaceutical ingredient (API), finished dose development (FDD) and finished dose manufacturing services (FDM) to pharmaceutical companies. Bespak is based in the UK with manufacturing facilities in King’s Lynn and Milton Keynes, an innovations centre in Cambridge and a subsidiary, IAC (Nelson, Lancashire), which produces anodised aluminium ferrules. Aesica was established in 2004 and has grown organically and through acquisition to provide a range of services across the pharmaceutical supply chain. It operates from five European sites (the UK, Germany and Italy), boasting commercial relationships with key global pharmaceutical clients, with the top five representing 57% of group revenue.

Consort Medical originally listed on the London Stock Exchange in August 1983 as Bespak. The name was changed to Consort Medical in 2007 (with the Bespak brand retained for its inhaled drug delivery division) to reflect the then broader business. King Systems was acquired in December 2005 for $95m (£55m) and divested to Ambu in December 2012 for maximum consideration of $170m with $135m received to-date as a function of an earnout clause based on King Vision blade sales. In November 2009, The Medical House was acquired for £16.9m, subsequently rebranded as Bespak Injectables. Bespak employs c 830 staff and Aesica c 1,250.

We value Consort Medical using EV/EBITDA coupled with an rNPV for the Bespak development pipeline. Based on calendarised EV/EBITDA multiples of 13x in FY16e and 12x in FY17e (0-5% discount to peers), the value of the current business is 1,080p/share, plus 240-319p for the pipeline, resulting in a group valuation of 1,320p to 1,399p. We use a three-phase DCF model as a reality check and this yields a value of 1,289p a share.

We forecast 5.1% revenue and 10.6% normalised EPS CAGR FY16-20e, with new product launches in the Bespak division and new contract wins in the Aesica division as the key growth drivers. We forecast 128bp EBIT margin improvement FY16-20e spurred by the same factors, but also increased efficiencies in Aesica. We envisage the return on the £230m invested in the Aesica acquisition (11.5x trailing EV/EBITDA) to reach 7% by FY18.

Consort Medical’s business is subject to sensitivities common to both medical device and drug manufacturing companies. In particular, it has a relatively high customer concentration, with the top five customers representing 57% of group revenues in H116. This is mitigated by long-term contracts and its focus on diversifying its product and customer bases. Moreover, there are risks pertaining to product development and commercialisation, ie clinical or regulatory failure or delays, new product uptake and supply chain rationalisation, delivery on business development and successful implementation of its growth strategy. The integration of the Aesica acquisition is progressing to plan, although the effectiveness of the wider cross-selling programmes remains to be assessed. It terms of currency risks, a 1c weakening of €/£ rate reduces revenues by £0.7m and operating profit by £0.1m.

In late 2014, Consort Medical added a second leg to its strong drug delivery business, Bespak, by acquiring Aesica Pharmaceuticals, a leading European pharma CDMO, for £230m. The commercial rationale for the deal is to offer pharma customers a suite of services enabling them to shorten product development cycles and streamline supply chains. In this note we review the early progress of integrating Aesica Pharmaceuticals and the delivery of Consort Medical’s overall growth strategy. We also review our forecasts and update our valuation with positive implications.

As shown in recent financial results, both divisions are delivering healthy financial returns (Bespak 70% and Aesica 30% of EBIT in H116) demonstrating strong margin improvement in H116, with Bespak reaching an all-time high. We expect the enlarged Consort to produce CAGR EPS of 10.6% in FY16-20e. This compares to -2.9% in FY12-15, a period marked by price pressure and the loss of a key contract. This prompted restructuring, but also investment in production automation and manufacturing systems, which led to improved efficiencies and product quality.

The Aesica acquisition is the largest corporate deal in Consort Medical’s history, crowning its strategic transformation, which aims to diversify its business, both horizontally to harness more of the value chain with pharma customers, and vertically into other new administration forms beyond its stronghold in inhalers.

One of management’s main objectives is to improve the group’s product and service mix and to sustain long-term earnings growth. Consort prioritises organic growth, but is ready to make acquisitions provided they meet the group’s strategic objectives and prove accretive to the group’s return on capital within a couple of years. Excluding equity financing, we estimate that Consort has a residual £36m in financial firepower before it reaches its debt covenants of 3x EBITDA.

Exhibit 1 illustrates the pathway of the corporate strategy, although activities are performed in parallel. An important objective for Consort is to capitalise on new drug administration modalities, as underlined by the February 2016 development/manufacturing collaboration and equity investment into retinal therapeutics company, Precision Ocular. More broadly, this objective has prompted it to invest in operational scale in the development and manufacturing functions. Another strategic goal has been to broaden the service offering to be able to capture a larger share of pharma companies’ supply chain activities, which has been catapulted by the Aesica acquisition (Exhibit 2). Indeed, one significant merit of the combination is the high degree of complementarity between Bespak’s and Aesica’s respective customer bases, with only four shared clients in the joint top 20. Moreover, we believe Aesica’s wide geographic manufacturing footprint should facilitate the expansion of Bespak’s already constrained production capacity over time.

Bespak’s core competency lies in the high-volume, high-quality development, manufacturing and supply of tightly regulated medical devices for drug delivery. These include valves, dose counters and actuators for metered dose inhalers (MDIs), dry powder inhalers (DPIs) and medical check valves. Consort is the world’s largest producer (500m units per year), competing mainly against other global suppliers such as Gerresheimer and West Pharmaceuticals. In recent years, Bespak has diversified into other delivery devices, such as nasal devices, autoinjectors and point-of-care diagnostics, but still has 87% exposure to the asthma inhaler market, which grew by 6.4% CAGR 2010-15, according to Consort. Bespak develops products on the basis of its own, as well as customers’ intellectual property.

Bespak has invested heavily in regulatory and quality systems in recent years, but also in equipment and industrialisation processes. Backed by contracted manufacturing volumes, Bespak has invested £20m in manufacturing the nicotine inhaler device, Voke, and £20m in DEV610, a novel dry powder inhaler device. We forecast Bespak’s annual revenue growth (CAGR) at 6.2% in FY16-20e, although we see upside potential to our forecast, reflecting the following factors:

Under the headline growth forecast, we expect a continuation of the FY13-15 trend, during which period the dominant inhaler franchise grew at 2% CAGR, while injectable devices (other devices) sustained 39% revenue CAGR. The primary factors underpinning growth in injectables are rapidly expanding use of biologic drugs and health economic advantages with self-administration. Specifically, the introduction of Bespak’s Vapoursoft, Syrina, Lila and Lapas technologies has elicited considerable interest among pharma companies with injectable drug portfolios. In November, Bespak unveiled a new highly compact autoinjector, Syrina 2.25. This standard-sized (2.25ml) pre-filled syringe can be adapted to the dose size and power source as determined by the viscosity of the drug. This reduces the risk of inappropriate delivery mechanisms, which can create safety hazards for users. Its key competitors in autoinjectors are Ypsomed (Switzerland), SHL (Sweden) and Owen Mumford (UK).

Bespak’s recent trading has sustained a solid growth trend in recent years (6.8% revenue CAGR 2010-15), delivering 5.4% overall revenue growth in H116. The dominant MDI franchise grew by 3.1%, including 26% growth from deliveries of Chiesi’s NEXThaler. Other devices, including Dr Reddy’s Sumatriptan autoinjector, saw sales jump by 30.7%. Service revenues, which we estimate at about 10% of Bespak’s revenues, leapt by 49.3%. Bearing in mind that the cycle from service revenues to product sales can be as long as three to five years, we see buoyant service revenue growth as an indicator of growth to come.

Bespak has 13 respiratory, nasal and autoinjector programmes in late-stage development or under regulatory review, each of which represents a minimum £3m peak revenue potential, but some up to £25m, based on the company’s assessment. The most recent addition in the past six months is VAL050, a supply agreement for a proprietary pMDI valve and actuator technology for Aeropharm (Sandoz). It is also in late-stage discussions concerning two other opportunities.

Consort’s capabilities in handling the interface between drugs and devices serve as the main link to its expansion into commercial drug handling by means of the Aesica acquisition. Aesica operates through three businesses that collectively address most of the drug development process, from manufacture of the active pharmaceutical to packaging the finished product. Optimising drug delivery device development and manufacture with API and finished dose formulation and manufacture offers pharma customers the potential to accelerate the route to market for new drugs.

In the Aesica division, Consort offers a broad range of integrated drug development and manufacturing services spanning inhaled, oral and injectable technologies. The division consists of three operating units that can, collectively, address most of the stages in the development of drugs and supply chain, from process development through to packaging the finished product for pharma company customers. Aesica employs c 1,250 people, mainly in production across five facilities in Cramlington and Queenborough (UK), Monheim and Zwickau (Germany), and Pianezza (Italy).

Aesica provides services to a wide range of pharmaceutical companies, although UCB is the largest revenue contributor (estimated at around 45% of Aesica’s sales), followed by AbbVie/Abbott (c 23%), with smaller contributions from GSK, Johnson & Johnson and Merck & Co. Aesica’s revenue mix reflects the legacy of having acquired manufacturing units from UCB, Abbott and Merck over the past decade.

Aesica generated revenue and EBITDA CAGR 2011-14 of 7.6% and 15.5%, respectively. Its operating cash flows have been consistently positive, despite heavy capital investments.

The majority of Aesica’s revenues arise from long-term manufacturing contracts in finished dose manufacturing (FDM). We expect to show modest growth from existing FDM contracts, reflecting the maturity of clients’ products. However, we forecast that Aesica’s 4.3% revenue CAGR FY16-20e will be spurred by new contract wins in FDM, helped by investments made in improving facilities and processes at Cramlington and Queenborough. Albeit from a more modest base, we also see a helpful contribution to growth from finished dose development (FDD), which offers the most significant opportunities for cross-selling and margin expansion in the long term. We expect the integrated development and manufacturing of drugs and delivery devices to improve Aesica’s efficiency, reduce costs and accelerate its product development process. Accordingly, we forecast the operating margin in the Aesica division to improve from 5.2% in FY15 to 11.0% in FY20, while management guides to low-teens margins in the medium to long term. This results in a 16.8% CAGR in Aesica’s operating profit in FY16-20e vs 9.4% for the group and 5.2% for Bespak. We note that one of the leading CDMOs, Catalent, generates a group EBITDA margin of 24%, albeit with a revenue base eight times larger than Aesica’s.

Operationally, Aesica and Bespak report as separate divisions. However, their respective commercial teams work closely together to facilitate introductions to customers and to secure combined formulation and device contracts. In management’s opinion, customers have reacted favourably to the joined-up approach in the past year, prompting numerous enquiries about device development projects based on Bespak’s own, as well as customer’s platforms. In October 2015, a new joint branding was launched at the CPhI exhibition in Madrid, the largest global trade event for the pharma services industry. In our view, the joint approach allows the device expertise to be brought in earlier to the customer, reinforcing Consort’s role as a device supplier.

Aesica offers an integrated supply chain management service to some of its customers and has announced the extension of this service. In addition to providing its finished dose, packaging and release operations to the customer, the service model provides management of product supply chains of upstream and downstream processes at third-party suppliers on the customer’s behalf. This additional service enables the customer to reduce the overall number of CDMO partners with which it deals.

Since Consort’s acquisition, Aesica has concluded a development programme for a product manufactured using the first semi-continuous processing line and technology installed at a CDMO. The product is now approved and launched in the first major market, with others expected to follow over the next two years.

Furthermore, Aesica has been working with a leading Japanese pharmaceutical company (which we believe to be Taiho) to provide the active ingredient for an anti-inflammatory formulation containing S+flurbiprofen. The patch has received market approval with the Ministry of Health, Labour and Welfare in Japan for the indication of osteoarthritis. It is in the process of supplying API materials for launch stock under a new long-term supply agreement, with demand for the new formulation expected to grow steadily from 2016.

Consort Medical’s investment in innovation and the resulting product launches are the key determinants for its organic growth, in our view. As an acquisitive company, Consort is additionally exposed to risks pertaining to integration of acquisitions in a timely and cost-effective way and the execution of its growth strategies.

The company is also subject to various other sensitivities common to drug and device CDMOs, on both the up and down side. In particular these include:

We believe the valuation of Consort Medical needs to take into account the underlying business, as well as the business pipeline, which we evaluate on a risk-adjusted NPV basis. As a reality check, we also evaluate Consort Medical’s earnings multiples against a broad peer group.

In our view, Consort Medical’s business model is unique in the context of the healthcare sector. Some of its closest peers are subsidiaries and divisions of wider groups involved in specialist contract development and manufacture for the pharmaceutical industry, such as Catalent, but also those involved in medical packaging solutions and drug delivery. In this context, we include AptarGroup, Gerresheimer, West Pharmaceutical Services and Ypsomed as peers. To benchmark its valuation against UK healthcare investments, we look at Advanced Medical Solutions, Clinigen Group, Smith & Nephew and UDG Healthcare.

Given the differences in capital structures between the constituents of our comparator group, we believe EV/EBITDA is the most appropriate parameter. With the international and UK peer groups trading at 14.2x and 12.0x 2016e EV/EBITDA, respectively, we note that Consort Medical trades at a 7% discount and 10% premium respectively. With 2015-17e EPS CAGR of 7.8%, below the 11.2% average of the UK peer group and the 22.4% (10.1% excluding Ypsomed) CAGR in the international peer group, we consider 13x FY16e EV/EBITDA and 12x FY17e EV/EBITDA to be justified. That derives an implied average valuation for the current Consort Medical operations of 1,080p per share.

For our DCF valuation, we consider the risk profiles of Aesica and Bespak’s underlying businesses to be similar and employ a WACC of 10% of the underlying business. For the business pipeline, we forecast known projects based on the company’s guidance that each of these will have peak revenue potential of at least £3m pa. We forecast an operating margin of only 15% (below Bespak’s 20%), success probabilities of 60-80% and a WACC of 12.5%.

We believe the development pipeline should meaningfully boost revenues from end CY16 onwards, In view of the undisclosed identity of many of these projects, our valuation may not adequately capture expected revenue growth (particularly if any of these programmes have significant potential, or material new contracts are secured).

On this basis, we value the Bespak project pipeline at 240p/share (at a 60% probability of success) to 319p/share (80% probability). When added to our peer group valuation of 1,080p/share, this gives a valuation range of 1,320p to 1,399p per share.

We have also performed a DCF-based valuation, including the financial impact of the product pipeline, as a reality check. We have employed a three-phase DCF, using our forecasts for free cash flows from our model from FY16 to FY20 to derive the first part of our NPV. The second phase sees the expected growth rates tapering from a high of 10% in 2021 to 3% in 2030, with a terminal value applied after that (using a 2% growth rate). We have used a 10% discount rate and assumed a tax rate of 18%. This approach suggests Consort Medical is worth 1,289p/share.

In FY16, we forecast reported revenue growth of 47.6% and 12.7% operating margin (90bp y-o-y margin contraction reflecting the full year consolidation of lower-margin Aesica, partly offset by Bespak’s operating margin improvement, forecast to expand by 90bp y-o-y to 20.7%). The forecast 7.2% growth in EPS in FY16e accommodates a 20.7% increase in the number of shares, stemming from financing the Aesica acquisition.

We forecast group revenue CAGR of 5.1% in FY16-20e, with Bespak generating 6.2% and Aesica 4.3%. Our group EPS CAGR in FY16-20e is 10.6%, upgraded from 9.5%, driven by the revenue growth and 128bp EBIT margin expansion over the period. We raise our EPS by 2% in 2016 and 0.5% in 2017 reflecting higher margins in Bespak.

Aesica was acquired for £230m, representing a multiple of 11.5x FY13 EV/EBITDA and we expect the company to have reached a ROIC of 7.0% by FY18. The transaction was funded by equity issue of £105m, with £116m of new debt and £10.0m of existing cash. Consort benefits from a £160m long-term credit facility with rates ranging from Libor plus 165-190bp. The key covenants are that interest cover (EBITDA/net finance charge) must exceed 3.0x and leverage (debt/EBITDA) must be less than 3.25x until 30 April 2016 and less than 3.0x thereafter. We forecast an average borrowing cost of just under 4% over the forecast period.

Consort Medical does not have an explicit dividend policy, but adapts the dividend payout in relation to its operating cash flow and investment requirements. We forecast DPS to stay static at 18.1p (dividend cover of 2.8-3.3x FY16-18e).

We forecast healthy operating cash flow, but the company has identified growth opportunities in both divisions, which should sustain capex at a high level of £25-27m in FY16-18. Thereafter, we expect capex to drop back to £17-18m. Accordingly, we forecast net debt to stay around £100m in FY15-17, but debt repayments to take place thereafter such that the group reduces its net debt/EBITDA ratio from 3.0x in FY15 in to 1.8x in FY18e. Net debt/EBITDA as reported at end-December 2015 stood at 2.1x.

Consort benefits from the UK Patent Box and R&D Expenditure Credit tax breaks, which are likely to last into the foreseeable future. Therefore, we expect the effective tax rate for continuing operations before special items to be 18% in FY16e-20e.