Actionable Ideas Update - 08/20/2024

Updates on: CPH.TO, BQE.V, MREO, ENZ, SPWH, and JBGS

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

Alright, it is time for a much overdue update on this blog’s open ideas.

Since inception in December 2023, I have pitched 10 ideas, 7 of which remain open. Here they are (prices at the close of market August 19):

Given many of these are longer-dated ideas that were only recently pitched, I don’t think the total shareholder returns column is particularly insightful yet, though I am generally satisfied with the performance of the ideas thus far, especially on a time-adjusted basis. While I obviously want each idea to generate outsized upside, my bigger preoccupation is with avoiding pitching stinkers, which I have mostly been able to do thus far with the exception of the disaster that has been Sportman’s.

While Sportman’s certainly won’t be the last loser I pitch, hopefully I can mitigate the losses with a high slugging percentage on the ideas that do pan out. So far, the biggest winners have been Cipher Pharmaceuticals (+180%), Nuvation Bio (45%, closed), and BQE Water (33%; 55% since first highlighted).

With the exception of CRON, which I published a separate update on last week, I have updates of varying durations to provide for all of the open ideas below.

Here’s how I would bucket them: 1) shorter-duration event-driven (MREO, ENZ); 2) fundamentals driven long-term holds (CRON, CPH.TO, JBGS, BQE.V); and 3) turnarounds (SPWH).

Cipher Pharmaceuticals

Let’s start with Cipher, which is a completely transformed company since my last update. There is a lot to contemplate here (all of it positive) and I will probably publish a separate long-form update eventually for this name as I did with CRON.

On July 29 Cipher finally announced the acquisition that has kept shareholders in suspense for most of the year, acquiring Natroba and its authorized generic Spinosad, a dermatology product used for the treatment of lice and scabies, for a price tag of $89.5m USD. To say that Mull and the team put the balance sheet to good use with this deal is an understatement, and the market certainly agrees with that sentiment, with shares up +70% since the announcement.

But here’s the thing: notwithstanding the post-announcement run and the stock now returning ~180% since I pitched it 6 months ago, I honestly think that the opportunity on offer here remains equally, if not more, attractive.

Going into the deal, Cipher was trading for ~9-10x EBITDA. The Natroba deal apparently doubles Cipher’s ~$12mUSD EBITDA, implying a transaction multiple of ~7.5x. Cipher funded the purchase with $40m cash, $40m debt, and the issuance of 1.47m shares at $8.91Cad. Given the doubling of EBITDA, the pro forma entity is currently trading for ~14x EBITDA. So we’ve gained several turns on the multiple since the acquisition was announced. But rightfully so. In fact, I’d argue that this multiple expansion might actually be an underreaction to the value that has been created.

For a detailed discussion on Natroba, I would recommend that interested readers give this great piece by Framp Files a read. What I want to do here is highlight the broader opportunity this acquisition has created and why I think a pro forma mid-teens EBITDA multiple is perfectly reasonable, if not cheap.

1. Cipher now has several avenues for growth,

When I first pitched Cipher, we were buying a high-yielding bond-like stream of cash flows attached to a stable, but overcapitalized business with low-to-no growth, and getting a free call option on MOB-015 commercialization.

Today, following the acquisition, this is firmly a growth stock.

For one, there is simply the opportunity to grow Natroba’s market share within the United States. As highlighted in the deal press release, the current standard of care for lice and scabies is permethrin (1%, 5%) with greater than 70% market share vs. a mere 22% for Spinosad. However, significantly, lice and scabies have been developing increasing resistance to permethrin for years, with estimates that its efficacy may now be as low as 30%. This obviously provides a lot of upside simply to the US opportunity should Cipher be able to grow Natroba’s market share. Given the nature of the product and the people in charge here, I’d frankly be surprised not to the see material market share capture, particularly for scabies, for which Natroba has patent protection until 2033 and a far superior complete cure rate to its competitors. Here’s Mull during the Q2 call last week:

Then, of course, there is the opportunity to expand Natroba beyond the United States. Cipher will be submitting the product to Health Canada for approval shortly. Given the Canadian pharma dynamics discussed in my original write-up, there is less competition and, by extension, consumers have less treatment options, which should open the door for Natroba to win some of this market fairly quickly considering Cipher’s in-place dermatology infrastructure and pre-existing relationships. Moreover, management have already indicated that they are in discussions to out-license the product in Europe and that the FDA data would likely be sufficient for European regulatory applications. Agreements to this end are expected within the next 12-months. With the European market of a similar size to the US, there is a ton of potential upside from licensing agreements.

Altogether, I expect Natroba’s headline EBITDA of ~$12-13m to be a lot higher a couple years from now. If, e.g., Cipher is able to grow Natroba’s earnings by 50%, which doesn’t seem particularly Herculean, then we are looking at a company trading closer to 10x EBITDA and an acquisition multiple far lower than 7.5x.

But there’s more to the deal than Natroba itself.

As part of the acquisition, Cipher has acquired the seller’s (ParaPro) 50 member sales and marketing team and will be using the latter’s footprint in Indiana as its new US headquarters. Obviously, this is a strategic move that positions it to capitalize on Natroba’s US growth opportunity, but even more so, it positions Cipher to leverage this infrastructure to further expand into the US and directly market its products there. There are at least three potential ways this comes into play at in the near-term:

• The most immediate and likely is that this infrastructure enables Cipher to move on from its Absorica licensing agreement with Sun, which expires next year, and to bring the product back in-house. This will enable Cipher to capture the entire economics of the product (rather than just royalties) but also could position them to grow the product (which has been is steady decline for years) — a task which Sun has not been equally incentivized to do. Even assuming they are unable to generate any growth, merely bringing the product back in-house would make a material difference to earnings. I estimate that in-housing of Absorica could conservatively result in ~+$10m of incremental EBITDA.

• Another angle, though more of a long-shot, is that this US infrastructure positions Cipher to secure a piece of the US opportunity for MOB-015. It appears that Cipher is certainly going to take a shot at this, though I certainly don’t consider this outcome as my base case. Of course, given Cipher’s projections on the size of MOB-015’s Canadian potential, any exposure to the US opportunity could be yet another game changer for the company.

• Finally, this US presence can now be leveraged for acquisitions of additional dermatology products. And we’ve been explicitly told that Cipher isn’t done looking at acquisitions yet:

  

  Given Mull’s sizeable stake in the company and the tremendous capital allocation he’s demonstrated in turning this business around, he certainly has my proxy to pursue more deals.

2. Cipher has a more diversified product platform.

At the time of the write-up, nearly all of Cipher’s earnings were attributable to isotretinoin, with market share advances in Canada offsetting declines in the US. Pro forma the acquisition, there is far less product concentration risk.

3. Cipher has improved size and liquidity

As the earnings power has grown, so too has the market cap and liquidity. This is now a far more investible company than it was at $5, yet another factor supporting a higher multiple.

4. A vastly improved capital structure

While Cipher’s war chest of cash made for attractive downside protection, it was a drag on the equity and clearly not being ascribed full value by the market. Having accretively deployed that cash, we are now looking at an attractively levered balance sheet that will help juice our returns as the company grows and generates increasing gobs of cash flow.

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So what does this all mean looking ahead?

Well, let’s think about what Cipher could be earning in three years time. Recall the smoking gun from the SIB prospectus projecting $34m of EBIT by 2027 at 60% margins? If we add, 1) Natroba’s US earnings + 50% growth (~$18m) and 2) incremental $10m from Absorica due to in-housing, we are looking at a company that could be generating upwards of $60m in operating income in three years, vs. a TTM figure closer to $12m (there’s honestly a line of sight to this being far higher). In other words, it’s possible Cipher’s EBIT could 5x over the next three years, before accounting for any other acquisitions. $60m EBIT put this ~5-6x 2027 EBIT.

Ask yourself whether that’s a fair multiple for a high-growth, asset-light, highly cash generative business with an attractive suite of products and proven capital allocators at the helm. I think not.

Assuming a deleveraged balance by 2027, throwing a 10x EBIT multiple on this gets me to a CAD listed price of >$30/share. I know that seems crazy given where we started, but I don’t think I am making any outlandish assumptions in my underwriting (feel free to push back if you disagree). In fact, there’s a good chance of more upside beyond that from further acquisitions, Moberg’s US rights, a well-executed global rollout of Spinosad, etc.

On the downside, let’s punitively assume Natroba fails to grow at all and, for whatever reason, MOB-015 never gets commercialized in Canada. Well, then we are still only paying a mid-teens multiple for an asset-light, high margin pharma company with perfectly manageable leverage and an ambitious and aligned CEO. Maybe that’s slightly rich, but those assumption are also very unrealistically punitive. In short, I struggle to envision a way in which we lose material money here even after this big run, absent perhaps a disastrous acquisition (although, even that risk has been substantially mitigated given how much fire powder was already deployed on Natroba).

Ultimately, this has been a case study in the power of prudent capital allocation and aligning yourself with an owner/operator hungry to create to value.

For my part, although I started purchasing shares in the $3 range, I’ve continued being a buyer of shares following the deal announcement. This is now my largest single holding and it continues to be my favorite bet in the market.

Sportman’s Warehouse

From the great, to the ugly. Ouch.

This has been a reminder of Buffett’s famous, but oft forgotten caution — “Turnarounds seldom turn.”

After what I viewed as a really positive Q4 report and commentary, all of those positives were effectively reversed in Q1. There’s a lot we can discuss as to why that is, but let’s start with the simplest: demand just hasn’t been there, and given the embedded operating leverage and working capital requirements as a retailer, the company simply hasn’t been able to generate the cash it needs to right the ship.

Let’s start with the glass half full. The biggest risk following Q1 earnings was liquidity: after making substantial progress in debt paydown in Q4, the company was forced to draw $40m on its revolver during the weak Q1, and while there’s generally seasonal working capital requirements, I was not expecting a draw of that size. That left the company with a mere $2.2m of cash vs. $162m of debt and $78.6m of remaining capacity on the facility.

On August 1, the company addressed this liquidity need, securing a $45m ABL term loan as well as an amendment on its revolving credit facility. This materially increases the company’s liquidity, which is apparently now $127m. This, coupled with what I expect (hope) will be normalization of inventory levels through the remainder of the year should be sufficient to get the company through some more difficult quarters. Obviously, I also take it as a good sign that there’s some willingness to lend here, admittedly at a fairly high cost.

The glass half empty view is obviously that taking on this high cost of debt is a pretty clear sign that the cash flow problems remain precarious. On top of this, we know there’s been real concerns about the health of the consumer, particularly as it relates to SPWH’s primary demographic. Moreover, we also haven’t seen much of an uptick NICS data, although July’s number did jump 5% YoY (these numbers tend to go up materially in the months leading up to a Presidential election, a trend that could be exacerbated this year given heightened political polarization).

Balancing these pros and cons, I’ve continued to own the stock and have been a small buyer of shares below $2. The main reason for this is that management, who have nothing to gain here in making promises they can’t keep, still have not revised their guidance of $45-65m EBITDA in for the year. While that doesn’t mean they won’t do so, and there’s no assurances they won’t simply let shareholders down, it just seems odd to not only stand by that guide, but also to reiterate it during the Q1 call (after recording negative 8m for the Q) if they had any concerns about reaching it.

At today’s share price, the market cap is a mere ~$70m (which is wild to think, considering the company was set to be acquired for $800m just three years ago - retail is a tough business!) and pro forma enterprise value is ~$255m. That puts this at only 5-6x the low-end of the guide, which coupled with the leverage, makes for a whole lot of upside if they can finally turn this around.

Ultimately, while I am cautiously optimistic there’s enough here to right the ship, investors obviously need to be aware that there are very real risks. This is certainly not a position I’d be willing to own in size at this point, but I do think it’s asymmetric to the upside at these prices.

Q2 earnings are scheduled for September 3 and I will provide some updated thoughts then.

BQE Water

Just a couple brief but important updates on this name.

Firstly, you may recall my update in June discussing one of BQE’s company-maker projects, the KSM project. In late July, project operator Seabridge Gold announced that it has received its Substantially Start Designation from the BC government, effectively giving the project regulatory go ahead. As I noted in my write-up, this is one of two major conditions needed to commence the project — the other being Seabridge securing joint venture financing. Seabridge’s subsequent communications have evinced confidence in getting a deal done, which is unsurprising to me given the size and quality of this asset.

As a reminder, the NI 43-101 for KSM indicates BQE earning something in the range of $9m of ARR from this project once water treatment operations start, which is approximately BQE’s entire recurring revenue today. And while operational services will not commence for several years following KSM coming online, BQE should fairly quickly see material increases to Technical Services revenue. This is a very large catalyst for the company which I believe the market is still failing to adequately price in (let alone the other company maker projects in the pipeline). Once Seabridge secures JV financing, I suspect BQE’s management will soon thereafter start discussing their views on this project.

Beyond this, I’d just note 1) that major shareholder and private investor Richard Hubbard has joined the board and 2) that Fairlight Capital, who have put up some really impressive returns since inception, appear to have taken a position in the company. These are small, but really nice developments in my view.

Enzo Biochem

The big update here is last week’s announcement that the company reached an agreement with the Attorneys General of New York, New Jersey and Connecticut to pay a $4.5m penalty to resolve the regulatory investigation in connection with the ransomware attack. While this is a higher figure than I would have thought, it removes a major piece of the overhang and brings us one step closer to having the ransomware liabilities resolved, which as a reminder also includes an investigation from the Utah AG and the class action litigation, in which Enzo’s motion to dismiss is currently pending.

Here is my base case for how this plays out from here: 1) Enzo’s motion to dismiss very likely gets denied; 2) the parties promptly thereafter reach a settlement; 3) with ransomware liabilities out of the way, the company returns the excess cash to shareholders, ideally through a tender; and 4) a sale of the remainco (ELS).

I’d note that ELS turned a segment level profit in Q2, continued to grow and expanded margins. Accordingly cash burn has become very minor, with net current asset value declining by only ~$1m sequentially. Because I was underwriting $3-4m of NCAV reduction per quarter, the $4.5m outlay doesn’t materially impact the NAV calculation from my initial write up. Absent an unexpectedly large further cash outlay to settle the ransomware issue, it is difficult to underwrite much, if any downside, at the present share price. On the other hand, I think there is a high probability of >100% upside, which will largely come down to what multiple attaches to ELS. That return could also be materially juiced if the company is able to buyback material shares in the low $1s.

As a reminder, the CEO (and now CFO) are heavily incentivized to effect a change of control and get this share price above $2, given the revised terms of the Transaction Bonus and the options package with $2 strikes (see here).

Time will tell, but I continue to see this as a very asymmetric set up.

Mereo BioPharma

Mereo doesn’t do quarterly conference calls, but Ultragenyx does, and they provided what I view as extremely bullish commentary around setrusumab’s phase 3 trials.

The takeaways:

1. They reiterated how strong the updated 14-month phase 2 data I discussed in the write-up was, noting that: “the p-value declining substantially tells that all of the patients are moving toward a reduction in fractures. So we feel that the effect is very large.” Moreover, and significantly, it appears that patients have continued to progress over a 17-24 month treatment period: i.e. patients are continuing to see statistically significant increases in bone strength and less fractures.

2. Placebo patients do not see improvements in bone marrow density, so there will not be any concerning placebo effect from that variable.

3. They expect the drug to work across Type 1, 3, and 4 osteogenesis imperfecta patients, which is 80-90% of the OI population.

4. Phase III is enrolling far more more Type 3/4 patients, which are more severe cases. This is important because it could increase the placebo group’s annualized fracture rate (AFR), which would increase the power of the study (i.e. it will be easier to show statistical significance).

5. Enrollment was reduced from 195 to 150, and it could have been reduced even further, because the AFR of 67% is way past what is needed. The patient size was kept at 150, however, because they wanted more Type 3 and 4.

Altogether, everything I heard from this call reinforces my view that setrusumab has something in the neighborhood of a 90% probability of success. Recall, we could see first interim results as early as year end, but that analysis won’t be shared unless the threshold is met, giving us an opportunity to play both that early potential readout and the alvelestat special situation, without much downside risk until 2025.

Though the move has been delayed, Mereo shares hit a new-high this week, closing yesterday at $4.50/share. I’d also note that there has been a crazy amount of 13f activity on this name and large blocks being gobbled in after-hours trading (see e.g. here)

There is still no word on any alvelestat deal, but I have a strong sense that we will get some big news on this in the next couple months, which could send shares parabolic, especially given how tight the float is.

JBG Smith

I don’t have much to add here beyond that I thought the Q2 update was solid and that everything looks to be tracking in the right direction. My key takeaways:

• 1) multifamily NOI grew 3.4% sequentially, with an 8.6% increase in renewal rents, and occupancy improving to 96.9% from 94.3% sequentially. In short, the multifamily fundamentals look incredible and keep improving; that should continue as only ~4% of inventory in the DC area is under construction;

• 2) further to multifamily strength, under-construction asset 1900 Crystal Drive was delivered this quarter and is being leased up faster than any other multifamily asset before it in the portfolio (now 50% leased) — this is a very high quality asset that will materially improve NOI, and by extension NAV, once stabilized;

• 3) office remains weak, but they had their strongest leasing quarter in three years;

• 5) aggressive buybacks continue, now having repurchased 8.6m shares YTD at an average price of $15.37 ($132m worth). JBGS has now repurchased 36% of FDSO since 2020;

• 6) they have continued taking bad office assets out of stock, which should help stabilize the market in due time; and

• 7) AFFO is way down due to all the office assets that have been taken out of service, but it's still sufficient enough to cover the dividend after all the buybacks. ($0.175/share which will be paid tomorrow, August 21).

This is a great collection of assets at an even better price and I am still a happy buyer of shares here.

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NB: these are not intended to be comprehensive updates; some of the information above may contain inaccuracies; please, as always, DYODD.

There’s a lot more depth we could go into for any of the names above, so please feel free to reach out if you want to discuss.