The long delayed Marketing Authorisations have now been approved, with the announcement of full approval being granted on 18th February. The initial delay was announced on 3rd December, so the time delay has cost Palla Pharma around two and a half months, during which time the company announced (1st February) that they are chewing through $1-2 million in cash per month. Ouch…

The H1-20 accounts showed PAL had $1.6 million in the bank and a standby debt facility with Washington  H Saul Pattinson of $16 million of which $12.3 million had already been drawn. This gave them liquidity of $5.3 million at 1st July 2020. On 23 September they announced the sale of their legacy manufacturing property in Tasmania for ~$3 million. On 6th November they announced that the standby debt facility with Saul Patt’s was being temporarily increased by $4 million to $20 million (although this temporary relief is due to expire at the end of April 2021). They are not cash flow positive so $12.3 million ($5.3 + $3 + $4) is the extent of their liquidity.

Assuming the announcement on 1st February held true for most of last year and the cash outflow was on average around $1.5 million per month, then they would have approximately 8 months of headroom before running out of cash. This would give them until around about…now!

The full year results for the year gone are being announced on Friday this coming week; I have little doubt they will show a very distressed balance sheet. The foundations are there for a very profitable business, but one with an immediate cash crunch. There is also a stated desire to invest approximately $4 million to increase production (previous announcements call out this has the potential to increase monthly revenue to about $12 million) now that the higher GM MA’s are bankable.

Would love to be a fly on the wall in the meetings ahead of the results announcements.

Summary

Opiate Manufacturer - 1 of only 6 narcotic raw material (NRM) suppliers globally.  They claim they are the lowest cost producer of NRM globally. Describes itself as 1 of only 3 fully integrated suppliers. Through vertical integration they aim to produce cheap NRM and convert it to manufactured product (tablets, etc.) to capture high GM (as opposed to just selling NRM to manufacturers). 

Focus is on UK market but had some sales into Asia and Africa in FY19 (note their financial year is January to December) and aiming for first sale into South America in Q420. Aiming to sell into France and Spain in FY21.

Positives

• ~39% of shares are held by long-term holders Washington H Soul Pattinson & Thorney Opportunities and Directors/management hold another ~4%.
• Through the purchase of Marketing Authorisations (MA’s) PAL can capture greater GM by selling manufactured product straight to distributors. 7 MA’s have been purchased with 2 waiting on regulator approval to sell into the UK.  
• Have exited a low margin agreement to deliver Active Pharmaceutical Ingredient (API) to a Contract Manufacturing Organisation (CMO); this has opened capacity to focus on the higher margin direct to market approach via MA’s.

Negatives

• To grow and maintain their low cost NRM position they will need to continue to invest in upstream growing activities or secure access to straw. I assume poppy farming for opiates is fairly regulated globally.
• Capex of ~$4 million is needed to expand facilities in order to ramp up revenue growth under MA’s. Net debt is relatively high at about $11 million (detailed in half-yearly). They seem to have lots of working capital under a facility with W H Soul Pattinson but only limited cash at time of half-yearly.

Risks

• Have diversified their growing capability but crop output can cause issues. The H1FY20 presentation discusses poor seed sales (due to weather) impacted Australian growing volumes and FY20 margins.
• They may need to raise capital to fund the facility expansion and potentially to pay down some debt, however, the company does call out in the half-yearly results that their debt facility will see them through the current strategy and business plans.
• Higher gross margins rely on the company receiving approval to sell product under their own MA’s. If this approval is not received they must look for other ways to increase gross margin. Sales under MA’s were originally going to begin in the December 2020 quarter and in late November they advised approval had been received, however, in December the company advised further questions had been asked by the relevant regulator and sales would now begin in 2021.
• The long-term CEO resigned with immediate effect in late December. It was explained that this was due to the personal and family toll of running the business and that he would continue to advise the company during the search for a new CEO.

Opportunities

• Expansion ($4 million capital outlay) opportunity to expand revenue of manufactured products from $4 million revenue per month to $12 million per month.
• Looking to grow international sales into other markets; Asia, Spain, France and South America
• Currently seeking approval on the remaining 5 MA’s to enable direct selling of manufactured product in the first quarter of 2021.

Valuation

• Reviewing 2019 accounts they made $17.3 million gross profit on $54.7 million revenue for a GM of 32%. Given their operating EBIT of approx $-312k we can back calculate business overheads of roughly $18 million. Very back-of-the-envelope…
• The company has identified the following revenue catalysts:
  • MA approvals delivering higher margins - GMs of 45% have been called out as product range skews towards selling straight to distributors
  • Capex of $4 million will enable capacity to achieve revenue of $12 million per month ($144 million per annum)
• So perfect future case has revenue of $144 million at GM of 45% delivering gross profits of $64.8 million. No idea on overheads at the higher production level so I will make a massive assumption and allow overheads to increase by ~40% on 2019 to ~$25 million. The result is an EBIT of around $39.8 million. 
• It makes for an interesting story:
  • Roughly 126 million shares on issue at share price of $0.75 (24th December 2020) gives a market cap of around $95 million
  • Assuming an EBIT of $39.8 million can be achieved some time in the not too distant future (let’s say 3 years) gives a future earnings to current day market cap ratio of around 2.5x
• Seems too good to be true right and it probably is; 2.5x is very low. But it does mean margin of safety is good. Even if something in the above analysis turns out to be very wrong and the valuation is 100% off….the multiple is still only ~5x future earnings. If I am 200% off then the multiple is 7.5x future earnings