ADMA Biologics: Almost Ready To Run Between The Toes Of Giants

9.1: Impact of LLE on revenue and gross margins at constant plasma and direct fractionation costs

Source: Grifols Presentation

This graph depicts the contribution margin of 5 proteins extracted from a single liter of plasma.

All fractionators use IgG as the revenue driver, but the more efficient processors are more able to cover their plasma and direct fractionation costs from every liter of IgG fractionated. The reality of LLE has pushed the larger processors to achieve greater scale and improve operational efficiencies. The nature of LLE is such that the ability of the fractionator to maximize efficiently gains and create the highest value end products, determines long-term economic success. Creating scale through excess capacity is not an option for the larger processors who have no incentive to use excess capacity if market conditions are not favorable. The economic relationships of LLE can't be altered by the size of the fractionation facility (the fact that facilities less than 100,000L capacity are uneconomical is related to inefficiency and not LLE).

LLE is such that if the ratio of market penetration to volume fractionated is held fixed (% of the market available/liter of plasma fractionated), total potential revenues are the same for a 100,000L facility or a 2,000,000L facility. The composition of plasma is such that only a given number of proteins can be extracted from every liter of plasma. The large processors, fractionate between 4 to 6 proteins, depending on end market conditions. Even if a processor increases the total number of end-products to the maximum number possible, revenues will be higher from the first liter fractionated, but the end-point (where only IVIG and albumin are fractionated) will still be reached and total revenue potential will still be dependent on the total market penetration of the processor and the scale efficiencies it can achieve. If a 4 product versus 6 product market scenario was depicted on a line graph, the shape of the declining revenue line curve would shift depending upon the point in time, when each of the end product markets becomes saturated, making further production uneconomical. As such, it is reasonable to assert that the industry has become less economically attractive for the smaller companies (that lack scale advantages), and even more unattractive for new entrants. The fact that the end market price of IVIG has increased significantly has not changed this dynamic. The increase in price has only changed the baseline of the revenue graph described above. As prices rose, the market has become increasingly difficult for the smaller players, as the larger processors have increased their scale and efficiency advantages.

9.2: A two-scenario revenue model projects a revenue range for the Boca facility of c.$200m-$500m per annum.

To create a firm valuation estimate for the Boca facility, a revenue model is projected using a low-end estimate of the potential revenues that could be generated from a standard 400,000L facility (Cohn/chromatography) processing four standard plasma products (IVIG as the revenue driver), with plasma cost incl. vs. cost not incl). This base estimate shows that a similar fractionation facility could generate c.$200m per annum. The model applies an all-in plasma cost of $150 per liter. It shows that operating profit can be increased by c.45%, when plasma is directly sourced. Management have estimated that a 'back-of-the-envelope'' projection based on current industry guided yields (for IVIG) of c.3.5-4.5 grams per liter (fractionated from a 400,000L facility) gives a potential revenue range of c.$150m to $500m (when the facility is operating at peak capacity). It is important to note, that these are base-level estimates, as that ADMA will be processing higher value hyper-immunes along with standard plasma proteins. This gives ADMA the potential to generate revenues well above these estimates. RI-002 should also be able to produce strong incremental margin growth in comparison to the incremental margin growth potential of traditional plasma products.

Source: Analyst Estimates

It would not have been economically viable for ADMA to process standard plasma products from the Boca facility with only three collection centers.

Typically, new hyper-immunes products are manufactured in pilot plants (inside the main fractionation facility) and processing typically commences with a throughput range between 1,000L to 5,000L. Another factor in ADMA's favor, is that RI-002's commercial potential won't be limited by a scarcity in plasma supply. Most hyper-immune operations are limited in size by the lack of plasma donors that contain the necessary rare antibodies. This is typically the case for hyper-immune's that have been manufactured for rare viruses such as Ebola, anthrax, rabies, West Nile virus or dengue virus. The patient populations that can benefit from RI-002 treatment, are also larger in size in comparison to these markets.

10. A net asset valuation model for the Boca facility shows that ADMA's shares are trading at a significant discount to fair value

To compensate ADMA for its business losses in relation to the shortcoming at the Boca facility, the BTBU transaction significantly undervalued the assets that were transferred to ADMA. As the land and buildings at the Boca facility are designed for a specialty use, and fair value is too indeterminate, the asset values are written down to a minimal fair value. The transaction placed a total value of less than $20m on the Boca facility itself. Inventory balances, equipment and intangible rights were also transacted at significant discounts to fair value.

Figure 10.1: Value of transferred assets in BTBU Transaction ($m).

Source: ADMA Biologics

Figure 10.2: A NAV model shows that ADMA acquired the facility at a significant discount to fair value.

Source: Analyst Estimates

The model breaks down the BTBU transaction by line item and compares the transaction values to the original purchase price that Biotest AG paid for the facility in 2007. Nine collection centers were included in that transaction and their value is subtracted from the calculation at the beginning of the model, using a low-end estimate of the average center values from Grifols' recent transaction with InterState Blood Products. A 2% depreciation rate (net of inflation) is applied. The applicable depreciation rate for the facility, based on a 20-year to 40-year life, was likely between 2.5% to 5% (on a straight-line basis). The value of the land and fixed assets will have appreciated over time, also but depreciated with use. The $50m in capital investment undertaken since 2007, will have offset some of the depreciation. Modeling this range of factors, yields a NAV of between $5.80 and $6.20, or a discount of c.40% to the current share price.

Figure 10.3: The construction of a new 400,000L fractionation facility on a green-field site w/ power, water and other infrastructure already available, would cost in the region of $200m












Source: Analyst Estimates

The cost of building a similar facility on a greenfield site, would be greater than $200m. In a transaction scenario, the Boca facility could realize a valuation considerably above these estimates. However, the value of the facility to ADMA's business is much greater than the potential sum of its NAV. ADMA has acquired the facility without needing to incur the high capital investment costs (usually required to build a new facility or expand capacity at an existing facility) and endure the long time periods, needed for construction and obtaining regulatory approval. Only $30.3m of the $63.6m total transaction value was allocated to land, buildings and equipment. Weighting this against the business benefits that ADMA receives through vertical integration, should allow ADMA to unlock substantial value from the transaction. Management has guided that the plant won't require additional capital investment and that Biotest's $50m investment following the 2007 purchase has sufficiently upgraded and automated the fractionation processes (ADMA management say $50m is lower-end estimate). It is possible that this significant NAV discount is due to concerns surrounding the facility's potential illiquidity in a future transaction scenario. This concern is not justified. Although there are only a handful of larger pharmaceuticals currently active in the plasma industry, there are several large private equity firms who have prior experience in the industry. Large fractionation facilities rarely come onto the market, and the opportunity to purchase a large facility, has only been afforded to large firms. Regardless, this thesis does not envision that ADMA will need to liquidate the Boca facility.

Figure 10.4: Recent transactions in the industry display a willingness by acquirers to pay 'full-price' for large facilities

Substantial transaction values have been realized for large fractionation facilities in recent years. CSL Ltd purchased the Rui De plasma business in China for $352m in June 2017 (from Humanwell Healthcare Group). The deal included a large fractionation facility, with a similar peak capacity to the Boca facility. Although the economics of the North American plasma industry are unattractive for new entrants (discussed in section 20 above), there are major growth opportunities in the global plasma industry, particularly in China. The Creat Group, a large Chinese private equity firm (affiliated with Shanghai RAAS, a china-based pharmaceutical conglomerate), recently received approved by CFIUS to purchase Biotest AG for $1.4bn (Biotest had $414.3m in debt). The plasma industry is growing rapidly in China, although fractionation facilities in the country are considered to below international industry standards. Creat Group might be seeking to take advantage of Biotest's recently developed plasma processing facilities in Dreieich, Germany. Creat purchased BioProducts Laboratories (originally created to supply UK national plasma requirements) in May 2016 for £820m (80% owned by Bain Capital and 20% by the UK Department of Health). From conversations with industry representatives it appears that Creat Group, under the stewardship of former BPL CEO John Perkins (formerly of Ampersand Ventures and Talecris) wants to position itself among the top three global plasma processors. It is possible that the firm spoke to Kedrion about a possible deal, before making an offer for Biotest AG. The CFIUS initially blocked the Creat proposal, on potential national security concerns relating to the holding of donor records and related information. A new proposal was accepted in January 2018, with a stipulation that Biotest's North American business is sold to a third party (ownership of these assets is currently held in a US trust). Acquiring Biotest's German technology assets is the most likely justification for the transaction. If the transaction closes, the proposed entity will not have regulatory approval to import plasma into China from the US or Europe, and won't be approved to import plasma from China into Europe. Overall, this activity shows a willingness by large private equity firms to enter an industry that is tightly controlled and largely scale determined. Of course, to compete successfully with the top three companies, the post-transaction entity would need to undertake very substantial capital investment to build the required operational capacity.

Biotest AG was struggling to make inroads against the dominant market positions of the two leading global processors. This dynamic likely played a role in Biotest's decision to recommend that shareholders tender their shares in favor of the Creat bid (and perhaps also in its decision to divest the Boca facility). Biotest had a North American plasma joint venture agreement in place with Kedrion (originally formed in 2014), with the aim of taking market share from the big three processors. These efforts initially delivered top-line sales growth for Biotest, but soon gave way to margin contraction. The BTBU was forced to book large expenses relating to higher unabsorbed manufacturing costs (resulting from the ramp up in staffing levels at the Boca facility) and in relation to unmet anticipated production levels for the distribution agreement (outlined in pg. 89 of Form 14A BTBU transaction proposal).

Biotest's total inventory and asset write-downs for 2016 amounted to €77.2m. The Form 14A transaction proposal, outlines that the BTBU booked inventory provisions totaling $27.6m for FY 2016, while $21.2m was included in the previous year. Some of these amounts were related to the lower of cost to market adjustments and lost validation batches (BTBU failed to pass an FDA inspection required for batch approval). This also demonstrates the disadvantaged strategic positioning of the smaller plasma processors in relation to the big three. Biotest AG probably had a relatively high-cost base, in addition to having a smaller industry market share. In the plasma fractionation business, the extent of the margin pressure experienced when expanding capacity, is determined by the efficiency of the processors cost base.

Figure 10.5: Biotest AG's shares initially rose to an all-time high as investors assessed the company's ability to expand its market share

Source: Financial Times

11. "Thou shalt not pass" - ADMA has a business moat that belies its small size

With a wholly owned specially designed fractionation facility, ADMA can now position itself as the sole supplier of a unique high-value hyper-immune product. This niche positioning will allow ADMA to sidestep the industry's extraordinarily high barriers to entry and high degree of market concentration. This was a major point of contention in the 2009 class action lawsuit filed at the Federal Trade Commission (against CSL, Baxter and the PPTA). The filing asserted that the structure of the industry carried a Hirschman/Herfindahl Index score of 2,579 (a score exceeding 1,800 is deemed highly concentrated). The filing also asserted that there was considerable inelasticity of demand in the industry and this was conducive to potential price fixing among the large processors. The lawsuit alleged that the defendants colluded in gathering and communicating market intelligence, which allowed the alleged conspirators to achieve an unfair level of market insight and in-turn fix prices and supply levels. During the hearings, representatives from CSL LTD, admitted that there were "immense barriers to entry" in the industry and there was no realistic prospect for an increase in the number of competing firms. It is reasonable to assert that the market has become even more concentrated since the 2009 trial.

Figure 11.1: The barriers to entry in the plasma industry are four-fold

1. Substantial upfront sunk costs

Each step of the manufacturing process involves substantial up-front, sunk costs; onerous and lengthy regulatory approvals by federal and state agencies; and specialized technical know-how and expertise.

2. Substantial IP portfolio

Market entry requires a significant amount of intellectual property, including trade secrets relating to purification of products and pathogen safety, and substantial product research and development.

3. Extensive capital investment and long lead times

The construction and maintenance of production facilities, including regular improvements necessitated by evolving standards of manufacturing practices, require extensive capital investment and long lead times to obtain the necessary governmental approval. It can take upwards of five years to design, construct and obtain regulatory approval for a green-field plasma fractionation facility. Regulatory hurdles impose significant barriers to entry and extend the time it would take to enter the United States markets, let alone make a significant impact on the market.

4. Necessity of building out large collection center networks

The number of independent plasma suppliers has dwindled significantly, and most independent collection and development capacity is already contracted to existing manufacturers. As such new competitors will need to develop their own domestic-based plasma collection centers and related infrastructure. Only plasma that is collected in the United States is certified for use in products sold domestically.

This combination of competitive factors has made the plasma market very unattractive for new market entrants. In combination with the economics inherent in LLE, a unique competitive dynamic is created in which the only approach to achieving sustainable revenue growth is by increasing production scale and efficiency.

Figure 11.2: Grifols is guiding for a six-year construction and approval process for its new facility at Clayton, North Carolina.

Source: Grifols SA

Achieving economies of scale in plasma collection and fractionation is the main strategic activity for industry participants. The large processors all maintain just one or two very large processing and fractionation campuses in North America. CSL and Grifols in particular, have built up very large processing capabilities in North America which has given them near insurmountable barriers to competition.

Alongside the lengthy construction and approval time frames mentioned above, there is the added complexity involved in either developing in-house engineering expertise or in finding third party contractors (very few engineering companies have expertise in large specialized projects in the pharmaceutical space). Grifols SA maintains its own in-house engineering division for large projects. In February 2016, its Board of Directors approved a new $360m capital investment plan specifically focused on its plasma manufacturing operations, covering the period 2016-2023.

It plans to develop 5.9m liters of additional fractionation capacity at its main fractionation center in Clayton, North Carolina (expected capital outlay of $90m). Grifols is guiding for a six-year construction and approval process at the facility. CSL LTD doesn't disclose specific details on its capital investment projects, but the company has invested $2.6bn in projects over the last five years, and has guided for a future capital investment rate of between 10% and 11% of sales.

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No aspect of this research piece is intended to be relied on as investment advice. The content is intended to be used and must be used for informational purposes only. It is very important to do your ...

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