Knight Therapeutics Post-Mortem

As mentioned in the Jonathan Goodman post, republishing this post-mortem of my investment in Knight Therapeutics will provide additional context for my thoughts about it currently. While Knight has managed to put more capital to work, including a large deal for the rights to Exelon across all its territories (the exact kind of deal I’d been wanting), I think this post has aged fairly well. I don’t just mean because the stock is down though admittedly that helps. I mean that Knight is a roughly $300 million in sales company right now, but in 2022 it invested just $26 million in intangible assets, vs over $50 million of intangible asset amortization. Through six months of 2023, Knight has invested just $8 million, again well under its amortization. 2021 had over $220 million invested, almost all of which was for Exelon. One of the appeals of the Goodman approach is he wasn’t actually investing much cash for product rights. That’s kind of still the case. In 2022, Knight obtained the rights to three patented drugs and three branded generics. That’s not an inactive year, despite the cash outlay of just $26 million. It just probably isn’t enough development for a company with sales of $300 million.

However, Knight has almost $200 million in cash. It raised that money to invest. It can go to buybacks, and I’m not opposed to that (in fact I’m happy to see a management team buyback so much stock if they believe in the company), but people bought Knight because they believed Knight could invest that cash at a high return. They want management to build a business, build a product portfolio and pipeline.

Anyway, I expand on these thoughts in the upcoming post coming out Monday, but reading this will probably give you a taste of what that post will contain.

I have been one of Knight Therapeutics’ biggest bulls out there. I’ve written about the company several times, possibly more than anyone else.

The idea was very simple when I first invested in it. Knight had a huge pile of cash and investments that was worth about $6 after subtracting all liabilities. It had a pharmaceutical business with about $10 million in sales and an EBIT loss of ~$6.5 million, but the business was growing a lot. Just with the products Knight held at the time I saw a reasonable path to EBIT profitability by maybe the end of 2020 (it was early 2019 at the time). I thought the pharmaceutical business and the optionality of the cash in Jonathan Goodman’s hands was undervalued.

The other view was that Goodman had raised way too much cash and was scared to swing the bat. The view was articulated well by Meir Jakobsohn, the CEO of Knight partner Medison. Jakobsohn was proven wrong in time (and his motives were self serving) but his proxy fight went as far as it did because he knew which shareholder fears to stoke.

Partly as a response to Jakobsohn’s activism, Knight filed for a NCIB to return some cash to shareholders. This all happened in the spring of 2019. In the fall, Knight announced it was using ~$370 million of its $780 million in cash to purchase Grupo Biotoscana (GBT).

While Knight paid more for GBT than it normally pays for acquisitions/assets (8.5x EBITDA vs 7x earnings historically) I rationalized the deal as it was the purchase of a platform.

You see, Goodman had (mostly) built Paladin, and Knight, on the backs of small drugs licensed from big pharma or foreign companies that didn’t want to deal with Health Canada. Goodman and team were the best (or close to it) at bringing small drugs to market in Canada. That was supposed to be Knight’s competitive advantage. Knight would see more product deals than its competitors because companies could trust Goodman would get the product approved and could likely sell more of the drug than others; in theory it would be the first call for many products, allowing Knight to get products at a great price. Alternatively, even if a product was shopped to several Canadian pharmaceutical partners, Knight could “win” an auction without being the highest bid because it could be trusted with the product.

I thought, and I think Knight management thinks, that Knight could become that trusted partner in Latin America. I was essentially taking Knight’s word for this being the case.

Knight has owned GBT (or a controlling stake in it) for over a year now. What do Goodman and team have to show for it?

Not one product in-licensed. Not one loan made. Not one equity investment. Not one company acquisition. Nothing.

I was disappointed but then, as a Knight shareholder, I became an apologist. Of course Knight hadn’t signed any new product deals. First of all, it would take a while to get a list of products that are available and worth targeting, the phone calls and flights to the owners of those products would take a while, then there was a pandemic, and any manpower Knight did have was most likely devoted to finishing the acquisition and getting to know GBT, plus any integration Knight could do. My expectations were unrealistic. But then I heard this on the Q2 call:

Source: TIKR

That sounds bullish, right? My first reaction to it was products in Canada and LATAM is exactly what I wanted from GBT. The more I thought about it, the more disappointed I was that product acquisitions had been a priority since last November, yet they couldn’t get a single product to sell in a single country? GBT had a business development team that was surely working on product rights before the acquisition. Yeah, maybe it takes a year for the Knight team to start from scratch to acquire a license (though with the types of products Knight focuses on that surprises me), but GBT had relationships in place and discussions happening. That Knight couldn’t acquire even the rights to a 1 million BRL product in Bolivia or Paraguay was concerning.

The lack of deals indicates a couple things.

• Perhaps GBT isn’t a particularly trusted partner in its regions? This would mean Knight has a lot of tough sledding to develop relationships, and if GBT isn’t trusted for good reason, Knight will have a lot of work ahead of it to develop the skills needed to be a trusted partner.

• Maybe the competitive environment in LATAM isn’t as favourable as I believed? Knight had to expand because it had too many competitors in Canada (and Knight was too big for the market), but if LATAM is nearly as competitive and Knight isn’t the preferred partner, why would Knight be able to achieve high ROICs on deals there?

• Maybe the regulatory environment there isn’t the hurdle for pharmaceutical companies that I thought?

I’m not saying any of those are true, what I’m saying is I don’t know. With GBT being so much of the business now (LATAM revenue dwarfs Knight’s Canadian sales) and because the platform was so important for future value creation, these doubts weighed heavily on me.

My other doubt came when I wrote this post. If you don’t want to go read other stuff I’ve written (I don’t blame you) here’s the relevant passage:

I want Knight Therapeutics to be able to in-license products from big pharma players who need cash…. In a different sort of crisis, they might be able to. With CoVid-19, I’m not sure that will be the case.

This only really goes for transactions where two companies have to agree on a transaction. For Knight to acquire product rights, it needs a counter party to out-license said rights. If pharmaceutical companies are going to get some sort of relief (however it may happen) and don’t need access to capital, then they likely won’t sell those rights for a price Jonathan Goodman is willing to pay. But for a company acquisition, it is much easier. If Knight wants to buy a whole company, all it has to do is offer a price that shareholders will accept. Many public companies are inexpensive right now, and if they remain so for a while and they have the right shareholder base (ie. low insider ownership), Knight could offer a premium price that is still objectively low and may be able to do some M&A.

What I was thinking about at the time was how in this crisis there was so much stimulus, and capital markets so open to raise money via debt or equity (look at the cruise lines and theatre operators) that Knight’s pristine balance sheet might not be of any use. Goodman had been waiting around for exactly this scenario, and yet because capital was so available to anyone who wanted it (except for those businesses you find on Main St in your town unfortunately), that dream scenario didn’t benefit Knight in any way.

If Goodman couldn’t deploy capital in 2020, when could he?

The free flowing capital, while taking a different form than governments paying everyone’s wages, probably doesn’t end for a while with interest rates so low.

In addition to Goodman’s advantage getting drugs to market (which has been competed away in Canada and may not exist in LATAM), his other advantage has been capital. He ran Paladin without any debt, and most of the time with a big cash balance. When capital was scarce in the sector, when capital markets were closed, and companies were looking to raise cash, Paladin was one of the only players in town. It’s not a perfect indication (because his other competitive advantage still existed) but look at Paladin’s activity in 2008.

Source: Paladin Labs Annual Report

I don’t know if you’ll be able to read that so I checked off the highlights that I think can be attributed to Paladin’s access to capital* – acquiring product rights, acquiring companies, becoming GlaxoSmithKline’s preferred Canadian partner, etc.

*I checked off an out-licensing agreement but this was like my third attempt at the picture and I’m not doing it again.

In 2008 Paladin was able to put about $40 million to work:

the Company invested $34,562 towards the acquisition of pharmaceutical product licenses and rights, $3,000 as an investment in a portfolio company, $1,446 towards the acquisition of Virexx, further described in note 14 to the annual consolidated financial statements, $531 in repayment of a balance of sale payable, and $510 for the acquisition of capital assets.

Paladin had revenues of just $80 million, so that was a great year. Compare that to Knight this year:

Source: Knight Therapeutics Q3 2020 Report

I highlighted the only line that is possibly a new use of cash that would contribute to growth (not counting the last chunk of GBT, which I’d put in last year’s cash use). And even that isn’t. Amortization of intangibles was roughly the same as acquisition of intangibles, and this was the explanation for how the balance changed:

Decrease mainly due to the depreciation of the LATAM currencies during the period and amortization, partially offset by additions of $18,665 mainly related to certain milestones payable under product license agreements.

So giving the benefit of the doubt, you’d say Knight spent $17.1 million growing its business this year, more realistically, you’d say $0*.

*This of course doesn’t include all the growth that goes through the income statement – salaries for the team trying to acquire products, salaries and legal costs moving products through to approval, etc. It’s not right to completely ignore this “capital deployment”. I’m not in my thinking about Knight, but this is my blog and that is hard to quantify and compare to 2008, so I’m not going to write about it.

Knight is now a $300 million revenue company, with more than $300 million in cash, but can’t use any of it.

Paladin’s strong balance sheet was a competitive advantage. Peers borrowed to the hilt, and if a hiccup happened, they needed Paladin’s cash. Or a company was in fine shape but just didn’t want to deal with Canada’s regulations, and Paladin was one of the few partners they knew would have the cash to pay for the product (didn’t need to borrow for it).

Knight’s balance sheet was supposed to be a strength. But there is just so much capital that Knight needs more than that.

In Canada, the Knight/Goodman name does still hold sway; ask anyone knowledgeable about the sector and I betcha Goodman’s name comes up. Because the niche – so called “singles and doubles” drugs – is not as overlooked and there are competitors for these licenses in Canada, it’s not the advantage it once was. If the name/track record isn’t a huge differentiator, and there is lots of capital out there, what is Knight’s advantage in Canada?

Same goes for GBT’s markets. If GBT didn’t have a Paladin-like track record as a partner, and the Knight team has no competitive advantage moving drugs through the regulatory processes of various Central American countries (they have no experience doing it), and capital is not scarce, and there either are competitors for licenses (or pharmaceutical companies will just acquire a company to be its distributor in the region), what’s Knight’s advantage there?

I honestly don’t think my investment in Knight was a mistake. When I first bought it, Knight was doing some good things and it looked like the playbook was still working in Canada. It couldn’t scale – with Knight’s size it was always going to need to expand outside of Canada – but I thought company could grow its Canadian business and eventually find the right partner(s) for the rest of the world. I also thought the huge pile of cash would prove to be a difference maker – at the time debt loads were hampering several pharmaceutical companies (Endo being a relevant example). That thesis has so far proven to be wrong, but I think at the time there was a good chance of it being right.

I am torn between this being me changing my mind in the face of new information (Knight’s lack of deal making shining a light on the excess capital and lack of competitive advantage in LATAM) or me failing to think long term. It might be both. I see a path where Knight is relatively flat (say between today’s price and $10) for the next 10 years, and as much as I like to think of myself as a hyper-rational investing automaton who can accept that as long as the 10 years after can bring my IRR up to 15% by buying now, in the face of uncertainty around Knight’s competitive advantages, it’s tough to invest now and hold my breath.

Without evidence to the contrary, I was prepared to believe the future would be more or less like the past. Now that doubts (rightly or wrongly) have crept into my mind, I have put the burden of proof on the bull case. Knight is a show me story to me now.

Recently there was a positive sign. Knight filed a base shelf prospectus to issue up to $360 million in shares or debt in the next 25 months. The press release included this language:

Following the acquisition of Biotoscana Investments S.A., Knight has access to more growth opportunities, including acquisitions of products as well as bolt on acquisitions of specialty pharmaceutical companies for its pan-American (ex US) footprint. The Shelf Prospectus provides Knight the financing flexibility without any incumbent obligation to use the instrument as it pursues larger opportunities.

Maybe the dollars are about to fly. Possibly I am an impatient child of an investor and I don’t have what it takes to invest “for my grandchildren”.

I really, really want to keep liking Knight. It wouldn’t take me much to fall in love with Knight again. Simply seeing a few small product deals like those I liked at Knight and Paladin- lowish peak sales drugs, later stage and/or approved in other regions, and acquired cheaply – and I would maybe add to my position once again. That’s the show me part. If I could see a few deals like that, it would be an indication of Knight’s trust in Latin America and that Knight can win products despite the abundance of capital out there.