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.
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.
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.
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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