Avid Bioservices (NASDAQ: CDMO) Remains Materially Undervalued: Laughing Water Capital

Laughing Water Capital, led by Matthew Sweeney, is bullish on Avid Bioservices Inc (NASDAQ: CDMO). The hedge fund recently published its Q2 investor letter (you can download a copy here) in which it discussed its investment thesis on Avid Bioservices and other companies. In this article, we’re going to focus on the fund’s comment about Avid Bioservices, a contract development and manufacturing organization focused on development and current good manufacturing practices (cGMP) manufacturing of biopharmaceutical products derived from mammalian cell culture.

Here is what Sweeney – the founder and managing partner of Laughing Water Capital – said about CDMO in the letter.

CDMO entered our portfolio as a small position, but has graduated to a midsized position due to its ~50% return. In my view shares remain materially undervalued vs. their potential looking out a few years. The crux of the investment is “good co / bad co,” whereby the cash flow profile of one business (drug development) had been obscuring the quality of the other business (contract manufacturing). Often in good co / bad co setups the damage from the bad co is limited to the reported financials of the combined company, but in the case of CDMO, I believe that the existence of the drug development company extended beyond the financials and negatively impacted the ability of the contract manufacturing business to generate revenue. We purchased shares shortly after the bad co was sold off.

The remaining contract manufacturing business is involved with the production of biologic drugs, which are extraordinarily complex (example: a molecule of Aspirin has 21 atoms, while a biologic drug may have 25,000 atoms). This complexity combines with regulatory oversight to create a business with high barriers to entry and high switching costs; it would be costly and time consuming for any customer of the contract manufacturing business to move to another manufacturer. Historically, given that CDMO was also working on developing their own drugs, any potential customer was thus wary that if CDMO were successful in developing a new drug, they may need to reclaim their manufacturing capacity for their own use.

An appropriate analogy might be buying a house. Imagine you spent several months searching for a new home that you intend to spend a lot of money on, and then live in for the next 20 years. You are down to the final two choices, both of which meet all your needs, but one of which comes with an eminent domain clause whereby you can be kicked out of the house with little or no compensation at any time. Which house would you choose?

Now that the development business is out of the picture, this eminent domain overhang has been removed, and it should be much easier for the manufacturing business to land new customers. This is important as the business is currently only operating at ~50% capacity. This unused capacity thus represents significant operating leverage, which will drive cash flow as the company reaches scale. New customer wins have been announced recently, suggesting that in the short period we have owned shares, the company has been moving in the right direction, and I expect more wins in the quarters and years to come. If the business ultimately gets to scale, the cash flow generated by its recession resistant, recurring revenues will deserve a high multiple, and it is not hard to imagine scenarios where CDMO doubles or triples a few years down the road. CDMO was presented at the Value X Vail conference by Adam Patinkin of David Capital Partners. I have known Adam for several years, and was happy to see that a talented like minded investor such as Adam independently generated a thesis on CDMO that is inline with our own.

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Having a market cap of $314.61 million, Avid Bioservices Inc (NASDAQ: CDMO) is engaged in providing a range of process development, high-quality cGMP clinical and commercial manufacturing services for the biotechnology and biopharmaceutical industries. The company’s services include cGMP clinical and commercial product manufacturing, purification, bulk packaging, stability testing and regulatory strategy, submission and support. It also provides a variety of process development activities, including cell line development and optimization, cell culture and feed optimization, analytical methods development and product characterization.

Shares of Avid Bioservices are up 39.76% since the start of the year. Over the past three months, the stock has surged 58.29% while it has gained 68.53% over the past 12-month period. The consensus average target price of the stock is $7.17 while the consensus average recommendation is ‘BUY’, according to analysts polled by FactSet. On Monday, the stock was closed at $5.73.