Synergy: Q2 Review
Aug. 29, 2017 8:05 AM ET|
13 comments|
About: Synergy Pharmaceuticals, Inc. (SGYP), Includes: IRWD
Patrick Mayles
Patrick Mayles
Long/short equity, event-driven, small-cap, mid-cap
(37 followers)
Summary
Synergy’s earnings disappointed in Q2, although net sales beat estimates by almost 20%.
We investigate the company's 10Q to aid in an analysis of the company’s financial health, and to assess the validity of consensus estimates that drove the post-earnings dip.
The greatest near-term risk to SGYP's performance is further dilution, while the greatest long-term risk is stalling sales growth in plecanatide.
Synergy Pharmaceuticals' (SGYP) financials have changed quite drastically from Q1 to Q2, but the market is not impressed. Its share price fell from 3.50 to a low in the 2.80s following an earnings miss, and closed on Monday at around 3.10. This puts SGYP's market cap around 680 million, roughly half of where it was at the beginning of the year, before the company had any FDA approvals or revenue to speak of. An interesting juxtaposition, when we consider the generally bullish nature of the market since January, in spite of a dearth of real developments to warrant such significant gains. In any case, Synergy has been on a slow decline since Jan 2017, and sunk even further when it published its Q2 earnings. This article aims to investigate the details of Synergy's 10Q, assess the validity of the consensus estimates that drove the post-earnings dip, and comment briefly on risks to share performance moving forward.
Great Expectations, Predictable Fallout
When a company's valuation is dramatically impacted by an earnings release, I think it is important investigate how reasonable the consensus estimates were to begin with. In the case of very small cap companies, there are generally fewer analysts rendering opinions, which can yield less accurate earnings estimates. The bitter irony is that these companies' share prices are often the most dramatically impacted by earnings surprises. As I look over the financials and implied trends over the last few quarters, I believe this to be the case for Synergy. Breaking down the most recent 10Q leaves one scratching his head as to how analysts married a revenue expectation of 1.96 million to a net income of roughly -56 million, given the company's bottom line trends in previous quarters.
Enter Revenue
Synergy Pharmaceuticals has three significant income statement figures that warrant the most attention. The main two are SG&A expense and R&D expense, and as of Q1 of this year, gross profit has entered the ranks. As a general rule, and due to the relative tininess of gross profit, net income for SGYP is a very close number to the sum of SG&A and R&D, making them essential for assessing the company's earnings. We will take a look at the behavior of these two income statement items later in the article. First, let's look at gross profit. With the recent (and welcome) introduction of revenue to the income statement, the metric has also become an important factor, although it is currently dwarfed by the other two.
Gross Metrics
The chart above gives an idea of Synergy's net sales, cost of goods sold (COGS), and the resulting gross loss following the first sales of plecanatide in March of 2017. Keep in mind that this means Q1 only saw one month of sales, the company's first revenue-generating month. Even considering this fact, the jump in revenue from $98,000 to 2.3 million is impressive and encouraging, and beat estimates by 20% (consensus was a reasonable 1.96M).
If you think COGS looks very high relative to revenue, especially in Q1, you're on to something. Here is an important note on Synergy's COGS accounting, as quoted from the 10Q:
"Cost of goods sold ("COGS") for the three months ended June 30, 2017 totaled $2.9 million, which includes
direct cost of manufacturing and packaging drug product and
technical operations overhead costs which are generally more fixed in nature, including salaries, benefits, consulting, stability testing and other services.
Technical operations are responsible for planning, coordinating, and executing the Company's inventory production plan and ensuring that product quality satisfies FDA requirements.
Technical operations overhead represents the majority of COGS in our Statement of Operations for the three months ended June 30, 2017."
SGYP capitalizes as inventory all technical operations expenses associated with bringing the drug to patients. This includes significant fixed costs, such as the salaries and benefits of various personnel from packaging to quality assurance, and overhead costs indirectly tied to the production of the drug. This accounting method means that Synergy's COGS features sizable expenses that might otherwise be found in other areas of the income statement, leaving it looking quite bloated in relation to revenue, especially for a pharmaceutical company.
With this fact in mind, and using the negligible net sales of Q1, we can safely postulate that the fixed portion of COGS, as of now, is somewhere between 1.8 and 2 million. Net sales grew by 2.2 million QoQ, while COGS grew by 1.1M, putting the marginal cost of revenue in this quarter at around $0.50. This number should shrink with time, as Synergy continues to grow into its inventory-related fixed costs.
Given the consensus estimate of 1.96 million for revenue, and an inferred quarterly fixed COGS of at least (1.8M), analysts clearly weren't looking to gross profit to support a thesis that net income would improve from ~(65M) to ~(56M) QoQ. So, where was this $8.5 million improvement in the bottom line going to come from? The only reasonable answer, from where I'm sitting, is a skinnier SG&A, R&D, or some combination of the two.
SG&A, R&D
The above chart shows Synergy's most recent three quarters in terms of SG&A and R&D spending, with the green line showing the sum of the two. Net Income is included to show how closely the two figures' sum matches it (note that Q4 2016 had an Unusual Expense item of ~14M). If the bottom line were to improve by more than 10%, as was predicted, it would have come from these two items. Was this a reasonable expectation?
Synergy is a young pharmaceutical company, juggling the nascent commercialization of plecanatide for CIC, while already investing to prepare its sales force and marketing muscle for an anticipated approval for IBS-C, according to the most recent 10Q. To this end, SG&A, which is primarily composed of marketing and sales expense in Synergy's case, has increased 20% QoQ, which is half the rate of increase that we saw in Q1. I believe the safe money should have been on SG&A increasing QoQ, and that 20% is an rather unremarkable figure. Research and Development expense has remained relatively flat, which seems predictable, since little has changed for the company in terms of drug development since Q1. A significant decrease in the figure would have been a stretch, given that the company currently has 3 different treatments in its pipeline.
Based on predicted revenue and the nature of COGS, analysts apparently expected an $8M decrease between these two expense items, at a time in the company's history when this is extremely unlikely. It would have been fair to predict a slightly lower net loss QoQ, and the increased net loss is indeed a disappoint. However, a reduction of 12% in the company's deficit, assumed to be driven by smaller SG&A/R&D, was unrealistic, given this company's need to play catch-up as it brings its products to market behind competitors. It should come as no surprise that SG&A didn't shrink, or even that it increased. Synergy is aggressively spending on establishing plecanatide in the CIC space, while also diverting sales and marketing resources ahead of a likely approval for IBS-C.
Synergy's Q2 performance was a mixed bag. Its ever-shrinking debt expense was less than half the previous quarter, and the company delivered with its first quarter of substantial revenue, beating expectations and raising hopes for a successful commercialization. However, these positive developments were eclipsed by a significant earnings miss, due to a 20% increase in SG&A which drove net income further into the red, but also to an overly rosy earnings prediction. In short, the 10Q wasn't as ugly as the price movement and earnings miss make it seem. However, there are significant risks that Synergy faces in the near and long term.
Real Challenges
I believe that the recent earnings miss has left Synergy undervalued. However, I acknowledge the significant risks that the company faces. The greatest near-term danger to share price is further dilution. Synergy has shown a preference, especially in the last year, for fund-raising through the sale of equity, rather than the issuance of debt. Shares outstanding have increased by about a third YoY, from 168 to 224 Million. It will likely be at least another year of hefty net loss for the company, as sales have a long way to go to outpace much larger bottom line figures. Fundraising remains a concern. Year to date, the company has financed a 138M net loss primarily through the sale of $122M in common stock. Logic holds that this trend will continue, as Synergy has demonstrated an aversion to debt and the expenses that come with it, and has even converted a substantial amount of existing debt to common stock in recent quarters.
Synergy's cash situation is always an issue. With $82 million in cash and an improbability of Net Loss ($74M this quarter) reducing substantially in Q3 or Q4, it is fair to assume that Synergy will need to fund-raise again. If history is any indication, it will be through the sale of common stock. This is something to account for as you assess the near term prospects of SGYP in the following months. It also raises the well-worn question of a buyout, or a revenue-sharing model akin to what Ironwood arranged, the latter warranting a total recalculation of what Net Sales growth will look like moving forward.
Speaking of which, a more existential threat to the company is sales growth. It is incumbent on Synergy to effectively commercialize its intellectual property, and so far they have done a good of that with plecanatide for CIC coming out strong in Q2, and IBS-C treatment approval to look forward to in 2018. However, they do not have the luxury of a slow growth curve, as they have accrued a substantial accumulated deficit leading up to this point, and financing heavy losses will only grow costlier in terms of debt, or more likely equity, as time goes on. I will have more to offer regarding a Net Sales prognosis closer to Q3 earnings, but weekly prescription growth has hitherto been strong, and the true test will be how COGS and SG&A move with that growth.
Conclusion
The Synergy story is very similar to what it was a year ago, with the notable exception that it now features revenue. The stock is still a nail biter, with equal parts huge growth potential and stark financial statements. I believe that, even accounting for a hefty risk premium, SGYP is a buy at this price. After all, what's more contrarian than to buy a cheap, high growth, high risk stock at a time when everyone else is paying huge multiples to invest in the "calmest market in decades"? The company's picture will become clearer as we have more data related to plecanatide's sales performance, but even in light of a difficult Q2 earnings, the company has a lot more race to run, and could be trading at a steal in August 2017.
Disclosure: I am/we are long SGYP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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