A view of growth and profit potential from the Laughing Water Capital 1Q Letter:
Avid Biosciences (CDMO) - Avid is our disposable biologic drug substance CDMO. Avid is set to benefit from tremendous operating leverage tied to filling recently installed capacity. However, Avid recently experienced one of the worst “own goals” that I have ever seen in public markets. Despite this blunder and resultant stock pullback, the long-term thesis is very much intact.
As for the details of this own goal, in March of 2021 Avid issued a ~$144M 1.25% convertible bond under SEC Rule 144A, which restricted the sale of these privately placed securities to qualified institutional investors until such time as the company removed the restrictive 144A legend that governed the bonds. The company agreed to remove this legend by March 17, 2022. There was nothing unusual about this arrangement at all – many securities come to market under 144A restrictions, and removing the legend is typically as easy as the company sending an email to the transfer agent and asking that the 144A legend be removed.
However, in the case of Avid, they forgot to send that email, and the legend was not removed.
The market, the company’s CFO, the company’s banker, the company’s legal advisor, and unfortunately yours truly were all blissfully unaware of this oversight until early last month when someone who had purchased more than 25% of the bond (probably around 80 cents on the dollar) notified the company that their failure to remove the 144A legend constituted an event of default under the bond’s indenture, and they were demanding immediate repayment. This forced Avid to pursue an emergency financing in the form of a new $160M 7% convert that matures in 2029. Most unfortunate is that the conversion price of the new bond is $9.89, vs. $21.21 for the old bond, and thus comes with significantly more dilution than I earlier anticipated.
There is a lot to unpack there, and none of it is good, and there is plenty of blame to go around on how this could have happened. From my perspective, removing a 144A legend is so routine that it is not something I have ever seen on any investor’s diligence check list (although I have added it to mine). Before this event I would have no sooner asked a CFO if he had scrubbed his company’s bonds than I would have asked him if he washes his hands after going to the bathroom, or if he looks both ways before crossing the street. These are things that one just expects to be done, especially when there is a CFO, internal legal, external legal, and the bankers who structured and sold the bond all involved. Not to mention that I have been told that for the original convert Avid used documents that were “off the shelf” from Morgan Stanley, and these documents did not allow for a cure period. If a cure period would have been specified, Avid could have simply scrubbed the bonds when they realized their mistake, and paid some sort of penalty rather than having to resort to an emergency financing. I assure you that Morgan Stanley has since updated their boilerplate in this regard.
In any case, this event does not affect the normalized revenue generating capacity of Avid, but it does affect free cash flow conversion and per share value as interest payments and future diluted share count have both gone up. It is impossible to say precisely how much per share value was destroyed by this blunder however, because the original bonds would have had to have been refinanced at some point in the first half of 2025 anyway. In my blue sky scenario I envisioned the business quickly inflecting before then in such a way that would have allowed the company to refinance with bank debt and pay off the 2026 convertible bonds with zero dilution. Alot of things would have had to go right for that scenario, but management did express confidence that this was within the realm of possibility.
However, more realistically I had my doubts and was already factoring in some additional dilution before the emergency convert, so the true delta in share count and interest rate are likely not as bad as the headline. In any case, Avid is still on their way to filling up their $400M in revenue capacity, and they will still likely achieve low 30% EBITDA margins when they do. Assuming conversion of the debt, free cash flow will be the same as I originally envisioned, but it will now be split over ~80M shares rather than ~70M shares. The net of this is that 2 months ago I would have said that I thought Avid was a few years away from being worth something like $30-33 dollars, and now I think it is a few years away from being worth something like $25-28 dollars. In sum, the upside here has been truncated. At the same time, based on the recent industry developments laid out above, my confidence in Avid’s ability to quickly fill their facilities has gone up. Either way, with shares presently around $7, I think there is plenty of upside left.
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