SWK Holdings – A micro-cap with a solid plan to compound investor capital
|July 9, 2014||Posted by Nat Stewart under Compounding Machines||
SWK Holdings (SWKH),
“…is a publicly traded, specialized finance company with a focus on the global healthcare sector. SWK partners with ethical product marketers and royalty holders to provide flexible financing solutions at an attractive cost of capital to create long-term value for both SWK’s business partners and its investors.”
SWK Holdings is a micro-cap stock with a unique platform and plan for creating shareholder value. The current medical royalty business was established in order to take advantage of a massive $450 Million dollar NOL, which exists due to losses the company suffered in its prior life as a software company. This is a tremendous benefit, as it means that if the company is successful with its investments, it will be able to compound cash flows tax free for a substantial period of time. The company will invest its own capital, and manage capital for external investors via a 100% owned registered investment advisor business.
CEO Brett Pope and Managing Director Winston Black are highly experienced investors in the healthcare sector, having previously managed multi-billion dollar healthcare-related portfolios for hedge fund Highland Capital Management LP, as well as a $200 million dollar royalty portfolio. The managers invested their own funds into SWK Holdings when they were hired, and have subsequently purchased additional shares. They stand to benefit handsomely if they can build book value and get the share price up over the next 3-5 years, as they have 750K of options that are well out of the money. They will also receive incentive bonuses that are directly tied to company profitability. In other words, this management team has “skin in the game” and has been given very strong incentives to succeed.
The Opportunity – Why Pharmaceutical Finance
1.) Achieve high current yield from investment in non-correlated assets
- Invest in royalty, revenue, equity & debt interests from healthcare companies, research institutions and inventors
- Royalties: strong underlying existing cash flow profile without material exposure to marketing, litigation or development costs
- Structured debt: high coupon drives current yield; backed by collateral value & paired with equity upside
2.) Utilize debt structures to protect principal through superior investment structuring
- Debt investments have a priority claim over pharmaceutical/royalty cash flows and assets, and have substantially better downside protection Loan-to-value cushion prevents overpaying for royalty assets
3.) Selectively pursue equity interests in products through outright royalty or product ownership
4.) Mitigate FDA risk and Company-specific risk
- Commercial-stage products with IP protection and/or regulatory moat
- If appropriate, bankruptcy remote structures are used to eliminate credit risk from the royalty seller
- Drug licensors remitting the royalty payments are typically well-capitalized issuers
5.) Create a diversified portfolio along multiple criteria
- Therapeutic category
- Product life cycle (new product launch, steady growth, mature asset)
- Marketer profile
The SWK Holdings Strategy – Focus on investing in “Legacy” assets that are not highly valued by larger institutions
1.) SWK will selectively invest in mature, “cigar butt” pharmaceutical products
2.) Many “legacy” products are not attractive for pharmaceutical companies to maintain
- Small, no-growth tail assets do not warrant sales force attention and do not meaningfully impact the PNL(1)
- Keeping such products forces Pharma to maintain much larger list of contract manufacturers than desired or maintain plants at suboptimal capacity(2)
- Pharma has divested such products historically due to M&A, manufacturing facility consolidation, etc.
3.) Legacy products typically sell themselves and can be managed by virtual operations
- Distributors can manage entire supply chain, including product ordering, retail distribution and payment collection
- Established drugs already have their place in the treatment armamentarium for targeted indications
4.) Opportunities exist in the US and Canadian markets
- Small products typically fulfill a distinct niche
5.) Product criteria include
- Well defined market and established treatment paradigm for the product
- Little-to-no sales force support required to achieve target sales levels
- Adequate IP or regulatory moat protection to limit exposure to generic challengers
- Established reimbursement
- High operating margins
Portfolio Objectives and structure:
- Target gross unlevered returns in the mid-teen%s; IRR further enhanced with OID, warrants and call premiums, resulting in equity-like return potential
- Utilize limited leverage on the portfolio to increase buying power and enhance returns to equity Investments
- Investments will include debt backed by existing pharmaceutical and medical device sales
- Based on opportunities, would invest in royalty securitizations, actual royalties, synthetic royalties or hybrids thereof, and legacy product opportunities
- Portfolio will be diversified by limiting the portfolio’s exposure to individual therapeutic classes
- intend to invest in FDA approved products, thereby limiting regulatory risk
- Will consider investments based on sales of pharmaceuticals or medical devices
- Majority of marketers are expected to be well-capitalized pharmaceutical and medical device companies
- Investments will be sourced through 3rd party underwriters and proprietary SWKrelationships
- Intellectual property or regulatory moat
- Medical rationale of the product
- Market size & competition and reimbursement
- Marketer core competencies
- Actual product license
(Note: The above bullet points were taken from the investor presentation found on the company’s website).
In order to execute on its strategy, SWK Holdings needs more shareholder equity
In order to grow and fully utilize the valuable NOL asset, the company will need to raise additional shareholder capital. On this front, two exiting developments have been revealed by recent SEC filings. First, the company has proposed a rights offering in order to raise $12.5 million in additional shareholder equity. These rights will allow shareholders to purchase .35015919 new shares for each current share held at the price of .87 cents per share – which is a substantial discount to the current price of $1.16 – $1.20. This rights offering will be open to all shareholders. In fact, in the S-1 registration statement the company explicitly states that:
“By pursuing a rights offering, we also are limiting the impact of the issuance of additional shares on our NOLs by allowing all stockholders to maintain their current ownership percentage of the Company.”
The registration statement also notes that management and officers are expected to participate in the rights offering, and that a fund operated by the largest shareholder (Carlson Capital) will act as a standby purchaser for any rights not exercised by other shareholders.
One interesting thing to note is that this is a capital raise by a micro-cap company that is completely under the radar. There is no promotion or hype, which sometimes can be typical of a micro-cap equity raise. Indeed, this is not a typical micro-cap situation in any way. The reason for this is very simple. The largest shareholder and management don’t seem to want new shareholders jumping in to take advantage of this opportunity. Indeed, if you look at it from their perspective, the best option for them is to invest their own capital, which will allow them to capture the massive benefit of the NOL’s via tax-free reinvestment.
Indeed, there is more to the capital-raise story. Carlson Capital recently proposed an $96 million dollar equity investment which would take place at $1.20 per share. In other words, it is 100% clear that Carlson Capital wants to “pile in” to this opportunity. The fact that they are looking to do this at book value and above the current share price is a very good sign. It strongly suggests that SWK Holdings has strong governance standards and is not going to stiff smaller shareholders. Indeed, everything I have seen and heard about this company suggests that minority shareholders will be treated fairly. I was particularly impressed by the statements Brett Pope made in the company’s first conference call. He seems to be a stand-up kind of guy.
Key risks being aware of:
1.) While everything I have seen points to strong corporate governance standards and ethics, there is always potential that the largest shareholder (a hedge fund) will take actions that harm the smaller shareholders – for example through a future dilutive equity raise or (in the future) by buying-out our interest at a price that does not reflect the companies strong economic prospects. This is at present an extremely relevant issue, as the company is currently negotiating with Carlson Capital on issues surrounding the equity raise. I noted that CEO Brett Pope is a CFA charter holder. I know this program has extensive ethics training, and (more importantly) this designation tends to attract people who take ethical obligations seriously. I believe that he will be a strong advocate for minority shareholder rights. I have limited knowledge of Carson Capital’s operations, however my hope is that this firm will act honorably, as they seem to have to this point. Regardless, I will be monitoring the situation and will post updates.
2.) Investment concentration risk – Until the company is able to raise additional capital, the portfolio will be relatively concentrated. The opportunity to diversify the portfolio is one reason (assuming that the managers will continue to find high-quality opportunities) why all shareholders should be in favor of the proposed equity raises.
3.) Related to the above, the company does take on default-type risk. While they do state that these companies have valuable collateral, my assumption is that there is still risk of permanent loss on any individual financing that the company partakes in.
4.) This is a thinly traded Micro-cap. Exercise caution when purchasing shares and use limit orders. Also, this opportunity is limited to relatively small investors. The company has a “poison pill” that prevents any shareholder from accumulating more than 4% of the equity. This exists in order to protect the legal status of the company’s NOL asset.
5.) Key man risk – The company relies heavily on the talents and skills of the two primary managers, Brett Pope and Winston Black
My bullish case for the company is as follows: Right now the company is trading at just under book value. If the company succeeds in earning a mid-teen ROI, this book value will be growing at (say) 15% per year. However, given that this is a unique asset class and an investment vehicle with structural advantages, I think that it is highly likely that it will end up trading at a decent premium to book value within two years. This gives me a target price of $2.32 per share to be realized two years from now, with additional and substantial growth potential beyond this. As the majority shareholder is currently willing to buy in at $1.20 per share, I think that something close to this price reflects a very favorable entry point for new shareholders.
Note: I own shares of SWK Holdings and intend to add to my position of the rights offering comes to fruition