Is Catalent a Buy?

The world's pharma and biopharma companies are sprinting to develop hundreds of treatments for COVID-19 and vaccines for SARS-CoV-2. Almost half of those have been pitched to drug manufacturer Catalent (CTLT -0.30%), which helps customers to safely and efficiently produce small molecule and biologic drugs in volumes sufficient for clinical trials all the way up to commercial sales. 

Investors have rewarded the company's position in the global value chain by pushing the stock to all-time highs. It helps that the contract development and manufacturing organization (CDMO) has inked deals to produce the potential SARS-CoV-2 vaccines from Arcturus Therapeutics and Johnson & Johnson. Although, to be fair, Catalent was on a promising trajectory before the health crisis began. 

Given all of the moving parts, investors might be wondering if the momentum proves sustainable when the coronavirus pandemic runs its course. Is this growth stock a buy?

Image source: Getty Images.

The argument in favor

Catalent is one of the preeminent drug manufacturers globally. Each year, the company manufacturers 73 billion doses of drug and health products for 7,000 customers. It counts 83 of the world's top 100 branded drug companies as customers, including 21 of the top 25 generic drug companies and 23 of the top 25 biologic drug companies. 

The company can trace its roots back to the introduction of its softgel capsule technology in the 1930s. Still a leader in softgel delivery technology today, Catalent has since expanded into quick-dissolve tablets, liquid dosing technologies, gene therapy vectors, and cell therapy platforms. 

The recent acquisitions of Juniper Pharmaceuticals, Paragon Bioservices, and MaSTherCell have positioned the business to become a leader in high-growth biologic drug markets. Investors have realized instant results. In the first nine months of fiscal 2020, Catalent's biologics segment grew revenue 67% compared to the year-ago period. Total revenue grew 20% in that span. 

The 2020 coronavirus pandemic has highlighted the prudent timing of the company's recent focus on building out biologic drug manufacturing capabilities. Pharma and biopharma companies around the globe have approached Catalent with 100 opportunities and 90 unique molecules specifically aimed at treating COVID-19 or inoculating against the SARS-CoV-2 virus. By the company's estimate, that represents nearly 45% of the product candidates in active development aimed at the health crisis. 

Catalent is quickly scaling operations to meet customer demand. It has hired 300 additional personnel to maintain 24/7 manufacturing schedules. It also announced high-profile partnerships to manufacture SARS-CoV-2 vaccine candidates from Arcturus Therapeutics (scaling to provide hundreds of millions of doses annually) and Johnson & Johnson (scaling to provide an undisclosed number of doses). 

With or without a sustainable bump in long-term revenue from coronavirus vaccine manufacturing, Catalent has solid growth opportunities in biologic drugs. In fact, there are over 1,550 clinical trials under way involving monoclonal antibodies, gene therapies, and cell therapies alone. Investors looking for a lower-risk way to tap into the growth of biopharmaceuticals might find this stock to be a great fit. 

Image source: Getty Images.

The argument against

Investors that dig into the finer details of Catalent's business will uncover one potential show-stopper: how income is distributed among shareholder classes. Sure, the business is growing at a healthy clip thanks in large part to acquisitions in biologic drug manufacturing, but financing agreements forged to close the deals are not kind to individual shareholders. 

Catalent has two classes of stock: common stock (what individual investors like you and me own) and preferred stock (what was handed out in return for $650 million to finance the acquisition of Paragon Bioservices). As the name implies, preferred shareholders rank ahead of common shareholders. In addition to earning an equal share of net income as common stock, preferred stock earns a 5% annual dividend. The dividend is paid from net income before profits trickle down to common shareholders. 

The result: Catalent is growing revenue and earnings at a healthy clip, but individual investors have seen their share of net earnings decline by 42% as preferred shareholders siphon profits. 

Data source: SEC filing. YoY = Year over Year.

To be fair, individual investors can still benefit from rising revenue and total net income through a rising stock price. That alone has made Catalent a great investment in the last year. But there are risks to the class divide. 

In addition to siphoning off the 5% annual dividend from the company's earnings, preferred shareholders can convert their shares into common stock at a price of $49.54 per share. That would amount to a premium of 57% based on the stock price on May 29. If preferred shareholders are tempted to convert their holdings, then it would dilute common stockholders by 8%. 

Of course, if preferred stock is converted into common stock, then individual investors wouldn't have to share earnings with a senior stock class. That could be a win-win scenario, especially as the stock price closes in on $80 per share. But the point is that the mere existence of preferred shares adds a layer of complexity to an investment in Catalent that many individual investors might not understand or might rather avoid.

Catalent is expensive right now, but don't ignore it

Investors with a long-term mindset can appreciate the growth potential of Catalent. The business spreads operational risk across dozens of locations and thousands of customers across the globe. As a leading manufacturing partner for clinical and commercial drug assets, investors don't have to be too concerned with disappointing clinical trial results from customers. That alone makes the stock an intriguing way to own a piece of the biopharma space.

That said, the market has placed a steep premium on the stock in light of recent manufacturing partnerships for SARS-CoV-2 vaccine candidates. Such deals might result in significant value in the next year or two, but they might fizzle out with disappointing clinical results. Either way, investors have to acknowledge the risk that they'd be overpaying for shares at current levels. And that's before factoring in the accounting complexities presented by preferred shares.

Given all of the moving parts, investors might want to wait to purchase shares until the stock price recedes from current levels. The business might very well be worth more than $12 billion in five years from now, but the volatility of the situation would suggest a better entry point awaits patient investors.