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The Value Investment Case for Enzo Biochem

December 3, 2018 in Best Ideas 2019, Best Ideas Conference, Equities, Ideas

The following article is authored by MOI Global instructor Jim Roumell, Portfolio Manager of Roumell Asset Management, based in Chevy Chase, Maryland.

Enzo Biochem was founded by Dr. Elazar Rabbani in 1976. Dr. Rabbani, a pioneer in labeling and detection of molecular diagnostics products, is the company’s CEO and Chairman. He is joined by co-founder and President, Barry Weiner. ENZ came to our attention one year ago when the stock was trading at about $12/share. We patiently kept updating our research on the company and when the stock hit the $4 level in the 3rd quarter, we ramped up our efforts.

ENZ owns one of the largest independent non-hospital-based clinical labs on the East Coast of the United States, in an industry dominated by non-hospital-based giants Lab Corp (LH) and Quest Diagnostics (DGX). ENZ’s footprint lies in the attractive tri-state New York area. The company recently expanded into the Mid-Atlantic and New England regions. ENZ operates a full-service clinical laboratory based in Farmingdale, NY, a network of over 30 patient service centers in NY, NJ and CT and a rapid response laboratory in New York City. ENZ has one of the largest clinical lab footprints (inclusive of LH and DGX) in the tri-state New York area.

Overall, Labcorp and Quest’s 7,500 labs represent about 20% of the clinical lab market. There are an estimated additional 7,500 other independent labs representing another 20% of the market. Hospital labs represent about 60% of total market volume.

In addition to its core lab business, ENZ is a diagnostic bioscience company that develops and sells its proprietary technology solutions and platforms to other clinical laboratories, researchers and physicians. These solutions are primarily in molecular diagnostics, which allow clients to analyze biological markers. Additionally, ENZ operates a therapeutics business that has had two drugs successfully complete Phase 2 studies. Lastly, given its 300-plus patent portfolio, ENZ is actively defending its intellectual property assets. In the past several years, the company has won over $100 million in settlements. ENZ has several active suits in progress with the prospect of capturing additional settlement or judgement wins.

ENZ is a classic RAM investment: a cash-rich unlevered company with five shots on goal, i.e., multiple ways to win. To wit, the company’s current market capitalization is roughly $155 million and its balance sheet boasts $60 million in cash. ENZ operates at roughly operating cash flow breakeven.

Clinical Lab Business

As noted above, the clinical lab business is dominated by Lab Corp and Quest. It should be thought of as being, more or less, an outsourced servicing business. Differentiation lies in servicing capabilities, not in the quality of specimen analysis. The dominant players are active consolidators in the space and regularly pay 2x to 3x revenue to acquire smaller labs, e.g., Lab Corp bought Sequenom for 2.9x revenue in 2016 (the latest available transaction with a publicly-disclosed acquisition price). Moreover, ENZ’s geographic footprint lies in a highly dense and desirable area. Thus, it’s take-out value would likely be at a premium to comparables in less dense locations. Here are links showing LH and DBX’s appetite for acquisitions: one, two.

The company’s net cash plus 2.5x lab clinic revenue equates to roughly $210 million versus today’s market cap of about $155 million based on a $3.30/share stock price. In other words, at the least, investors get everything else for free, and more likely are even getting ENZ’s clinical lab business at a meaningful discount to its private market value. The company’s current enterprise value of roughly $95 million equates to only 1.6x a conservative 2019 lab revenue estimate of $60 million. Here’s what’s free: Diagnostic Products, Therapeutics, IP Litigation and the optionality on investing in a Disruptive (vertically-integrated) Diagnostic/Clinical Solutions platform.

Diagnostic Products

ENZ generates roughly $30 million annually from the sale of its proprietary testing kits. As stated in the company’s most recent 10Q, “In the course of our research and development activities, we have built a substantial portfolio of intellectual property assets, comprised of 336 issued patents worldwide, and over 151 pending patent applications, along with extensive enabling technologies and platforms.” Recent product revenue declines (now stabilized and expected to grow) were primarily driven by the company’s decision to reduce the number of products it sells. Neither LH or DGX make any mention of possessing patents in their SEC filings.

However, we believe the real value of ENZ’s product diagnostics capabilities lies in its ability to monetize a vertically-integrated platform that can deliver significantly more cost-effective lab testing services in an environment where reimbursement payments are continually under pressure. AmpiProbe is the brand name of the company’s newer molecular diagnostics platform. It’s estimated that about 2% of healthcare spend goes toward diagnostics. In July 2018 the company announced the validation of three high quality, low cost biomarkers for detecting cancers and their progression, especially in women’s health. In the announcement, ENZ stated, “The global cancer biomarkers market is projected to reach more than $20 billion by 2022, up from $11.5 billion in 2017.” The company went on to say, “These cost effective, high quality primary antibodies function with our full open system workflow and complement Enzo’s strategy of introducing lower cost testing solutions for the clinical laboratory market.” In October 2017, New York state Department of Health approved ENZ’s new women’s health infectious disease panel, which can test for up to 13 different infections from one single swab sample.

Nonetheless, on a standalone basis, product businesses like ENZ’s (based on real internally built IP) would typically fetch somewhere over 2x revenue. For example, Fluidigm Inc. (FLDM), Harvard Bioscience (HBIO), and Nanostring Tech (NSTG) are all currently valued between 2x and 4x EV/Revenue. All three companies have high SG&A and R&D costs and, as a result, have poor operating margins and cash flow.

Therapeutics

ENZ Therapeutics focuses on the creation and development of commercial drugs. It currently has eight drugs in its pipeline that are in various stages of development from Discovery to Phase II. These products are intended to treat gastrointestinal, infectious, ophthalmic, and other diseases. This unit does not currently generate revenue. We believe ENZ will look to monetize this unit in the near-future. Management has indicated that it has no intention to pour money into financing Phase III studies. Our research indicates the value of this business unit is roughly $30 to $40 million.

IP Litigation

During fiscal years 2011 to 2016, ENZ netted (after legal costs) $67 million from legal settlements and licensing revenue. In May 2016, the company announced that it had settled with Thermo Fisher Scientific on two patent infringement lawsuits for $35 million. In January of 2016, the company announced a $9 million settlement with Agilent. A $21 million settlement with Illumnia, a $10 million settlement with Affymetrix and a $9.5 million settlement with Siemans were awarded in 2015. Consider the fact that ENZ has already collected its current EV in gross litigation settlements/royalty payments. The current round of litigation (unlike the first rounds), occur with some tailwinds, i.e. settlements underscoring the fact that the company’s IP has real value. Certainly, the IP litigation results, effectively a measurement of some fraction of the company’s IP, make clear that the company’s IP is worth more than the settlements.

ENZ continues to pursue an active campaign to defend its legitimate IP asset base with cases now pending against Hologic, Becton Dickenson, Abbott and Roche. Moreover, this potential value-creating option is more than a pie-in-the-sky pipe dream given its track record and the nature of the outstanding lawsuits. ENZ has six patent infringement cases outstanding on contingency basis in Delaware overseen by John Desmarais, the same attorney who won prior cases for the company. Mr. Desmarais is a highly successful plaintiff attorney who can carefully pick and choose the cases he wants to pursue.

Mr. Desmarais was formerly an Assistant U.S. Attorney for the Southern District of New York. He was ranked in Best Lawyers in America 2017 and as New York Patent Lawyer of the Year. Mr. Desmarais’s $1.5 billion win for Alcatel-Lucent against Microsoft resulted in one of the largest plaintiff’s jury verdicts in a patent infringement action. We believe his on-going involvement with ENZ, spread amongst six cases, creates favorable odds that meaningful settlements are on the horizon for the company.

However, ENZ’s “big” litigation cases involve Roche Diagnostics and Hologic. ENZ recently had a major victory when the judge denied Roche’s move to dismiss the case and set a trial date of April 1, 2019. Pre-trial motions are set for this month. What makes this case particularly noteworthy is that it involves both patent and contract breaches. Unlike its six Delaware cases, ENZ is financing the Roche litigation and consequently will be entitled to 100% of any settlement proceeds. The potential litigation settlement awards could well be in the hundreds of millions of dollars. However, such figures are highly speculative and thus we place a present value of a modest $50 million in total net IP litigation awards.

Disruptive, Vertically Integrated, Diagnostics/Clinical Services Platform

The real long-term optionality for ENZ’s lies in its vertically-integrated platform of cutting-edge diagnostic kits with an open-architecture for analyzing specimens that delivers a significantly more cost-effective solution to the marketplace. In fact, ENZ believes that its emerging platform provides 30% – 50% savings to the current molecular diagnostics industry. ENZ offers solutions across the entire diagnostic workflow: patient sample, sample collection, sample processing, analytical detection to clinical results. The company believes that it can leverage its own platform to provide outsourced diagnostic processing for those labs in the country that are less cost-efficient. ENZ is unique in combining diagnostic product development capabilities with a service platform. We agree with the company that this structure will enable them to be a low-cost provider.

There is nascent, but growing, evidence that ENZ is well-positioned to be a potential disrupter. It is signing up big insurers and recently announced being named an In-Network Provider to the fourth largest national insurer in the country. Further, the company is beginning to win clients from customers as far away as AZ and CA who are saving money even after shipping specimens overnight to ENZ’s primary lab in Farmingdale, NY. The company believes that even after further reimbursement erosion it will maintain healthy gross margins, estimated widely to be 35% – 55% versus the industry average of 30%. To wit, per the company, “Enzo’s integrated structure overcomes cost of goods layering thereby producing affordable products and services needed to combat increasing reimbursement pressures.” For instance, Mr. Weiner walked us through an example wherein their Hep-C diagnostic test/service can be done at a significantly lower cost than Roche.

We believe ENZ’s team is energized and excited about its future. We recently sat down with management and believe they possess a clear vision and are on the cusp of leveraging ENZ’s significant IP assets while also being committed to controlling costs along the way. SG&A expenses have dropped from 47% of sales in 2013 to 41% in 2017. Messrs. Rabbani and Weiner have been together for nearly 40 years and own roughly 7% of the company. To be clear, ENZ as a potential industry disrupter is a very interesting option, but by no means guaranteed. What we find so attractive in our investment is that we don’t believe we’re paying a dime for that option or the other ones described above. One way or another, we believe ENZ’s moment is about to arrive.

Sum of the Parts (SOTP)

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Disclosure: The specific security identified and described does not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that investments in the security identified and discussed was or will be profitable.

Evidence of Rare Events: False Positives in a Sea of Noise

December 3, 2018 in Best Ideas 2019, Best Ideas Conference, Equities, Skills

This article is authored by MOI Global instructor Sean Stannard-Stockton, President and Chief Investment Officer of Ensemble Capital, based in Burlingame, CA. For additional articles by Sean and his colleagues, visit Intrinsic Investing.

Investors are suddenly grappling with the possibility that the economic expansion is nearing its end and a recession could be just around the corner. We discussed the context for these worries in mid-October, but today let’s discuss why even strong evidence of a relatively rare event such as a recession does not actually suggest a recession is likely. This does not mean a recession will not happen, only that investors need to be cautious about predicting relatively rare events even when the evidence is strong that they might occur.

In Nate Silver’s wonderful book The Signal & The Noise: Why So Many Predictions Fail — But Some Don’t, he explains the difficulties of forecasting and introduces the reader to the Bayes Theorem. Bayes Theorem offers a formula for calculating the probability of an event, based on knowledge of conditions that might be related to the event.

For instance, declining homes sales is an event that has already happened with the number of homes sold so far in 2018 coming in below the same time period in 2017. This may be evidence that a recession is coming. Existing home sales declined in the late 70’s , the late 80’s and the mid 2000’s all in the lead up to a recession. However, in both 1995 and 2014, home sales also declined, and not only was there not a recession, but the years following 1995 saw robust economic activity. Further, home sales did not decline in 2000, yet there was a recession in 2001.

So what does this tell us about the probability that a recession is coming soon now that we know that home sales are declining? There have been four recessions in the last 40 years and three of them have been preceded by a decline in home sales. There have been five instances of home sales declining and three of them were followed by a recession. So it does seem that declines in home sales offer meaningful evidence that a recession may occur. But how much weight should we put on this evidence? That’s where Bayes Theorem comes in.

You might look at the data on home sales and decide that since 75% of recessions have been preceded by a decline in home sales, this means that there is a 75% chance of a recession occurring soon. But while this line of thought is intuitively appealing, it is completely wrong. It ignores the fact that recessions are relatively rare as well as the fact that sometimes home sales decline and no recession occurs (a false positive).

There have been four recessions in 40 years (10% odds of happening). Since recessions can last for more than one year, you might also say that the US economy has been in recession for about eight of the last 40 years (20% of the time). So let’s split the difference and assume that in any given year there is a 15% chance of a recession. (Note: these are estimated odds for illustrative purposes only). And don’t forget that there have been five instances of home prices declining and yet only three were followed by a recession.

So this is where the math gets interesting.

  • Recessions occur 15% of the time.
  • When a recession occurs, 75% of the time it is precede by a decline in home sales.
  • 40% of the time that home sales decline, a recession does not follow.

Now we can calculate the probability of recession given we know home sales have declined. It must be higher than 15% since that’s the odds of a recession happening any time. But how high? Remember 75% of recessions are preceded by a decline in home sales, but 40% of the time that sales decline no recession occurs.

Using the assumed probabilities above (remember, they’re being used for illustrative purposes, we’re not arguing that this simple math can predict recessions) Bayes Theorem, calculates a 15% probability of recession in any given year and a 25% probability of recession in the event that you observe homes sales have declined.

You can do the math yourself using the calculator below. If you don’t like the assumptions I used (15%, 75%, 40%) plug in your own. You can learn more about how to use the calculator here.

Only 25%? That’s higher than the 15% odds if you have no evidence either way. But why don’t the odds increase more? It has to do with the relatively low probability of recession at any given time as well as the meaningful frequency with which home sales decline and yet no recession occurs.

Here’s how Silver puts it:

“When we fail to think like Bayesians, false positives are a problem… As there is an exponential increase in the amount of available information, there is likewise an exponential increase in the number of hypotheses to investigate. For instance, the U.S. government now publishes data on about 45,000 economic statistics. If you want to test for relationships between all combinations of two pairs of these statistics—is there a causal relationship between the bank prime loan rate and the unemployment rate in Alabama?—that gives you literally one billion hypotheses to test. But the number of meaningful relationships in the data—those that speak to causality rather than correlation and testify to how the world really works—is orders of magnitude smaller. Nor is it likely to be increasing at nearly so fast a rate as the information itself; there isn’t any more truth in the world than there was before the Internet or the printing press. Most of the data is just noise, as most of the universe is filled with empty space. Meanwhile, as we know from Bayes’s theorem, when the underlying incidence of something in a population is low (truth in the sea of data), false positives can dominate the results if we are not careful.”

Bayesian probability analysis is not intuitive. And you weren’t likely to have been taught it in school where classical or “frequentist” statistics are taught (remember all those lessons about rolling dice and flipping coins?). But investing is dominated by Bayesian probability problems.

  • What are the odds that Netflix subscriber growth slows given that Apple has announced a new streaming service?
  • What are the odds that homes prices decline given interest rates have recently increased sharply?
  • What are the odds that electric vehicles will see mainstream adoption given that Tesla has shown the ability to take very high levels of market share within the US luxury car market?

These are tough questions. But the key insight from Bayesian logic is as Silver puts it “When the underlying incidence of something in a population is low (truth in the sea of data), false positives can dominate the results.” It’s human nature to weigh recent experiences with a higher probability than its actual chance of occurring in reality and it’s also human nature to connect events that memories recall being related. This can result in intuitive probability assessments by investors that dramatically depart from what a more robust mathematical analysis would forecast. For this reason a tool like Bayes theorem can help us better calibrate our intuition based forecasts so that we have a better ability to judge the true odds of important events and the decisions we’d make to deal with them.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Jean Philippe sobre Calloway’s Nursery

December 3, 2018 in Ideas de inversión, MOI Global en Español

NOTA DEL EDITOR: La siguiente idea de inversión, escrita por Jean Philippe Tissot, miembro de MOI Global, es extraída de una carta anual de Tissot Ayram Family Partnership.

* * *

El año pasado pasé tres semanas en Dallas. Allí aprendí sobre una Micro-Cap llamada Calloway’s Nursery [CLWY]. CLWY se encuentra en Dallas, por lo que podría participar en algún «método de cotilla»1.
CLWY es una cadena de 20 tiendas de alto margen relacionadas con plantas y jardines en Dallas Fort-Worth y Houston. La empresa posee 11 propiedades de las 20 tiendas. En diciembre de 2014, vendió una tienda en Houston con una ganancia financiera de US$10 millones: esta cifra proviene del estudio de los estados de CLWY, ya que no hay una declaración de divulgación sobre esta transacción. No necesito ser un genio para saber que el valor de los bienes inmuebles es más alto que la capitalización bursátil actual de toda la empresa, que en el momento de escribir esto, está alrededor de los US$57 millones.
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Traits of an Ideal Investor in Metis India Opportunity Fund

December 1, 2018 in Best Ideas 2019, Equities, Ideas

This article is authored by MOI Global instructor Gaurav Aggarwal, Portfolio Manager of Metis Capital Management, based in Mauritius.

Even after managing external money in India for over seven years, it remains a mystery to us why investors are enamored with flimsy stories (largely irrespective of their level of truth based on any reasonable analysis of past vs. future). Treating all EMs as a group tourist activity seems to have been institutionalized.

For example, not making a strategic investment in the fast-growing $2 trillion listed Indian equities universe (via our fund or otherwise) is likely not the most optimal course of action if year 2030 was compressed to today. For us the goal and timeline are clear: capture for our partners (goal is to deliver minimum 17% net USD annualized) the fair share of the wealth creation that will occur during next 12 years as India nears $10 trillion economy (12% annualized nominal growth).

The best offense oftentimes is a good defense and for Metis that practically means to make sure we are continuously internally stronger/wiser (this write-up was notable this quarter for us to think more rationally about money) to withstand any external pressures in this joint long-term endeavor to sustainably build wealth over the next decade+.

We want to make sure that our partners are not expecting something that is not your managers main aim (i.e. the critical difference between yearly outperformance vs. outperformance over 5+ years—i.e. willing to take lumpy 17% over next 12 years vs. those more comfortable with 12-14% with lower annual return range). Thus, we have posted on our website the following requisite traits of investors in our fund, including your managers who are second largest investors on a combined basis:

Traits of an ideal investor to optimize his/her long-term (minimum 5+ years) investment return in Metis India Opportunity Fund (MIOF):

1. Have a true long-term outlook and clear vision (MCM goal is to deliver 17% annualized USD return till 2030 when Indian economy will near $10t at an annualized return of 12%). Practically this means the desire and ability to hold on through largely unavoidable, temporary rough patches.

2. Long-term conviction on India. To gain this conviction in sufficient dose would probably require hours of discussion with your managers (which we welcome) and hefty comparative country analysis but as a heuristic, especially at frequent times of panic about Indian story, internally as self-motivation your managers ask: Why not India? Why won’t a diverse, fastest growing/youngest population with affinity for technology, aspirational, and democratic country with a low base across industries grow to a middle-income or even developed country in our lifetime? Without having sustained long-term belief (as opposed to near term worries/gripes about multitude of issues, economic or usually non-economic in our experience) the ability to execute #1 optimally is lowered.

3. Being situational focused and not painting with a broad brush. One can have long-term belief in India yet not find enough value in the overall market. Thus, finding value in partnering with managers such as ourselves who are 100% focused on analyzing individual businesses and their competitive dynamics, leadership, and valuation. Thus, understanding at a gut level that Indian markets, like most others, given its size and low base, there are no paucity of great businesses, run by shareholder friendly management-owners, and selling at least at reasonable value (we like to buy much cheaper).

4. Appreciate the process more than outcome for simple reason that we have numerous innings left and thus what is most important is the likelihood of future outperformance. We like to keep improving on our art of understanding and valuing businesses from a ground up approach to ensure 2030 goal is achieved.

5. Desire to give back in their own way and not fundamentally driven by accumulation of money for its own sake. This is more personal but we feel it’s important to mention in order to keep the right perspective as time & markets march on.

Below quotes from Warren Buffett were spoken in reference to general bull market environment (i) and to the US financial crisis in 2008 (ii.) but we feel it can be inverted to explain and give guidance for general conditions in current Indian markets (i.e. replace United States with India in the 2nd quote).

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