Veru Healthcare (NASDAQ:FHCO), formerly known as the Female Health Company, is an interesting company in that it was very simple to analyze just before the merger last year but became very complicated to analyze after the merger. The merger happened between two companies, The Female Health Company (FHC) and Aspen Park Pharmaceuticals, Inc. (APP). Let’s examine what has caused the two companies to be merged and forecast what lies ahead for the combined company.
A single product that was successful but not successful enough for the long term
Prior to the merger, the Female Health Company was simple to analyze as the only product that the company sold was FC2 female condom, which, by the way, is the only FDA-approved female condom in the world.
Let’s dig a little deeper on this female condom since it is the only profitable and, therefore, most important product for the combined company. The company was able to make profit successfully with the female condom, and the main customers have been the government agencies around the world. As a result, the company was able to afford to pay dividends from January 2010 to April 2014, and investors were optimistic about the company’s future as reflected in the share price going up to over $9. However, the profitable and dividend payout trends did not continue, and the stock suffered dramatically with its value going down more than 50%.
The first root cause was that unlike typical consumer products sold to the large population, the female condoms were mainly sold to only several large government agencies. This downside led to unpredictable and volatile sales trends, making it hard for the company to pay out consistent dividends. See the excerpt from 2016 10-K below that explains the consumer concentration risk.
Source: 2016 10-K
The second root cause, which is also related to the first one, was that the management has failed to diversity the consumer base to individuals as male condoms are a superior product in many aspects (e.g., cheaper, easier to use, more effective to prevent STDs).
Why did the merger happen between the Female Health Company and Aspen Park Pharmaceuticals, Inc.?
From FHC’s perspective, Overton Parrish, then-CEO of FHC, knew that its business model of the single product company is prone to the buyer concentration risk as discussed above and wanted to diversity the company’s product portfolio. Also, from his personal point of view, Overton Parrish was over 80 years old, didn’t seem to be excited about getting involved in day-to-day business operations, and wanted to leave that responsibility to someone else.
From the APP’s perspective, the company was burning through its cash without any real commercial products and needed cash to support the development of its drugs in the pipeline. FHC was a perfect company to be merged, as the female condom has proven to generate positive operating cash flow, and FHC has additional $10M credit line as a backup from BMO Harris Bank that the combined company can tap into if necessary.
Was the merger the right decision?
The consensus from the stock market says no clearly. When Overton Parrish, then-CEO of FHC, expressed his interest in various M&A opportunities, the share price went up to above $2 at one point in anticipation of a good deal. However, as the merger was getting materialized and becoming a reality, the share price dropped to around $1 level as investors were disappointed with the deal.
Why were investors disappointed?
First, the merged company’s risk profile changed 100% as it moved from a single product company to a start-up pharmaceutical company. Most investors, prior to the merger, invested in the company because the company was profitable and was simple to analyze with only a single product. The investors didn’t like the complexity that came with the merger.
Second, the company’s new CEO, Mitchell S. Steiner, has a poor track record of running another pharmaceutical firm, GTx Inc. (NASDAQ:GTXI), which he co-founded, and he had served as its vice chairman and chief executive officer from September 1997 to April 3, 2014. See the performance of the stock below where I adjusted the end point to April 3, 2014, when he resigned as CEO.
Source: Google Finance
See also the articles regarding the resignation of Mitchell S. Steiner as GTx CEO:
Third, many argue that the merger was not fair to FHC shareholders as FHC gave out too much ownership to APP, a new pharmaceutical company with no real commercial products. In the merged company, FHC shareholders own only 55% of the combined company shares and APP shareholders own 45%.
Fourth, as highlighted above, there is no real proven pharmaceutical product from Aspen Park Pharmaceuticals. In order for the pharmaceutical products to be profitable, the company has to go through multiple-stage FDA approval process and the market should accept the drug favorably over other competitors’ products, both of which are very challenging tasks. Let’s examine both of the scenarios more closely.
What lies ahead in the short term (over the next two years)?
As an investor, you should pay close attention to whether or not Tamsulosin DRS gets the final FDA approval for the following reasons:
- Tamsulosin DRS is the only late-stage drug in the pipeline.
- The management stated during one of the investor calls that it would first focus its investment on low-risk high-return products (i.e. Tamsulosin DRS). In other words, if Tamsulosin DRS fails, then the company is left with only high risk products, and therefore, the stock is expected to decline significantly.
What lies ahead in the long term?
The company’s long-term success all depends on whether or not the company can bring any of the pharmaceutical products in the pipeline to the market successfully before the company burns all the cash from the female condom operation and $10M credit line.
For those of you who are not familiar with the FDA drug approval process, review the FDA document to get a high level understanding of the process.
To estimate the success of the company in the long term, we need to know:
- Drugs in the pipeline and which phase they are in
- Probability of the final FDA approval for each drug
- Probability of commercial success after the FDA approval
- Estimated drug sales that can justify the development cost
1. Drugs in the pipeline and which phase they are in
Drug Development Cost: This slide also shows the estimated development cost at around ~$50M by the management. Since most managements are usually optimistic about their future, I would increase the cost estimate to ~$70M to be more conservative. We will use this estimate later in the analysis.
2. Probability of the final FDA approval for each drug
First, let’s review the chart below to estimate the probability of the drugs passing each stage.
Based on the info above, you can do a very rough back-of-the-envelope calculation to calculate the probability of the final FDA approval for the drugs in the pipeline as shown below.
- Tamsulosin DRS: 58.1% x 85.3% = ~50%
- MSS-722: ~10%
- APP 944: ~10%
- APP 111/222: Less than 10%
3. Probability of commercial success after the FDA approval
Even if the company manages to get the final FDA approval on a drug, the company has a long way to go in terms of making the drug a commercial success in the marketplace. Big pharma companies spend millions of dollars to advertise and promote their drugs, but Veru Healthcare is a small company that can’t afford such big spending in advertising and promotion activities. Therefore, let’s assume that the probability of the commercial success is at around 10%. You can change the number for your calculation if you believe this number is not accurate.
4. Probability of at least one drug in the pipeline getting the final FDA approval and commercially successful
Probability of the final FDA approval x Probability of commercial success
- Tamsulosin DRS: ~50% x 10% = ~5%
- MSS-722: ~10% x 10% = ~1%
- APP 944: ~10% x 10% = ~1%
- APP 111/222: Less than 10% x 10% = Less than ~1%
If you add them up, then you finally get ~8% chance that at least one of the drugs in the pipeline becomes commercially successful
5. Estimated drug sales that can justify the development cost
In the section above “1. Drugs in the pipeline and which phase they are in”, I showed you the estimated drug development cost would be around ~$70M. The question now is how much drug sales should the company have in order to justify the development cost of ~$70M if one of the drugs were to successfully come to the market? The expected value of the drugs in the pipeline should be at least the same as development cost ($70M).
Expected value = Probability of at least one drug in the pipeline getting the final FDA approval and commercially successful (~8%) x Estimated Drug Sales
A simple math would show you that the estimated drug sales should be at least $857M to justify the development cost of ~$70M. As mentioned above, this is my rough back-of-the-envelope calculation just to see how hard it would be to have a successful pharma product and emphasize the importance of containing the development cost.
My expectation is that in the short term, the stock could move to one of the two extreme directions over the next few years depending on whether or not Tamsulosin DRS gets the final FDA approval. In the long term, anything could happen, but my analysis doesn’t show promising aspects in this company.
I would not recommend the stock to average risk-averse investors. However, if you are willing to take the risk and have some spare money, then you may take the chance, bet on the small probability, and reap a big reward if the success scenario were to become a reality.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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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