On the cover of the fifth edition of Dr John Oxford’s book Human Virology is a picture of the Wuhan strain of the coronavirus. It was published in 2016.

The virus spherical, with hundreds of nasty looking bulbous projections on its surface. Viewed through a microscope, the projections resemble the sun’s corona. Hence the name. 

Showing me Dr Oxford’s book is Cathal Friel, the Chairman of the small cap pharma services company Open Orphan (LN:ORPH). Friel is showing me the book because five weeks ago his company, Open Orphan, acquired the virus-fighting company founded by Dr Oxford. 

The company is called hViVo. Open Orphan started negotiations to buy it in November, the deal formally closed on the 20th of January. Right in the middle of the deal, the coronavirus pandemic hit the news. 

Human coronavirus

You’d forgive Friel if he had mixed emotions about the outbreak. hViVo is a viral epidemic specialist. It has a state of the art 24-bed quarantine lab, with all the IP and infrastructure needed to quickly test new drugs and cures. Working on the coronavirus, the pharma giant Merck has booked up hViVo’s entire quarantine facility.

Investors were clearly paying attention too. In early January, trading in Open Orphan’s shares hit an all-time high as buyers flooded into the market.

Undoubtedly, Open Orphan got lucky. Nobody could have foreseen the outbreak. So why, then, did Open Orphan buy hViVo? 

It’s all part of Open Orphan’s two-year strategy. Starting last summer, and through acquisitions, Open Orphan has built up a modest-sized pharma services business. The final step of the plan is for one of the industry giants to come in and buy it. 

Fastnet to pharma

The Open Orphan story starts, bizarrely, with an oil explorer. After co-founding Merrion Stockbrokers (sold for €80 million in 2006), Cathal Friel went looking for oil in the Celtic Sea. He set up Fastnet Oil & Gas in 2012.

Fastnet didn’t have any luck with the oil exploration, so in 2016 it decided to pivot into a similarly hit-and-miss industry: early stage drug development. It took over a privately held drug development company called Amryt Pharmaceuticals. “A pharmaceutical company is high risk, high reward”, says Friel. “Like oil and gas — if you find the right drug it’ll go through the roof, if you don’t it’ll collapse”.

Amryt was focused on treatments for rare diseases, sometimes known as orphan diseases. Treatments for orphan diseases don’t have a mass market, so they’re often less thoroughly-researched than treatments for common diseases. Big pharma companies don’t tend to focus on them. Against the odds Amryt had success with its orphan drug discovery business. It now has an enterprise value of £450 million.

The Amryt experience taught Friel a couple of things. The first is that there’s money in orphan drugs. The second is that there’s a better, less risky way to make money in the pharma business than finding new drugs.

Pharma, without the risk

Icon is one of Ireland’s great companies. Started in Dublin in 1990, it’s now an industry-leading global giant worth over €8 billion. 

Icon is in the drug development business, which is related but different to the business of finding new drugs. Icon is what’s called a CRO — a clinical research organisation, or contract research organisation. 

What Icon does is help big pharma companies test and develop their drugs. Big drugs companies like Pfizer and Roche go to Icon and pay them a fee for their services. 

Icon takes no risk. It gets paid whether the drugs pass trials or fail. In the pharma business, where trial results are highly unpredictable, this is crucial. 

Open Orphan is trying to build a miniature Icon. Like Icon it gets paid by pharma companies to develop drugs; like Icon it gets paid whether the trial is successful or not. Unlike Icon it develops orphan drugs for smaller drug companies. Where Icon works with Pfizer, Open Orphan works with Genmab and Carna Biosciences.

Open Orphan’s terms with its customers are very favourable. It gets paid on a cost-plus basis, meaning it’s paid for all it’s expenses plus a bit extra to allow for its profit. 

A merger mania

Another thing about the CRO industry is that it’s highly concentrated. There are seven or eight large players who between them control 60 per cent of the market. Then there are hundreds of tiny firms. 

The big players dominate because their main customers are the large pharma firms. They like dealing with the one major partner who can provide a full comprehensive clinical trial solution for all their needs.

M&A is common in the CRO business. Icon for example has built itself up by bolting on smaller CRO businesses — it’s done 28 acquisitions in total since 1990.

M&A has been particularly busy lately. According to Bloomberg there was $24 billion worth of MA in 2016 and $13 billion in 2017. The big CROs are the ones doing the acquiring, along side private equity groups like Carlyle who’ve joined the market recently. 

Open Orphan’s plan, then, is to be bought up by a bigger player. The way to get snapped up by a bigger player in this industry, according to Jeffries’ David Windley, is to built up a special capability in a niche area: “The big CROs are not interested in acquiring a tiny version of themselves. To be an attractive acquisition target, the smaller CRO would have to be expert in something — whether it be liquid tumour oncology, patient engagement technology, or rare diseases.”

Built to sell

Open Orphan is positioning itself, then, as a rare disease CRO and therefore as a desirable acquisition target. How has it gone about building a rare disease CRO?

The first step was acquiring Venn Life Sciences. Venn has been knocking around for years. It first floated on Aim in 2012, with a share price of 35p. That turned out to be as good as it got for Venn; over the following seven years the share price drifted steadily downwards. When Open Orphan acquired Venn for £5.7 million in June of 2019 it was trading at 2p. By then Venn was losing £5 million on revenue of £22 million. Open Orphan paid 0.25 times revenues for it. 

Why did it acquire Venn? Venn was a nearly-complete CRO business with a lot of fat to cut. Overheads at Venn were huge, particularly in the management layer. Friel says “Venn, when we took it over, had 179 staff. We got rid of 45 staff last year and revenue went up”.

Venn offers drug development services up to phase II. In addition it’s creating a potentially-valuable database of clinical trial data, which can be used to quickly run tests on computer without requiring extra lab work. It also has a virtual salesman product, which is a sort of customer relations management tool which is aiming to undercut the market for highly-paid pharmaceutical salespeople. 

At the end of last summer, having taken over Venn Life Sciences, Open Orphan was making the case that it needed another acquisition to get to that magic £30-40 million mark. The amount of revenue needed in order to be a viable takeover target.

The hViVo deal went through, as we’ve seen, in January. Open Orphan paid £11 million for it, all in shares, at a valuation of 0.8 times revenues.

How do Venn and hViVo fit together? hVivo specialises in challenge studies for viruses, which are a specialised part of the drug development business. It’s a service Venn did not offer. The two businesses hang together quite nicely in that they each develop drugs for rare diseases, but in different ways. 

hVivo has raised more than £100m since its IPO in 2012, much of which has been invested in the business. For example it owns the 32 bed quarantine lab, challenge models for quickly testing treatments for various diseases, and 49% of a universal flu vaccine called Imutex, which has passed phase II trials.

What about the coronavirus? Well clearly it’s tough to know what’ll happen with it. But it could help Open Orphan if it pushes governments to pay for a generalised flu vaccine, something they haven’t been willing to finance before now.

As with Venn, there’s been a lot of cost-cutting going on at hViVo. It got a new management team last year. Friel says, “Trevor Phillips and Tim Sharpington came in 18 months ago they took out 11 million of the overheads”. Like Venn, hVivo is expected to be cash flow positive by the end of the first quarter — ie by April 2020. 

Who’d buy it?

Open Orphan is currently valued at just shy of one times sales. It’s hoping to get to two to three times sales and then get picked up, presumably at a nice premium. What’s more, this is all meant to be wrapped up in the next year and a bit.

The next question is, how likely is a bigger CRO is come in for Open Orphan? Friel is very confident

Getting to a 2-3x multiple is easier said than done. Open Orphan’s constituent companies had been losing an awful lot of money. Even if cutting costs, particularly salaries, gets it to cash flow positive in the first quarter, there’s still a long way to go to profitability. The best CRO businesses make a net margin of 8-15 per cent. For Open Orphan that would be a net income of £3m or so, which is a long way from Venn Life Sciences’ £5m loss in the year leading up to June 2019.

The next question is, how likely is a bigger CRO is come in for Open Orphan? Friel is very confident: “Every time a company gets to £30 or £40 million [sales] they get bought up. Because it’s cost-plus. And they make loads of cash.” The CRO M&A market looked to peak in 2016, at least among big companies. Deals in 2018 and 2019 look to have been fewer, and for smaller companies. According to Capstone Headwaters, an M&A advisor, there were 27 deals in 2018.

According to David Windley of Jeffries, a broker, the question is whether a CRO of Open Orphan’s scale is big enough to be acquired: “The big players have been making acquisitions of players with 200-500 million in revenue… without a special capability, it’s too small for them to bother with”. 

When it comes to the fabled acquisition, it’ll all come down to whether the CROs need to specialise in orphan drugs. Results Healthcare, a consultancy, says big CROs want: “specialised players who can offer key capabilities otherwise lacking from the acquirer’s portfolio”.

From £5m loss to £100m valuation

Nine months ago, Venn Life Sciences was headed to the wall. It was losing increasing amounts of money and running out of cash. The Open Orphan deal recapitalised the business and provided a lifeline. How healthy is it today?

For small caps, the cash flow statement often tells you more than the income statement. That’s because there are all sorts of ways profit can be defined upwards or downwards. Cash flow is harder to fudge. 

Small caps also don’t have easy access to credit and other types of financing. If the cash runs out, that’s often the end of the business. That’s why for small caps, particularly turnaround cases like Open Orphan, cash in the bank, operating cash flow and free cash flow are the key numbers to watch. Operating cash flow tells you how much the core business is making or burning. Cash in the bank tells you its margin of safety.

How does Open Orphan stack up? It’s got £7.2 million in the bank right now. Both components of the business, Venn and hVivo, have been losing money and burning cash. But both companies have been in cost cutting mode. And as we’ve seen, both arms of the business are expected to turn cash flow positive this year. Added to that, it has just £1.6 million in debt. 

Cutting costs and getting out of the red is the first step. The next is to make a profit. It would be difficult to justify an acquisition of any business which isn’t accretive to earnings on day one. Then the hope is, once Open Orphan has demonstrated it’s a profitable, sustainable, specialised CRO, a bigger player will come knocking.

Open Orphan acquired the two businesses for .25 and .8 times revenue, respectively. A healthy CRO would expect to be valued at two to three times revenue. So that’s the plan. Get the thing valued at about two to three times revenue, which would be somewhere between £60-100 million. Today it’s worth £31.4 million. 

Friel’s staying positive. He expects to get it done – and quickly at that. “Let’s not hang around,” he says.

The coronavirus mania should have pumped up Open Orphan’s share price. That didn’t happen. What happened instead was a massive spike in trading with little reaction in the share price. Big institutional investors, who’d been in Venn Life Sciences for years, saw their chance to get out. “Our share price should have doubled”, says Friel. “But we had Jupiter at 7 per cent. And they just wanted out. The problem with small caps in London, you’ve lot of institutions who have just said ‘anything below fifty million, we’re out’”.

So Open Orphan shareholders are sailing into the wind. Big institutional investors are still looking to offload their stakes in the company. Jupiter has gotten out but according to Friel, there’s another big investor still looking to sell.

Friel’s staying positive. He expects to get it done – and quickly at that. “Let’s not hang around. Sometime around the turn of the year once we’ve proven we’re cash flow positive, once we’ve proven we can make money, once we’ve gotten rid of all these middle management, hopefully look for an exit by the turn of the year. And not be greedy.”