Catalent: How Concerned Should One Be?

Last year, I concluded that I did not see a catalyst yet for shares of Catalent (NYSE:CTLT). I noted that the company had a decent value creating track record and that the company maintained operational momentum despite the pandemic being on its retreat. While the lagging share price has improved appeal, I specifically noted that this should not be confused with a situation in which appeal was to be found.

A Look Back

Catalent is a partner for pharmaceutical and biotechnology companies, helping its customers to bring products to the market in a faster fashion. The company does this by providing oral, injectable and respiratory technologies, among others. Catalent provides these technologies at scale to the industry, being more effective and efficient than in-house solutions by these large manufacturers.

Shares traded at $20 per share in 2014 when the company went public, and I was cautious amidst modest growth and an elevated debt load. At the time the company was valued at $4.3 billion, a valuation applied to a business which posted $1.8 billion in sales, $204 million in operating earnings, although interest costs ate all these operating profits at the time.

In a rather steady fashion, shares had risen to the $60 mark pre-pandemic, with growth in part aided by a near billion deal for Cook Pharmica in 2017 and a $1 billion deal for Paragon Bioservices in 2019. Sales rose to $3.1 billion in 2020 on the back of these deals, with adjusted earnings of $2.11 share looking quite fair and clean.

During 2021 it was evident that momentum was very strong as sales rose to $4.0 billion with adjusted earnings coming in at just over $3 per share, causing shares to rally from $60 pre-pandemic to a high of $140 in 2021. With a valuation in excess of 40 times earnings, I was naturally very cautious, even as the company saw continued momentum. This was evident in the 2022 outlook, with sales seen up to $4.4 billion and earnings seen around $3.40 per share, as this momentum gave management confidence to pursue a $1 billion deal to acquire Bettera Holdings.

Over the summer of 2022 shares have fallen to $108 per share, even as momentum was quite strong. Alongside the release of quarterly results during 2022, the company hiked the guidance, with sales seen at $4.85 billion by the third quarter and earnings seen as high as $3.75 per share. Net debt of $3.6 billion and improved earnings resulted in leverage falling to 2.6 times. Moreover, the company guided for high single digit increase in sales in 2023, in part it announced another $475 million deal for CDMO firm Metrics Contact Services last summer.

With shares down a lot to $108 over the summer and earnings power having improved a great deal as a more than 40 times earnings multiple has fallen to 29 times earnings, which has improved appeal, not to be confused by the fact that appeal was seen, I found the multiple too high to get involved.

Implosion

While calling the valuation rich in the summer, little could I have imagined that shares would be down 70% in the time frame of less than a year, with shares now trading at just $33 per share.

In the end, the company posted its 2022 results in August of last year, a year in which sales rose 23% to $4.83 billion. Net debt of $3.7 billion translates to a 2.9 times leverage ratio based on $1.3 billion in adjusted EBITDA. On the back of organic growth and dealmaking, the company guided for 2023 sales to advance further to a midpoint of $5.10 billion, EBITDA now seen at $1.35 billion and adjusted earnings at a midpoint of $695 million, for earnings equal to about $3.80 per share.

Shares plunged to $50 in November when the company posted disappointing first quarter results, with reported sales flat at $1.02 billion, as growth was held back by a strong dollar. The lack of growth was very disappointing as the company cut the sales guidance to $4.75 billion, with EBITDA now seen down to $1.26 billion. These headwinds translate one-on-one on the bottom line, with the midpoint of adjusted earnings guidance now seen at $607 million. Pro forma for the Metrics deal, net debt jumped to $4.4 billion and amidst pressure on EBITDA, leverage ratios jumped to 3.6 times.

Shares rallied to the $70 mark in February as the company posted a 6% fall in sales to $1.15 billion, as the company reiterated the full year guidance while net debt was flat at $4.4 billion, amidst flattish leverage trends. Shares were furthermore lifted as takeover speculation emerged with Danaher (DHR) reportedly interested to acquire the business, after the valuation has been reset a bit.

In May, the company warned that it had to delay the quarterly earnings report, originally scheduled on the 9th of May. This came after the company already outlined a warning in April, indicating that it expects productivity issues to hurt the bottom-line results, set to materially affect the third quarter results. The company quantified the impact of all of this at $400 million, both in terms of sales and EBITDA, which is a massive profit warning of course.

This suggests that EBITDA might fall to roughly $850 million, pushing up leverage ratios to more than 5 times based on the net debt load as of the end of the second quarter. Worse, on the 12th of May the company postponed the anticipated release of the quarterly results from the 15th of May to the 19th of May, indicating that the situation is quite messy internally. Besides reporting, this furthermore goes out to see that productivity issues are not limited to a single plant, but three plants.

Concluding Remark

The latest set-back makes that earnings for this year will largely be evaporated following the latest setback as leverage ratios increase rapidly to dangerous levels. On the other hand, the market value has shrunken to about $6 billion, for an enterprise valuation in excess of $10 billion, down two-thirds from the peak last year.

Following this move, I am getting appealed on the hope/expectation that the business in an ordinary course of operations should be able to earn >$3 per share, which should reveal massive upside. The issue is that current earnings are not seen at this rate due to massive internal and operational issues, as well as a Covid-19 retreat. While a year´s worth of lost earnings power is not a big concern, it is concerning that the business has taken on quite a lot of debt for a series of deals being pursued, which have jacked up leverage ratios to dangerously high levels.

Hence, the question is how deep the issues really are and if clients are leaving as a result of the internal turmoil, but if the situation can be stabilized, debt concerns alleviate, and no shares have to be issued to shore up the balance sheet, all options are on the table with the prospects for (future) investors looking good.

For me, the story remains more or less uninvestable at this point in time, as I am waiting for the release of the third quarter results, and associated commentary, before reconsidering a stance.

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