Research - Seeking Alpha / HBIO Harvard Bioscienc
Post# of 63700
Research - Seeking Alpha / HBIO
Harvard Bioscience Spin-Off Likely To Drive 50% Near-Term And 100%+ Long-Term Upside
Harvard Bioscience ( HBIO ), a leading supplier of life science research tools, has a solid multi-year growth record, an exceptionally broad product and customer base, and a clean balance sheet. Despite this, shares have languished in a narrow trading range for the last 9 years, have no research coverage, and little institutional following. In recent years, growing core EPS has been masked by mounting operating losses associated with the company's Regenerative Medicine Device business unit ("RMD" or the "HART" spin-off) - which we believe has left shares meaningfully undervalued. Specifically, shares currently trade at 23x trailing 2012 reported non-GAAP EPS of $0.22. However, they trade at just 13x 2012 EPS, excluding RMD. We expect the upcoming HART spin-off to provide a catalyst that will drive at least 50% upside to shares near-term, and potentially 100%+ long-term returns if the company pursues a shareholder friendly, value-maximizing plan. Of course, if HART's regenerative medical technology pans out - and there is reason for optimism - shares could return several hundred percent.
Preface
Harvard Bioscience ("HBIO" or "the legacy company") fits many of the criteria we like in an investment: it is under-followed and undervalued, has an upcoming catalyst (a spin-off in September/October), and offers an extremely asymmetric risk/reward profile. At the same time, a common thread in most of our articles is an investor-friendly management, often identified by insider buying, stock repurchase programs, or other investor-aligned activities. Based on a reading of all SEC company filings, beginning with its IPO S-1 in 2000, all available earnings transcripts, and all press releases, it is difficult to view HBIO's board and management as anything but self-serving. Specifically, it has poor corporate governance policies, an entrenched board and management, and a tendency to pay generously for management's poor performance. We detail these points later. Ironically, it is in large part due to the company leadership's history of acting in its self-interest, that we are particularly optimistic about the probability of a very positive investment outcome.
Investment Thesis
HBIO has a solid, diversified, life science tools business. This segment's growing profitability has been hidden by a promising, but unrelated, money-losing, early stage regenerative technology division. HBIO reported 2012 non-GAAP Operating EPS of $0.22, however, excluding $0.16 of losses from RMD, non-GAAP EPS would have been $0.38. The RMD unit is scheduled to be spun-off in the next 2-4 months, which should clarify to investors the profitability of HBIO's core business, and also realize value for the spin-co. Specifically, we expect HBIO to trade at 15x non-GAAP EPS of $0.40 that we are modeling for 2013 - or $6 per share - and the HART spin-off to trade to a value of at least $1.50 per HBIO share (it could easily trade much higher). The sum of the separate entities is worth at least $7.50 per current HBIO share, representing 50% upside from the current price.
However, we believe it's probable that sometime post-spin, HBIO will be sold to a larger competitor, likely for $8-$10 (or more) as there could likely be $7-$10 million ($0.20-$0.30) of operating cost take-outs resulting in EPS of $0.60-$0.70, without accounting for potential acceleration of top-line growth. This equates to a combined value of $10-$12, or over 100% upside versus current prices.
With the recent retirement of 74 year-old HBIO CEO Chane Graziano, and the upcoming exit of HBIO President David Green (who worked with Mr. Graziano at HBIO since inception in 1996) and CFO Tom McNaughton who are both going to HART (the spin-co) there will soon be no experienced executive in place to run HBIO. Given that Graziano, Green, McNaughton and other members of management own 14% of HBIO's stock and 16% of options, there would appear to be significant motivation to pursue an investor-friendly, value-maximizing company sale. Given the exit of senior management from HBIO to HART, the complexity of new management succeeding in a build-up strategy (which has failed for most of its 13 years as a public company), the shareholder value maximization created by the sale of this attractive asset to a larger competitor, and a Board which has overseen a diminishing of shareholder value, it would be unconscionable for HBIO not to be dressed up, and then put up for sale.
We are confident that HBIO will hire a new CEO who will be heavily incentivized to prepare the legacy company for a sale. We also note, that the departure of Green and McNaughton from HBIO to HART makes us confident that HART itself could have some very good news ahead, and be worth far more than our conservative estimate of $1.50 per HBIO share.
Background
HBIO is a global developer, manufacturer and marketer of a broad range of specialized products used to advance life science research. The company's products are sold to tens of thousands of researchers in over 100 countries, primarily through the company's 850 page catalog, website, distributors (GE Healthcare at 6% of sales is the largest customer) and field sales. The company has sales and manufacturing operations in the United States, the U.K., Germany, Sweden and Spain. From its outset, tuck-in acquisitions has been a core part of HBIO's growth strategy. According to the most recent 10-K, they have made 25 business or product line acquisitions since March 1996.
Harvard Bioscience has a history that dates back to 1901 when the company was founded under the name Harvard Apparatus. In March 1996, a group of private equity investors, in tandem with Chane Graziano (HBIO's recently retired Chairman/CEO), and current interim-CEO and long-time HBIO President David Green, acquired a majority of the existing business of the predecessor.
The IPO
The company went public in December 2000 , pricing below the targeted range, but still raising $46.5 million for the company. With an $8 IPO price and 24,782,422 shares outstanding, the market cap stood at $198 million. The valuation was particularly impressive as the company traded at over 6x trailing revenue, especially since the original investors and the company had spent less than $20 million to acquire Harvard Apparatus and for subsequent tuck-in acquisitions. The valuation was even more astonishing considering the actual business. HBIO sold a wide variety of tools used in life sciences research to scientists at universities, institutes and companies - with much of the sales via a 1,000+ page catalog (today it's been reduced to 850 pages). The underwriters dressed up the offering, stating in the prospectus :
"We have designed our tools to accelerate the speed and to reduce the cost at which our customers can discover and commercialize new drugs. By providing research tools, we participate in the revolutions in genomics, the study of genes, and proteomics, the study of proteins, without bearing the risks inherent in attempting to discover new drugs."
As exciting as this may sound, selling a broad swath of research tools to scientists for drug discovery is not a high growth business, and certainly was aggressively priced at 6x trailing revenue. Management advised that growth would be enhanced by accretive tuck-in acquisitions, which was core to the strategy - and has remained so.
On paper, both Graziano, and the 36-year-old Green were wealthy men, and over the next couple of years, each took the opportunity to sell a healthy portion of their shares - while their private equity partners cashed out entirely.
HBIO shares traded at, or above the IPO price for much of the next few years, hitting an all-time high of $14.50 on September 4, 2001. Between its December 2000 IPO and the end of 2003, HBIO made no fewer than 10 acquisitions, spending much of its IPO proceeds on acquisitions to help accelerate growth. At the same time, the private equity investors and Mr. Graziano and Mr. Green were reducing their stock ownership of HBIO.
The big miss of 2004
On May 6th 2004, HBIO reported 1Q revenue in-line with guidance, but EPS was well below the expectations set with just a month remaining in 1Q ( guidance was provided March 2nd ). It guided a very weak 2Q, and reduced full-year EPS to $0.22-$0.24 from previous $0.31-$0.33. It ultimately missed this guidance and earned $0.17 .
The closing price on May 6, 2004 was $8.55. On May 7th, the stock closed at $4.70, a stunning 45% one-day drop. Remarkably, in the 9 years since then, the stock has never traded above $6.26, which was reached on March 30, 2011. The great growth story was over, literally overnight, and the stock began trading on more realistic growth assumptions and financial metrics.
Despite the miss, HBIO President David Green didn't hesitate to enter a 10b5-1 stock trading plan to sell up to 20% of his shares, barely a month later.
Rejected buyout offer
On December 12, 2007, HBIO received an unsolicited buyout offer at $5 a share from Skystone Advisors LLC, who owned 15.4% of outstanding shares and was a shareholder since April 2006.
The letter begins:
Dear Gentlemen:
Skystone Advisors LLC ("Skystone") is pleased to submit to the Board of Directors of Harvard Bioscience, Inc. (the "Company") an offer on behalf of HSO Limited Partnership and HSE Master Fund Limited Partnership (the "Funds) to acquire 100% of the outstanding shares of common stock of the Company not currently owned by the Funds for $5.00 per share in cash in a negotiated transaction. We would consider increasing our offer price after completing due diligence should the Company provide us with additional information demonstrating greater value...
and continues in the 3rd paragraph:
We believe that our offer presents a superior financial alternative for the Company's stockholders as it represents a significant premium of 20% over yesterday's closing sale price of the Company's common stock and a 25% premium over the closing price immediately prior to the Company's announcement of a share buyback on December 6th. We believe $5.00 is a full price and represents an attractive opportunity for all shareholders to realize appropriate value for all of their shares during a time when liquidity is decreasing for micro-cap securities, including Harvard Bioscience. We note that marketplace liquidity for the Company's shares has worsened with average daily trading volumes dropping 17% in the past five months relative to the first half of 2007. In addition, the stock is down 19% year to date despite the Company growing earnings per share 9% year over year. In comparison, the Company's peer group* has appreciated 31% year to date.
Source: 13D filed December 12, 2007
Less than 48 hours later, the offer was summarily rejected. The response follows:
Dear Ms. Nelson,
Thank you for your letter addressed to the Board of Directors (the "Board") of Harvard Bioscience, Inc. (the "Company") dated December 12, 2007. I have discussed this letter with the Board and the Board's conclusion is that the offer made by Skystone Advisors LLC("Skystone") is not in the best interests of the Company's stockholders as the Board believes the Company's current strategy of organic growth plus tuckunder acquisitions can deliver better value to the Company's stockholders than the offer made by Skystone.
Sincerely,
Chane Graziano,
CEO Harvard Bioscience, Inc.
Source: Harvard Bioscience press release December 14, 2007
We believe a company management and Board have every right to reject an unsolicited takeover offer. However, in our view, as soon as a company does - especially when they do it in 48 hours, a period of time that suggests little serious consideration of merits - the onus is on the company to perform as it claims it will. The onus is even greater when the company is led by a management and board that were in place for many years prior to the offer, and then in place for many years post offer - that is a leadership team that has been given ample opportunity to execute.
A failure by HBIO's Management and Board
Without question, HBIO's leadership has failed miserably. Shares closed today at $4.99, below the offer price presented to the company 5 1/2 years ago - an offer price which Skystone noted, "we would consider increasing." CEO Graziano wrote that he and his team could, "...deliver better value to the Company's stockholders than the offer." There is not a single shareholder from the time (who still owns shares) that benefited from the Board's decision to reject the offer, besides the very well remunerated members of management and the Board.
As if to rub salt in wounds, just over a month later, on February 6, 2008, HBIO's Board approved a poison pill , limiting the ability of any potential acquirer to engage with HBIO.
Of course, if you were management, making a seven-figure salary, despite failing to perform for shareholders, we understand why you might want to maintain the status quo . HBIO has provided a very generous compensation structure to a management that has failed to provide a positive return to shareholders.
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Not surprisingly, HBIO also has an entrenched Board of Directors. Notably, the company has a staggered Board, the newest member of which, joined in 2006, with three of five members dating to 2000. In addition, the sole Board member who does not qualify for Social Security is 64. A geriatric, entrenched Board might be somewhat acceptable if it was filled by business luminaries, or if the strategy they oversaw had succeeded (or even come close), but under the tenure of this Board (dating to 2000) investors have lost money. Importantly, over that period, HBIO has pursued a build-up/acquisition strategy, making the role and insights of the Board all the more essential. Unbelievably, the company has added no new blood or younger perspective, since adding George Uveges in 2006. Embarrassingly, the Board has dramatically increased its compensation in recent years - for what, we're not sure, certainly not for stock price performance. We believe the spin-off of HART is a very positive sign of an effort to create value, and are confident that the Board will monetize its HBIO options by pursuing a sale of the legacy company, likely at a significant premium to current prices.
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Despite our issues with management and the Board, and in part due to our confidence that it will continue to act with self-interest, we are very positive on shares. Of course, given the track record of HBIO management and the Board, an activist investor would have a very compelling argument if the legacy company did not pursue a value maximizing strategy.
A funny thing has happened over the course of the years: HBIO stock has become really cheap.
Since 2008, HBIO has enjoyed uneven growth. The company has continued with its tuck-in acquisition strategy, typically buying companies with $3-8 million of revenue for 5-6x EBITDA, with the idea that HBIO could significantly increase margins given its greater scale. Over the past few years, HBIO has missed guidance several times, although nothing of the magnitude of 1Q 2004.
From the 6x trailing revenue of the IPO, shares now trade at under 1.3x trailing revenue, and 13x trailing EPS excluding RMD. The company has grown steadily over time, in large part due to its acquisitions. While this is not a business we like at 6x trailing revenue, it's a business we love at the current valuation.
Below is a slide from HBIO's investor presentation from last September (they have not updated it subsequently) available on their website. Revenues for 2012 actually were shy of expectations, at $111.1 million.
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Source: Harvard Bioscience Investor Presentation Sept. 2012
The company has also increased earnings over time. Excluding RMD, 2012 EPS was $0.38, not the $0.41 estimated below. We are conservatively modeling $0.40 for 2013, based on reduced op-ex (based on completed restructuring), and modest top line growth (per management guidance).
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Source: Harvard Bioscience Investor Presentation Sept. 2012
To provide valuation perspective, both Becton, Dickinson ( BDX ), and Thermo Fisher Scientific ( TMO ) trade at 2.5x TTM revenues, which would imply a value over $9 per share for stand-alone HBIO. We recognize that these are much larger companies, but we believe these multiples are important, because they reflect what a large acquirer could pay to buy HBIO. We believe HBIO's EBITDA and EPS could be substantially higher, with duplicative costs removed (i.e. sales force, manufacturing, administration, public company expense), and therefore sales most accurately reflects HBIO's value. This does not even include the likely higher sales of HBIO products that could be achieved by a larger organization. Simply put, at 13x trailing earnings (ex-RMD) and 1.3x trailing revenue, with a defensible, extremely broad product and customer portfolio, shares are ridiculously cheap.
We believe HBIO's diverse business units are very attractive and competitively well-positioned. In the very short term, results are likely to show tepid growth due to sequestration issues (baked into guidance), although management guided to y/y growth for revenues and earnings on its 1Q 2013 call . We estimate 2013 revenue and non-GAAP EPS (excluding RMD) of $115 million and $0.40, respectively.
The company has tens of thousands of customers, ordering a wide spectrum of different products (to get a full sense of product range, you can look at all of HBIO's divisions here and then look individually at each unit's product sells). Some of their segments include:
HBIO business units
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Source: Harvard Bioscience Investor Presentation Sept. 2012
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Source: Harvard Bioscience Investor Presentation Sept. 2012
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Source: Harvard Bioscience Investor Presentation Sept. 2012
The HART Spin
HBIO plans to spin off its Regenerative Medical Device unit (which will be called "Harvard Apparatus Regenerative Technology" and have the ticker: HART) in the next few months (likely late 3Q or early 4Q). This is a division that has been of increasing focus and expense to the company for several years, and is an area which they believe has significant promise. In fact, there is so much excitement about this segment's potential that President (and current interim CEO) David Green, who has been with HBIO since its inception in 1996, and CFO Tom McNaughton are both departing to run HART.
For over a year, management has been contemplating a way to remove the expense of HART from HBIO, while highlighting its potential. Last year, it decided to pursue an IPO, and filed an S-1 on December 12th. The company was going to issue 1.7 million shares (prior to underwriter over-allotment) at $10-$12 per share, have HBIO contribute $10 million, and have HBIO retain 8 million shares, which it would distribute to shareholders approximately 120 days following the offering.
However, on April 9th, the company announced that it was postponing the offering due to market conditions. On May 1st, it announced it would instead spin off HART and contribute $15 million to the company. It also said, that because of the documentation it had put together for the S-1, and ongoing dialogue it had with the SEC, the spin could occur fairly quickly.
In our view, a likely reason for the failure of the IPO was its structure. Specifically, new investors, interested in the regenerative medical device story, would own approximately 20% of the company, and could potentially see massive amounts of HART share dumping when the 8 million shares became unlocked via distribution to owners of the legacy company - a very unattractive scenario. For reasons we detail below, we believe that even using conservative assumptions, HART will likely be worth at least $1.50 per HBIO share.
Harvard Apparatus Regenerative Technology - the next big thing... perhaps
We are taking a conservative approach regarding the value of HART, although it could conceivably become a very large, very successful company. According to HART's S-1 :
We believe our technology could enable surgeons to cure nearly all primary trachea cancers. Our products address the critical challenges to trachea transplant: the shortage of suitable donor tracheas and the risk and expense of lifelong anti-rejection drug therapy. Because the scaffolds are synthetic, our technology will eliminate the need to wait for suitable donor tracheas. Our technology also obviates the need for anti-rejection drug therapy because the surgeon uses the patient's own bone marrow cells to seed the scaffold. In addition, patients with trachea cancer treated using our products have not required either chemotherapy or radiation therapy after the transplant, thus potentially eliminating the significant side effects and expense of such therapies. Because these substantial costs and risks can be reduced or even eliminated with our technology, we believe our products can both help save lives and reduce overall healthcare costs.
Essentially, HART has created a scaffold, which in concert with a patient's own cells, could build a new trachea that addresses trachea cancer and trachea trauma. This technology could be extended to treat additional afflictions, as well.
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Source: Harvard Bioscience Investor Presentation September 2012
Importantly, trachea cancer is fairly rare (approximately 2,400 cases per year) and particularly life-threatening (usually fatal - median survival is 10 months). As a result, the number of participants in a clinical trial is anticipated to be low, and the hurdle for regulatory approval should not be particularly high.
Based on the number of cases of trachea cancer, trauma, and agenesis (the condition of being born without a trachea), the addressable population for the trachea transplants using HART's products is 6,500 per year, exceeding $300 million in annual revenue.
Source: Harvard Bioscience Investor Presentation September 2012
In addition, the basic technology platform has applications for Esophageal cancer and heart and lung transplants, although the company's research in both of those segments trail that of the trachea.
Source: Harvard Bioscience Investor Presentation September 2012
The evidence, both actual and circumstantial, looks promising
We are always wary of micro-cap companies that make claims of developing transformative technologies. Typically, when something seems to be too good to be true, it is. To be clear, we are not medical experts, and, as always, suggest that you do your own due diligence. That being said, there is healthy evidence that HART may be the real thing. The company has now performed multiple trachea transplants, with amazing success. Of the transplants, two patients have died (we are sorry to report, that Hannah Warren passed away on July 6 , due to complications with her esophagus, and not due to issues with the new trachea).
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In each of the above cases, HART technology provided new tracheas for patients who otherwise had no hope. Importantly, HART's work has been well documented through multiple peer-reviewed articles published in the Lancet , one of the world's most highly respected medical journals. We don't know whether HART's technology will ultimately succeed, but we know it has had success to date, are working with highly regarded medical institutions (i.e. Mayo Clinic), and are producing peer reviewed articles.
We also know that David Green and Thomas McNaughton are leaving their long-time jobs as President and CFO, respectively, of HBIO to lead HART. Given their track record at HBIO of acting in their self-interest via generous salaries and option grants, we have a hard time believing that they would go to HART if they were not extremely hopeful of its success. Prior to the pulling of the HART IPO, the S-1 noted that post IPO, and prior to distribution of 8 million shares of HART to HBIO shareholders, that Mr. Green would be spending 95% of his time on HART, and Mr. McNaughton 50% of his, before moving full-time to HART. It is clear to us, where both Mr. Green and Mr. McNaughton's attention is focused. As has been the trend, there is no free lunch for an HBIO or HART investor, as Mr. Green and Mr. McNaughton will receive options to acquire 6% and 1.5% of HART, respectively.
Valuation of HART
While HART could generate hundreds of millions of dollars of annual sales over time, and potentially merit a valuation far in excess of HBIO, we are assuming what we believe is a fairly draconian valuation.
Specifically, when HBIO was going to IPO HART, they were going to issue 1.7 million shares at $10-$12 per share, and contribute $10 million. They would then distribute tax-free 8 million shares of HART to HBIO shareholders after 120 days. Based on the low-end of the range (and the over-allotment), the company would have a market cap of ~$100 million and an enterprise value of $90 million. Given the value of other regenerative technology companies such as Neuralstem ( CUR ) with a market cap of $112 million, and BioTime ( BTX ) with a market cap of $218 million, and each with similar levels of cash and nascent sales, we believe the low end of the valuation was realistic and did not get done owing to the additional 8 million shares that would have been distributed. However, taking a conservative 50% haircut to the enterprise value, we arrive at an EV of $45 million, or $1.50 per share of HBIO.
Conclusion
We expect HBIO's upcoming spin of HART to unlock significant value. We believe that on its own, HBIO likely trades up to approximately 15x EPS ex-HART, or $6, and using conservative assumptions, HART is worth at least $1.50 per shares of HBIO. We expect HBIO's Board to prepare HBIO for a sale. Ironically, the roll-up strategy that HBIO failed to implement for the benefit of shareholders, is exactly what makes sense for its larger contemporaries. And selling to a peer is precisely what will maximize value, and, by our estimates, result in a sale price of $8-10 per share.
In our view, HART represents something of a lottery ticket, albeit one with pretty exciting odds. With its clinical successes to date, peer-reviewed articles, and a historically self-serving management signing on to lead HART, we believe HART could ultimately prove to be worth more than HBIO. Of course, we are not relying on such an outcome to see meaningful upside to shares.
If we're wrong, we don't see much downside. HART will get spun, and HBIO will have significantly improved financials. We have little doubt that there are numerous acquirers who would happily buy HBIO at a premium to current prices.
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