Microcap Harvard Bioscience is spinning off a high-potential, loss-making division, and the market isn't recognizing the value, leaving an attractive special situation. My Special Situations portfolio is buying $1,000 of the company on the next market day.
Harvard Bioscience has two divisions: the Life Science Research Tools unit and the Regenerative Medicine unit. The latter business, called Harvard Apparatus Regenerative Technology, or HART, gets all the headlines for its regenerative medicine, which produces replacement organs using stem cells. The U.S. Department of Health and Human Services estimates a $100 billion market for regenerative medicine in the coming years.
Currently, HART's trachea product is in the clinical stage, and it foresees using its methods to grow organs such as hearts, livers, and kidneys for transplants. Initial work has been positive, with successful tracheal transplants reported in the peer-reviewed journal The Lancet, as well as mainstream papers such as the Wall Street Journal and New York Times. Commercialization won't begin until 2015, if the company receives EU approval for its first product. It's all exciting stuff, but I'm not interested.
What I am interested in is the remaining parent, the tools division, which is about as boring as the other division is exciting. It develops, manufactures, and markets specialized products for the life sciences, including syringe pumps, ventilators, and spectrophotometers, among 11,000 other products. Harvard focuses on this range of niche offerings in order to fly below the radar of the bigger players. It uses direct sales (58% of revenue) -- such as its salesforce, website, and 850-page catalog -- but also third-party distributors (42%) to sell to researchers at universities, government labs, and pharma companies.
To grow, the company uses a combination of in-house product development and tuck-in acquisitions (25 since 1996) that leverage its distribution network. Using this approach, Harvard Bioscience targets a 15%-20% annual growth in earnings per share.
The special situation
Harvard Bioscience is undertaking the quintessential Greenblattian special situation: a spinoff of a high-potential, loss-making division from a stable, cash-generating parent. Removing the loss-making division from Harvard's books, the transaction should double the parent's profitability, leaving a very cheap stub stock. And where does that losing division go? It becomes a clinical-stage company working in regenerative medicine. That spinoff has sex appeal to spare, but I'm interested only in the cheap parent.
Harvard intends to sell 20% of the subsidiary for $20 million in an IPO shortly, retain the remaining 80% for four months, and then spin that stake out to shareholders. Because the spinoff should comprise such a huge portion of Harvard's market cap, I want to own the stock before the transaction happens.
It's also great to see a management that wants to create value through a spinoff, instead of having its arm twisted by activist investors. But that makes a lot of sense, since management owns 14% of the stock outright and has another 14% via options.
For the year, Harvard Bioscience expects non-GAAP (ahem, "adjusted") earnings in its life science division of about $11.5 million, or $0.40 per share. Its HART unit expects to lose $6 million this year. So what could Harvard be worth as two separate businesses?
In the table below, I've chosen a range of earnings for the parent (in millions) and a range of multiples. For the valuation of HART, I've used a 40% haircut up to the full implied value of the IPO of $100 million.
Value of HART
Price Per Share
With the spinoff providing a clear valuation on that side of the business, we have little downside on the remaining parent and the possibility of substantial gains -- low-cost optionality. As a rough guide, it looks like the parent is trading at three times earnings, netting out HART's full implied value of $100 million. And remember that the parent aims to grow earnings 15%-20%, something that should draw Wall Street's attention. I peg the downside at $4 and the upside at $10.
The most obvious risk is that the IPO of HART doesn't happen. The IPO market has been somewhat weak lately, and selling even $20 million of HART stock -- despite the potentially huge upside -- could be difficult. Even if the IPO does happen, execs may decide at any time to shelve the spinoff. But that seems unlikely, given management's buy-in and the strong economic rationale for the transaction.
Even if the spinoff happens, the small size of Harvard Bioscience may mean that it remains underfollowed. The market may not notice the high growth Harvard is aiming for, and would be unlikely to pay a high multiple for the stock, trimming the possible upside.
Harvard Bioscience relies a lot on acquisitions to grow its revenue, so the company needs to make smart buys. For serial acquirers, in particular, this is a big risk. In Harvard's case, it has $59 million in goodwill and intangibles of a total $131 million in assets -- relatively huge. This risk is mitigated by the fact that Harvard's purchases are largely "tuck-in," so that any one bad purchase is unlikely to hurt much. Also, the high executive stock ownership -- the CEO has 8.4% -- should help protect us against reckless empire building. But a series of bad buys could leave us questioning management's acumen.
Foolish bottom line
On the next market day, I'll be buying $1,000 of Harvard Bioscience in my Special Situations portfolio.
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The article I'm Putting Real Money on Harvard Bioscience originally appeared on Fool.com.
Jim Royal has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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