LONG OPPORTUNITY: LCI (NYSE) LANNETT CORPORATION: STRUCTURAL BENEFITS OF KREMMERS ACQUISITION: 100% UPSIDE

Transcription

1 LONG OPPORTUNITY: LCI (NYSE) LANNETT CORPORATION: STRUCTURAL BENEFITS OF KREMMERS ACQUISITION: 100% UPSIDE

2 Executive Summary Lannett Corporation ( LCI ) shareholders have a unique opportunity to realize sustainable free cash flow yields in excess of 20% and growing The Valeant Pharmaceutical ( VRX ) & LCI stock price correlation is unwarranted The Kremmers Urban Pharmaceuticals ( KU ) acquisition from UCB has only levered LCI to 3.5x EBITDA Several valuation, liquidity and future cash flow benefits have been overlooked by the analyst community Cash flow sweep Net working capital improvements Cash tax deductions (which are not GAAP EPS dilutive) Bankruptcy risk is remote LCI is able to comfortably repay the KU acquisition debt under a wide range of scenarios A conservative valuation of LCI shows 100+% upside from current levels The DCF valuation is robust over a wide range of scenarios LCI trades at a large discount to its peers in the generic drug industry 1

3 Table of Contents 1. Industry Context 2. Areas of Concern 3. Overlooked Upsides 4. Credit Metrics 5. Base Case Valuation 6. Sensitivity Analysis

4 Section One INDUSTRY CONTEXT

5 Stock Price Fundamentals or Herd Mentality? A 90% price correlation between two stocks, even when they are in the same industry, is rarely warranted Figure 1 2

6 North American Generic Stocks Relative Performance LCI s stock price has decoupled from its industry peers Figure 2 3

7 Material Information Disclosures by LCI LCI has outperformed VRX since mid-march 2016 Figure 3 4

8 Section Two AREAS OF CONCERN

9 Overview: Areas of Concern It appears that some analysts are relying on the initial KU acquisition SEC filings. Since that time, there have been some negative developments The ultimate EBITDA multiple paid by LCI has increased from 12x to around 16x The KU revenue losses do not appear limited to the major customer and/or LCI hasn t been able to recover as much of the lost revenue as they expected The terms of the acquisition debt deteriorated by the time the financing closed Management has indicated several times that it is considering additional acquisitions and is not interested in selling the company Along with friendly shareholders, management control up to 40% of the shareholder register o This does not include institutional investors who may vote with management Shareholders hoping for a takeover premium payment from a larger competitor during the next few years are likely to be disappointed Moody s credit criteria provide an incentive for generic drug manufacturers to grow via acquisitions 5

10 LCI Ended Up Paying 16x EBITDA for KU While a higher multiple than anticipated at deal announcement, it is in line with the industry public trading comps (which exclude a control premium) Figure 4 6

11 Revenue Losses At KU Extended Beyond the Major Customer LCI s revenues stand-alone revenues have declined only marginally Figure 5 7

12 Final Acquisition Financing Terms Were Less Favorable Credit market conditions deteriorated appreciably after the KU deal announcement Figure 6 8

13 Final External Financing Was Only Down $70 million Net proceeds were down an additional ~ $50 million due to a higher OID Figure 7 9

14 Pro forma earnings dilution LCI management tends to report adjusted earnings which is closer to our Cash EPS calculations Figure 8 10

15 A Sale of LCI Appears Unlikely LCI management has indicated it does not want to sell the company. With 30% to 40% of the shares friendy to management a hostile bid is a low probability Figures 9, 11 and 12 11

16 We Consider Future Acquisitions by LCI to be Likely Moody s assigns its highest factor weighting in the generic drug industry to size of the business. This incentivizes firms like LCI to become serial acquirors Figure 10 After the end of Q3 2016, on April 8, 2016, LCI drew down the entire balance on its revolver ($125 million). $50 million of this may be used for the 12% notes buy back. Given that: (a) LCI has around $240 million of cash and equivalents; and (b) LCI recently repaid the entire drawn balance on the revolver ($28 million), It is possible that LCI has used the revolver as a bridge financing for another acquisition An acquisition of this size (<$125 million) would probably not necessitate an 8K filing to disclose the deal terms 12

17 Section Three OVERLOOKED UPSIDES

18 Overview: Overlooked Upsides The changes to the initial KU acquisition SEC filings combined with the fine-print in the purchase agreements and the debt documents reveals a number of upsides On a consolidated basis, LCI is only levered 3.5 x EBITDA The cash purchase price paid to UCB was ultimately reduced by the senior notes, the LCI warrants and the working capital adjustments The final purchase price adjustments provides LCI with a number of material cash tax (IRS) deductions. These amortization deductions are not GAAP EPS dilutive There are also OID cash tax deductions that further reduce cash taxes LCI has significantly reduced the combined LCI/KU net working capital requirement over the last 12 months. This provides a liquidity benefit equal almost 10% of the external indebtedness The debt structure includes a 75% excess free cash sweep. The company will de-lever a lot sooner than many analysts expect. The cash sweep also provides a free cash flow yield benefit to shareholders. The amount of scheduled (i.e. mandatory) debt amortization each year until FY2021 is relatively low Both the cash sweep requirement and the credit spread will decline over time as LCI de-levers the company Given movements in credit spreads, a refinancing of the senior secured debt is possible management has also committed to refinancing the senior notes Until the KU deal, LCI was under-levered. It is probably above its optimal cost of capital at the moment but should approach its optimal capital structure in a few years 13

19 The Final KU Purchase Price Was Below Expectations The cash purchase price benefited from working capital adjustments and the warrant & senior note consideration issued to UCB Figure 13 14

20 Free Cash Flow Benefits of the Excess Cash Flow Sweep Analysts have overlooked the 75% excess cash flow sweep in the acquisition financing documents. Figure 14 An incremental FCF yield benefit of ~ 3% may not appear consequential when compared to a ~ 29% FCF yield. However, many companies in the S&P500 have a FCF yield of less than 3%. 15

21 Cash Sweep & Credit Spreads Decline with Leverage In our base case, LCI should achieve these hurdles in just a few years Figures 15 & 16 16

22 Pro Forma Net Debt is a Reasonable 3.5 x EBITDA LCI used the KU deal to adjust its consolidated leverage Figure 17 17

23 A Refinancing of the Senior Secured Debt is a Possibility Management has stated it is working to refinance the 12% senior notes. There has also been a reduction in credit spreads, OIDs, etc for senior secured debt Figure 18 There is a 1% prepayment penalty if LCI seeks to refinance and/or cash sweep the senior secured debt before November

24 The KU Purchase Price Allocation Was Favorable to LCI Analysts focusing on book taxes are overlooking $30 million per annum of cash tax deductions. These items are not dilutive to GAAP EPS Figure 19 19

25 Taxes Benefit from the Loss on Unamortized OID at Repayment The negative impact of the acquisition debt raising OID is partly mitigated by cash tax deductions at debt repayment Figure 20 20

26 Significant LCI/KU Net Working Capital Improvement The cash flow benefits of the net working capital reduction is around $100 million in just 4 months since deal close. This is in addition to the purchase price working capital reduction. Figure 21 21

27 LCI s Cost of Equity is Currently Around 16% Using a target leverage ratio of 25% reduces the levered equity beta (from 2.2x to 1.7x) but increases the WACC from 9% to 11% Figure 22 22

28 LCI Was Under-Levered Prior to KU If the equity market capital of LCI remains constant, the leverage ratio should approach the optimal level by FY2019 (and sooner if the stock price improve) Figure 23 23

29 Section Four CREDIT METRICS

30 Overview: Credit Metrics Despite all the talk about LCI being over-levered, we cannot see any signs of impending financial strain In our base case 4% revenue growth LCI has little difficulty complying with its debt covenants LCI exceeds the Moody s credit metrics for a B rating. It achieves a Ba rating on the basis of the credit metrics (not taking account of qualitative credit factors) The LCI Board of Directors still have a large number of strategic alternatives which they can implement if the company starts to show signs of financial strain Aside from the cash sweep, debt amortization obligations are relatively minor until FY

31 LCI Should be able to Comply with its Debt Covenants Scenario assuming 4% annual revenue growth from Q annualized figure Figure 24 25

32 LCI Easily Meets Moody s Quantitative B Credit Metrics In fact, putting aside qualitative factors, LCI appears to be able to meet the leverage metrics for a Ba rating Figure 25 Apart from the treatment of cash and cash equivalents, there are a number of other areas where the leverage ratios in the senior secured debt documents differ from the Moody s credit ratios, including:: Restructuring costs Deal synergies Stock based compensation Contingent obligation earn-out Settlement agreement Capitalization of lease obligations Etc 26

33 Even with a High Cash Sweep, LCI Meets the Ba Criteria Moody s focuses on gross debt providing an incentive to utilize the cash sweep even when entitled to reduce the annual % sweep under the loan documents Figure 26 27

34 Aside from the Cash Sweep, LCI has Minimal Amortization Initial consideration of bankruptcy risk is still years away Figure 27 28

35 Bankruptcy Risk? Management has a large number of strategic options to alleviate future financial stress Figure 28 29

36 Debt Covenant Compliance is Robust It would take a drastic change in both revenues and costs for LCI to breach its debt covenant leverage ratios Figure 29 30

37 Section Five BASE CASE VALUATION

38 Base Case Free Cash Flow Yields are Significant Based on 4% revenue growth and the May 16, 2016 stock price. KU generates significant incremental free cash flow Figure 30 31

39 LCI Trades at Much Lower Multiples Than Its Peers Partly this discount reflect the higher leverage of LCI, but it also overlooks the higher ROE, Free Cash Flow generation and other positive attributes of LCI s economics Figure 31 If LCI was to trade at the median public multiple of its comparable generic drug peers, the current stock price would more than double. 32

40 DCF Unlevered Free 4% Revenue Growth Figure 32 33

41 DCF Valuation: ~ 90% upside Our base case unlevered free cash discounted cash flow valuation employs a 5.0x EBITDA exit multiple in 2022 and an 11.0% pre-tax, nominal WACC Figure 33 34

42 Section Six SENSITIVITY ANALYSIS

43 Overview: Sensitivity Analysis Our three sensitivity cases are driven by different revenue CAGRs: 1. +4% : Moody s industry revenue growth forecast (base case) % : a downside scenario % : the consensus analyst long-term revenue growth rate In all 3 scenarios we utilize a 75% cash sweep 35

44 Free Cash Flow Yield is Strong Under All 3 Sensitivities Combining the flexibility of a cash flow sweep with a high free cash flow yield suggests the market correlation with VRX has overshot to the downside Figure 34 The higher FCF yield in FY2017 for the downside case may look counterintuitive. It is the new result of lower cash taxes, lower COGS and, most importantly, a net working capital reduction. On the other hand, net working capital needs are increasing for both the Moody s case and the Street consensus case in FY

45 The DCF Valuation Upside Applies to a Wide Range of Inputs Even with reasonably conservative growth and exit multiple assumptions, LCI is drastically undervalued. Also, our base case 11% WACC is arguably too high Figure 35 37

46 Under All 3 Scenarios LCI is De-Levered by FY2019 The optimal capital structure may be achieved as early as FY2018 Figure 36 38

47 Under All Sensitivity Cases LCI Has Ample Liquidity The maturities in 2021 and beyond do not currently appear to be at risk Figure 37 39

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