This past week I sold my entire position in Crescita Therapeutics.
In Q3 Crescita collected a $5 million royalty payment that was owed to them by Taro Pharmaceuticals. The collection of the $5 million royalty payment adds cash to an already exceptional balance sheet.
Even with such an exceptional balance sheet, Crescita will not fare well in another COVID lockdown. With COVID cases rising all over the world I used the recent increase in share price to exit with a small gain. It’s not just COVID that influenced my decision to sell. There are some other issues with Crescita that I’ll address.
Crescita Q3 2020
On November 11th Crescita Q3 2020 financials were released.
Crescita Therapeutics was successful in collecting the $5 million owed to them by Taro Pharmaceuticals. The $5 million payment was made as a result of a royalty adjustment between Taro and Crescita.
This brought the total cash on the balance sheet to $13.8 million. That’s pretty impressive for a company with a fully diluted market cap of $17.6 million and was recently as low as $9.8 million.
Commercial skincare sales and contract manufacturing and development revenue both bounced back to a more normal level but royalty revenue has been limited in 2020.
Pliaglis royalty revenue is critically important for Crescita’s profitability. The company did manage to earn $516,000 in royalty revenue in the quarter when excluding the large royalty payment.
Crescita also announced that after the quarter they had signed agreements for the sale of Pliaglis in Mexico, Austria and China. Long term it looks like Pliaglis sales should increase as sales in new countries begin but the sales in China are not expected until 2023.
Even in a tough pandemic environment, the company faired reasonably well. After subtracting the $5.2 million royalty payment Crescita has used $612,000 in cash in 2020. My concern is that costs have returned to near pandemic levels and with another lockdown, Crescita will again have a large selloff.
Reasons Why I Sold Crescita
U.S. Market with Taro Pharmaceuticals
Crescita lives and dies by the success Taro has selling Pliaglis. One of my big concerns is this, has there been a material change in Taro’s abiltiy/willingness to sell Pliaglis in the U.S.
The first indication that something could be wrong was the restrictive amendments announced in Q4 of 2019. My understanding is that pharmacy benefit companies use these amendments to target high margin drugs that harm their profitability. As a result, Pliaglis was targeted. I wrote a little more in-depth on the restrictive amendments in my full year 2019 post.
The company said at the time that it was too early to judge how these amendments would affect sales. This is still the case. Management has not commented on its effect. This is a potential risk for Crescita’s hugely important Pliaglis revenue. If this limits sales of Pliaglis in the U.S. this is a major problem.
My second concern is Taro’s willingness to keep selling Pliaglis. Taro has been underpaying Crescita apparently due to the complex tiered royalty agreement. Now that Crescita has received the $5 million payment and a higher royalty payment from Taro will Pliaglis get the same attention as before? Has the relationship been impaired due to the large payment and increase royalty payment requirements? If it has this is a major problem.
Taro is a $2.7 billion company with the last twelve months revenue of $600 million. In 2019 Crescita earned $2.9 in royalty payments. If we attribute all of this to Taro at a 15% royalty rate for Crescita that is $19.3 million in sales for Taro. That is only 3.2% of Taro’s TTM. The point I’m trying to make is Pliaglis is a very small portion of Taro’s revenue. If Pliaglis is a less profitable drug to sell due to the increased royalty payment and restrictive amendments then Taro could put less emphasis on Pliaglis sales.
Commercial Skincare Segment
Crescita’s commercial skincare segment has always caused me concern. The cash generated by Pliaglis is being used to fund the cash-burning commercial skincare segment.
By Crescita’s own admission the skincare business is very competitive. Using their four brands Crescita has tried to differentiate itself by selling higher-end products through spas and medispas. The expansion of Dermazulene in China is undoubtedly interesting but this is only a small portion of revenue. For the past nine months, only 8% of revenue has come from outside North America.
While I think the strategy to focus on spas/medispas is well thought out I find it very difficult to predict with any certainty when the commercial skincare care segments reach breakeven. Crescita acknowledged the same with a $1.9 million impairment charge on intangible assets related to non-prescription skincare. They felt it was necessary to write down some of the value of their non-prescription skincare assets due to decreased demand.
I wrote a post last year with some thoughts on microcap executive compensation. It was an expansion of an article written by Ian Cassell. My conclusion was I preferred companies that paid their executives with a reasonable base salary and incentivize them with well thought out cash incentive plans. I also prefer modest share-based compensation, especially for profitable, cash-generating companies.
The bloated compensation for Crescita’s management is a major hindrance to profitability. The above five executives were paid $2 million in 2020. It is only fair to point out that 2019 was an exceptional year for Crescita because of the numerous upfront and royalty payments they received. This leads to large annual incentive plan compensation. While writing this executive compensation factored more heavily into why I sold Crescita than I originally anticipated.
5% of gross profits in 2019 was eaten up by CEO compensation. In comparison Xpel Inc. pays it’s CEO $613,000 USD or $796,000 CAD. The big difference is Xpel is a $1 billion company with $43 million in gross profit in 2019. Xpel’s CEO accounts for 1.4% of gross profit.
This might not be a totally fair comparison. Xpel is in a completely different industry and is a more established company but Xpel is an example to follow in terms of zero dilution, earnings growth, modest executive compensation and wonderful value creation for shareholders. Why not compare other companies to Xpel.
I also have an issue with executives being paid such high cash compensation but then get options thrown in as well. Crescita has a low fully diluted share count. Options are meant to provide long term alignment with shareholders. I don’t think this is accomplished when cash compensation greatly outweighs the benefit the CEO would receive from a higher share price. If the board truly wants the executive team to be aligned with shareholders they should have encouraged them to buy shares below net-net-working-capital.
Board of Directors
The generous compensation isn’t only for executives. The board of directors is also well compensated.
Other companies I own pay their directors more reasonable compensation. NamSys pays its directors in the $15,000 range while Namesilo does not compensate its directors.
My last point on executive compensation is the ownership level of the CEO. CEO Verrault made a significant purchase of shares through a rights offering in 2018. He purchased 649,351 shares at $0.53. This was a substantial commitment for Verrault who had only been with Crescita for about a year.
Since then CEO Verrault has not made any additional purchases even though he has been compensated $1.5 million in cash since 2017. Even while trading below net working capital no one from Crescita purchased any shares.
Failed Execution on Stock Buyback
The failed execution of the stock buyback is a smaller reason why I sold Crescita. I believe CEO Verrault has done a good job allocating capital since taking over the company. The ability to buyback shares opportunistically has not been done well.
If I learned anything from The Outsiders book it’s that opportunistic stock buybacks can be a very powerful tool for wealth creation. The CEO’s in the book were very aggressively buying back shares when their company’s shares were trading at large discounts. The CEOs in Outsiders were not afraid to buy back shares during uncertain times when prices were at the biggest discount.
Crescita had an active normal course issuer bid prior to the COVID lockdown. The company was buying back shares in the high $0.80 range and even as high as $1.00. On March 24th Crescita cancelled its NCIB to preserve cash during the peak of the pandemic.
Management commented that the optics of buying back shares while employees were laid off were not good. This is understandable but it’s the tough decision like buying back shares during times of uncertainty that have the chance to create the most value.
And now that shares have returned to the $0.80 range Crescita announced a new share buyback. Being unwilling to buyback shares at a price that is less than cash on the balance sheet was a missed opportunity.
Why I Sold Crescita: COVID-19 Lockdown Part II
The possible COVID lockdown could be coming to Canada is the biggest reason why I sold Crescita Therapeutics. Crescita is not a “COVID company”.
During the spring lockdown, Crescita was deemed non-essential and was forced to close its manufacturing facility. In addition to its own facility, spas and medispas were closed across the country. COVID cases in Canada are exploding and the holiday season will only exacerbate the pandemic. I predict we see widespread closures again which will have a negative impact on Crescita since its main sales outlets will be deemed non-essential and closed.
The commercial skin care business will be negatively affected but so will Pliaglis sales. Pliaglis is used to prevent pain prior to certain procedures. The list of procedures Pliaglis is used before are elective procedures: tattoo removal, dermal filler injections, facial laser resurfacing, hair removal and treatment of varicose veins. A decline in Pliaglis sales will have a greater effect on the bottom line since Pliaglis sales provide all the profitability.
So am I basing my decision to sell more on macro factors instead of actual company performance? Yes, I think you can argue that I am. While Crescita took steps to cut costs and preserve cash in the spring costs have returned but sales will suffer if another lockdown is imposed. Will Crescita cut costs again? I’m sure they will but once again they will need to ramp up production and sales again. The business development efforts will also be delayed as a result of lockdowns and a much-needed increase in Pliaglis sales in Europe could be delayed.
With the share price appreciating into the $0.80 range I think the margin of safety for Crescita is gone. If Pliaglis sales suffer due to lockdown or issues with Taro the company will suffer. The margin for error is too slim. If Crescita returns to the net-net-working-capital range or about $0.50 based on Q3 numbers, I will consider buying again. There are too many uncertainties with a possible lockdown coming for me to feel comfortable owning Crescita.
And just a friendly reminder to whoever reads this. I reserve the right to change my mind on a stock. All I do on this blog is to document my thoughts and am not trying to give any stock-picking recommendations. I continue to preach patience and try not to sell unless I have thought it through. I took this opportunity to sell Crescita at a small gain and will continue to watch to see how the company weathers the pandemic.
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