Actionable Ideas Update - 11/14/2024

CPH.TO, CRON, ENZ, JBGS, MREO: Thoughts on Q3 Earnings and Other Developments

Disclaimer: Nothing on this blog is intended as financial or investing advice. Please do your own due diligence.

With most of the names in the Raging Bull Investments portfolio having reported results in recent weeks, it’s time for an update.

Cipher Pharmaceuticals

The path of a multi-bagger, sadly, is rarely “up and to the right” without interruption. Inevitably, there will be periods of underperformance and significant drawdowns. Naturally, stocks that have returned multiples in short-periods of time tend to have a lot of enthusiasm baked-in, which in turn makes them very susceptible to any tempering of expectations. The question for long-term holders is to ascertain, as unemotionally as possible, whether the stock price is telling us something about the fundamentals or not.

Though shares are still up 150% YTD, its been a really rough few months watching the stock steadily decline as the large-cap indices hit ATH after ATH. Since the highs of ~$19/share in late August, Cipher has experienced a ~35% drawdown and now sits at ~$14 (shares have rallied 12% today while I was writing this, so excuse my use of $13 in the valuation exercise).

After retracing much of the Moberg-induced overreaction I discussed previously, the stock sold off yet again on last week’s Q3 earnings. Optically, the reason for this appears to be elevated operating expenses pro forma the Natroba acquisition, which resulted in a mere 17% increase in EBITDA YoY despite topline growth of 71%; in other words, the acquisition appears to have had a deleterious impact on operating margins.

I think that is definitively the wrong takeaway, which becomes clearer with further analysis.

Here are the headline numbers for the Q (in USD):

Starting with the topline, Product Revenue increased by $6.3m or 213%, to $9.3m. Most of that obviously is inorganic growth from Natroba ($5.4m), but notably $900K of that is due to organic growth from Epuris, which grew 32% (the stickiness and relentless market share capture from Epuris continues to impress me). Investors should note, moreover, that these numbers only reflect two quarters of contribution from Natroba, given that the deal did not close until the end of July. Making that adjustment, Product Revenue would have come in even higher at ~$12m. Licensing Revenue was down significantly YoY due to Absorica overearning in the prior period, but contribution from this segment has now become increasingly immaterial. Adding its further $1m contribution gives us a normalized quarterly revenue of ~$13m, or ~$52m annually.

A very welcomed piece of information we received from this print is how accretive the Natroba deal is to gross margins, good for a 1500 bps increase from 64% to 79%. This is something worth keeping in mind as we work through this analysis. At 79% gross margins, our normalized $52m of revenue converts to $41m of gross profit.

Now on to the piece that has apparently spooked the market: total quarterly operating expenses came in at ~$8m, up ~4-fold from the prior year, which had the result of completely wiping out GAAP earnings. Cipher helps us look through this by providing an adjusted EBITDA metric, which shows that ~$3.5m of that opex is increased amortization from the acquisition as well as one-off acquisition costs, but that still leaves us with ~$4.5m of quarterly operating expenses and that’s without a month of contribution from Natroba.

I think investors are taking this number, adding an extra month of Natroba (call it $6m total), subtracting that from our $10m quarterly gross profit and arriving at $16m of annual EBITDA, or a 30% margin; then putting some multiple on that number and concluding the stock is way too expensive in the high-teens. But that approach both fails to normalize opex and fails to consider what is going to drive value for this company ahead.

On finding a normalized number, Cipher again helps us by providing a breakdown of expenses and explanations for each category.

As you can see, both the “Professional Fees” and “Other SG&A” categories increased not just as a result of Natroba/ParaPro, but also at the legacy business. These expenses were unusually elevated this quarter and management made that clear on the call:

We also know that Cipher sees room to improve the cost structure of ParaPro, but let’s bracket that for a moment. (see the earnings call transcript re the transitory impact due to the co-promotion partner, etc.)

Legacy Cipher’s SG&A was about $6m; let’s bump that to $7.5m to account for added management and increased scale. The headline EBITDA margin for the Natroba deal was 50%, which implied ~$12.5m of EBITDA per the release, or ~$7.5m opex given 80% gross margins. To be conservative, let’s bump that to $10m, which puts the combined entity at ~$18m of annual opex (ex. non-cash D&A). If so, this means normalized EBITDA (assuming no growth) is $23m ($41m of gross profit - $18m opex) and our EBITDA margin is ~45% (23/52). As a sanity check, this largely corresponds to Cipher’s pro forma historical financials:

At today’s share price of $13.60 (CAD) and net debt of $30m, EV is $280m USD, or 12x EBITDA. Is that a fair price? I’d argue we are worth a couple more turns given the capital-light, cash-generative model, but I can understand why a “value” investor might not see this as interesting (remember, this was a deep-value idea when I pitched it in January).

But here’s where it helps to put your growth investor hat on and ask where this is going.

First of all, we need to remember that Natroba is a growth asset. With only 1/4 of the US market share, a competitor product that no longer works, and Cipher’s ambitious leadership, I would expect Natroba’s US revenues to grow at a decent clip moving ahead, with de minimis incremental opex. If Natroba is generating just over $30m of revenue at 25% market share, then the market is worth $120m. Assuming they can take their market share up to 35%, that’s an extra $10m at 80% gross margins, or $8m of gross profit (again, with no incremental opex).

Natroba will also grow, with minimal investment, through Canadian commercialization and global licensing agreements, which will likely start contributing by 2026. I have no idea what those avenues will contribute, but let’s say it’s another $4m of gross profit.

So right there we have increased our gross profit by 30% or $12m up to $53m, and that $12m drops right to EBITDA given no incremental opex. Therefore, through very conservative growth estimates for Natroba achieved at very little cost, Cipher’s combined EBITDA could be ~$35m in a couple years (assuming zero growth from the rest of the business, e.g. Epuris). That means we are only at 8x EBITDA looking out, which in my view is way too cheap.

But that’s not the end of the story.

Significantly, management has made clear that the US business’ cost structure is inefficient and needs to do more business to be justified:

This means that the gross profits of its acquisition targets drop right to the bottom line, creating a ton of operating leverage. And we know that sizeable acquisitions are coming, with Mull noting the targets would contribute $30m of revenue. I laid out some hypothetical math for how this might work here, showing the value that is created by adding ~$20m of gross profit with no incremental opex — through both operating leverage and multiple accretion. However, this is just for illustrative purposes, and the math will look different (and better) given Mull’s intimation that they are targeting royalty/licensing deals, meaning that margins may be lower due to royalties, but the acquisition cost may be lower as (e.g. milestones) as well. In any event, a $30m revenue acquisition could easily contribute a further $15-20m of EBITDA and add $150m to $300m of enterprise value assuming a 10-15x multiple for Cipher (the higher end of that is justified, in my opinion, due to the capacity for value creation, which I demonstrated above).

Add that $15m to the $12m we can achieve through organic Natroba growth, and Cipher could easily be doing $50m of EBITDA in a couple years, meaning stock is currently at <6x EBITDA (perhaps a bit more than that given leverage/equity needed to funded the acquisition(s)). Moreover, I don’t think any of that growth is low probability or high risk — it should all be attainable without material expansion of the cost structure or use of the balance sheet.

And of course, then we have our other avenues of growth, which I am treating as free call options: e.g. Moberg Canada (which could add another $30m+ of EBITDA if it works out), Piclidenoson (which management spent more time than they have in the past discussing during the recent call), and a termination of the Absorica licensing agreement with Sun and an in-housing of that product to fold right into the ParaPro infrastructure). I am not giving these options any value, but I’d be surprised if at least one of these doesn't work out.

Ignoring those options and using $50m of EBITDA at a 13x multiple, Cipher is worth ~$33/share CAD, or nearly 3x today’s price.

In closing, I’d also note that continued appreciation of the USD vs. the CAD should benefit the company.

This is still my largest position and I am happy to continue adding at these levels.

Cronos Group

On to another one of my favorite ideas at the moment, Cronos, which I believe is significantly more attractive now than when I pitched it back in March. Indeed, after the stock appreciating nearly 50% shortly after my write-up, it has now completely round-tripped and is back in net-net territory again; at the same time, the underlying fundamentals of the business continue to improve, despite a frustrating regulatory/industry backdrop.

At the business level, some key highlights from Q3 earnings:

• Net revenue increased 38% YoY to $34.4m USD (note ~$4m of that increase is due to GrowCo now being consolidated); even excluding GrowCo that $120m annual run-rate is ~25% higher than the 2023 exit rate at the time of the write-up;

• That growth continues to be accompanied by improved efficiency, with opex actually down ~$3m on the quarter YoY adjusting for non-cash impairments;

• As a result, EBITDA was -$6m vs -$15m in the prior quarter;

• Spinach is now the #1 cannabis brand in Canada overall, and has 17.2% share of edibles. (Brand power will become increasingly important as the capital cycle plays out!).

• The new supply agreement with GrowCo gives Cronos the option to purchase most of its production. This is an overlooked strategic development that should have a material benefit on costs.

• The balance sheet continues to be a fortress, with $862m of cash (vs. a market cap of ~$800), tens of millions in loan receivables and real estate, and no debt. There is a meaningful discount to liquidation value;

• The excise tax continues to consume ~30% of the topline.

Some items to double click on.

I continue to be impressed by the company’s ability to grow the top line whilst materially slashing costs in an environment where cannabis prices continue to be depressed (i.e. revenue growth is coming from volumes/market share capture, not pricing). I would note that not every producer has been so lucky; e.g. CGC saw its domestic revenues decline materially.

Investors should keep in mind that current pricing is not economical, and the weak producers will continue being flushed out until we get rationalization. If you believe cannabis has a future in Canada, as I do, then rationalization will happen and those pricing increases will drop right to the bottom line. Until then, Cronos has the balance sheet to outlast the competition easily.

With the recent sell-off, Cronos is now a net-net growing at 30% a year, capturing increasing market share, and not burning any cash. I have never, frankly, seen anything like this, and it goes to show you just how awful sentiment around the cannabis sector is.

Which brings me to the industry and market dynamics, which are clearly outweighing the relevance of fundamentals to investors.

Firstly, on election day, Florida voters rejected Amendment 3 — a proposal that would have constitutionalized the legalization of cannabis. This, coupled with a Trump win/Republican sweep, caused the MSOS index to get hammered. That Cronos group, which does not do material business in the US and is not even fairly valued for its domestic business, declined by double digits on this news is a signal of just how irrational and unthoughtful a lot of investors in this space continue to be. Moreover, I am not even sure the Florida vote provides a strong read through to the future of cannabis in the US at the federal level. Trump and his new administration, though conservative in name, have taken a rather libertarian stance on a number issues thus far and have really started to coalesce around the theme of deregulation, which could very likely apply to cannabis. Indeed, Chris Christie noted this week that he expects Trump to deschedule cannabis; meanwhile, Trump’s Attorney General nominee, Matt Gaetz, is one of the handful of Republican Congress members who have actively supported cannabis legalization, previously voting in favor of a House Democrat sponsored legalization bill. In short, I am skeptical the US outlook is as dire as the market is making it out to be, nor in any event does the US outlook have much bearing on the Cronos story at this point in time.

Moving to the domestic backdrop — this is an area that warrants frustration and one that is not likely to resolve itself until a more business friendly government comes into the fold (there is a federal election next year). This week, Organigram CEO (disclosure: long) Beena Goldenberg published an op-ed complaining that illicit cannabis continues to account for 30% of the market (which has depressed pricing) and that the reason for this largely attributable to government overreach and taxation. I agree.

Holding your breath for this Canadian government to do something economically rational would be akin to suicide, but the Liberals are done for soon, and if the government wants to continue benefitting from cannabis industry’s tax revenues, they are going to need to reform their approach, otherwise there will be no cannabis industry left to tax. The obvious, and simplest, place to start would be an amendment of the excise tax to be in line with those levied in the alcohol and tobacco industries — this alone, even without market prices increasing, would likely turn Cronos substantially EBITDA positive.

Consolidation continues apace in the legal cannabis industry, but until taxes and other regulations are reformed, the illicit cannabis market will continue to weigh on a rationalization of supply.

Time will tell how this unfolds, but at a net-net valuation, we are taking on very little risk to find out.

Enzo Biochem

Enzo, ever quiet, dropped its 10-k a few weeks ago. Momentum at ELS slowed a little, which is annoying, but there were two far more notable disclosures apposite to the event-angle.

First, further to the earlier court filing noting that the parties to the class action had agreed to settle the case (we should have the precise terms within 15 days), the 10k notes that a provision for the class action has been made in the financial statements. This means the overhang is effectively cleared and the major risk to the thesis — an unexpectedly high liability — is now off the table.

Second, and in consequence of the first point, the company announced a special dividend of $0.10/share payable on Dec. 2 to shareholders of record as of Nov. 15. Obviously, a dividend of ~9% of the market cap is a nice treat into year end, but the more important thing is what it signals. Enzo, despite ELS’s improvements, is still not profitable at the corporate level and remains a ways off from being so. Therefore, returning 10% of your cash and ~15% of your net current asset value to shareholders surely means one of two things: either management sees a clear path to becoming cash flow positive in the near/mid-term or this is step one in a liquidation/asset sale process that is about to ramp once the litigation amounts are finally paid. I highly suspect it’s the latter.

So what might we get in a liquidation? (note provisions have been taken for litigation sums).

This is a wide and imprecise exercise, but the point is to illustrate that even under the punitive bear case we are unlikely to lose material money from here, whereas the upside could be significant. The range of outcomes largely turns on cash burn assumptions, ELS valuation (I use 1x, 1.5x, and 2x sales), and real estate valuation (it is almost surely more than $10m at this point). I’d note that given management’s incentives and options packages, they likely believe (or at least hope) that there is >$2/share in value sitting here, and the bull case could well be higher than I am providing for (albeit, I did find the company’s decision to payout a dividend, rather than to do a tender, slightly odd given senior management’s options are struck at $2, and returning capital via dividend makes that hurdle more difficult to reach).

The final thing I’d note is that this dividend may be treated as a return of capital rather than taxable income given Enzo’s enormous accumulated deficit, but I am not certain of this, so don’t hold me to it.

JBG Smith

Not much to update here and I am treating this as a low priority idea for the moment. I still very much like this company and these assets as a long term hold, but with office headwinds continuing in National Landing and the 10-yr drifting higher, I am skeptical the near-term returns here will be strong.

For now, I’d just note the following:

• Management have continued buying back shares, having now repurchased 38% of shares and OP units since 2020 at an average price of $19.88/share, including 10.8m shares at $15.61 this year. FDSO now sits at 98m, vs 102m when I wrote it up in July. Coupled with the ongoing $0.175 quarterly dividend, the distribution yield has been in the teens for the year. I do, however, expect the buybacks to slowdown moving forward.

• Multifamily segment continues to be very strong with 96% occupancy and effective rents up 4.5% for new leases and 6% for renewals. Same store NOI increased 3.5%, while formerly “under-construction” asset 1900 Chrystal Drive is now in service and 62% leased. This is a high-quality asset and the company expects this development to contribute $23 of NOI once stabilized, which is worth $420m at a 5.5% cap rate. Total normalized mutlifamily NOI is ~$160m, which will trend towards $180m once the other under construction asset (2000/2001 South Bell) gets delivered next year. My pro forma segment NOI has come down a bit due to the sale of Fort Totten for $86m.

• On the other hand, office continues to be tough, with occupancy down 1.5% to 80% QoQ and a further 475K sq/ft ($21.5m of annual rent) vacating over the next 6 months. This will bring occupancy down to 70% after excluding assets that will be foreclosed on. The company notes however that leasing activity has been picking up. Moreover, Amazon’s (National Landing’s anchor tenant) announcement of a return to a 5-day in-office work week could be a big boon for the office dynamics and National Landing real estate valuations at-large. On the other hand, the Trump administration’s purported objective to gut the bureaucracy could threaten government jobs, which is worth keeping an eye on given the government is the company’s largest tenant.

• Altogether, using the same approach I laid out in the original write-up, my estimate of NAV/share is slightly below $25, with a lot of room for expansion if office cap rates improve and as the large development pipeline (which I am valuing at book) comes online. Happy to provide my math to anyone interested, but I’ll leave it at that for now.

• Debt remains optically high but not concerning, with $121m of office debt maturing this month which will be a foreclosure, and $340m maturing next year, which is nearly all attached to a quality multifamily asset which will be easily refinanced.

Mereo BioPharma

You may recall that there is a timing element to this event-driven set-up that creates a unique de-risking dynamic: specifically, per the company’s commentary that they are looking to have alvelestat Phase 3 ready by year-end (which will require some form of monetization through a partnership/financing), we are able to bet on that event crystallizing what could be a lot value in relation to the market cap before taking on any clinical trial risk for the lead asset setrusumab, which will release first interim results in the coming months only if the endpoint is met (i.e. we could get upside from this as well, without the material risk of a bad readout announcement, which should not come until after the second interim in mid 2025).

Frustratingly, we have not heard much of anything from the company regarding alvelestat outside of some comments at a fireside chat a couple months ago around complexity of deal terms, which has brought into question the likelihood of anything being announced before the end of the year.

However, the company provided an update yesterday that might serve as a clue. After releasing earnings, Mereo filed an odd and ambiguous 8-k noting that it has amended the alvelestat licensing agreement with AstraZeneca, specifically modifying the development milestones and Mereo’s payment terms. It’s not easy to comprehend the contractual consideration being offered for the amendment, nor is it clear what the motivation for the amendment is now, after 7 years. It may just be housekeeping (the amendment date is on the heels of the exact anniversary of the execution date), but I think there’s a good chance this isn’t a coincidence and the parties are fortifying their rights in advance of a larger deal for the asset. To that end, it’s also a good sign that the earnings press release reiterates that alevelstat “will be Phase 3 ready around the end of 2024”, which would be a weird thing to say with only 6 weeks left in the year if you weren’t highly confident in that outcome. The problem is that I am not clear on whether Phase 3 ready simply means the clinical trial framework will be ready, or that the financing to launch that trial will also be in place.

In short, I see little risk in continuing to hold this for now, though I will need to reconsider positioning if we don’t get any alevelstat news by year end. For now, it’s a high priority idea for me.

***

I have no updates for BQE Water and Northern Ocean, which will both report in the latter half of the month. I will provide an update over the Substack chat, if not a full form like this.

Happy to chat through any of these names as always.

Disclosure: I am long shares of CPH.TO, CRON, JBGS, ENZ, MREO, BQE.V, NOL.OL, and OGI.