Value investing

With $19.5 Million in Coffers from Asset Sale, Sonoma Pharmaceuticals Sets Sights on Breakeven

Roughly two years into their turnaround plan, Sonoma Pharmaceuticals (NASDAQ: SNOA) ended October with perhaps the most substantive move to date to meet its initial goal of commercial breakeven. The company said it sold its Latin American and Caribbean Microdacyn-related assets to Invekra S.A.P.I. de C.V. for $19.5 million plus a decade-worth of royalties.  Invekra is the holding company for Laboratorios Sanfer, the Latin American distribution partner of Sonoma.

Money in the Bank Now…and Later 

Sonoma has already been paid $18.0 million in cash from Invekra and will be able to collect the remaining $1.5 million in escrow upon delivering certain equipment to Invekra, which is anticipated during February 2017.  With respect to the royalty, Sonoma is entitled to 3% of all Latin American and Caribbean revenues outside of Mexico.  Invekra has committed to a minimum royalty payment of $250,000 annually for the next ten years, meaning Sonoma is guaranteed at least another $2.5 million in revenue from the divestiture.

To say that Sonoma sold all its rights and assets to all of Latin America is bit of an overstatement.  The company smartly held on to dermatology rights in Brazil, the second biggest dermatology market in the world, trailing only the United States.

The Target Is, and Has Been, the U.S.

When Sonoma embarked on righting the ship late in 2014, selling off its stake in Ruthigen to Pulmatrix (NASDAQ: PULM), changing leadership and revamping the sales model, the cornerstone of the game plan was to focus on the lucrative U.S. dermatology market. Instead of relying on partners to sell its products domestically, Sonoma introduced a small sales force of its own and spelled out intentions of continuously growing the sales team and adding new products to their sales bag.

The company is looking to get a bigger share of the ~$13 billion U.S. market that is comprised of about 14,000 dermatologists working at around 8,000 practices.  Sonoma has been crystal clear in its multi-prong approach to grow its footprint in its core market, namely through a larger sales force, slow and steady prices increases, introducing at least four new products each year and using cash from non-core markets to build the higher-margin U.S. derm business.

To that point, Mexico is not a primary focal point of Sonoma’ growth strategy.  It’s a low-margin, low-growth market that has been challenged to expand, hamstrung in part due to lingering weakness in the Mexican peso.  In the quarter ended June 30, 2016, product revenue in Latin America was $1.1 million, down $460,000 (30%) compared to the year prior quarter.  Further, product licensing fees and royalty revenues had nearly evaporated due to amortization of upfront payments from Sanfer, which were slated to come to an end next September.

Incidentally, product revenue in Europe and the rest of the world (which Sonoma also retains) during the latest reported quarter increased 82% year-over-year to $1.0 million.

Growing U.S. Sales

Sonoma management hasn’t wavered in its commitment or approach to greater market capture in America.  After basically stripping U.S. sales to nothing to reboot the business model two years ago, product revenue during the latest quarter improved 74% from the year earlier quarter to $1.4 million.  Sales have been bolstered by the launch of eight new products and a sales team that started with just a handful of people expanding to 22 seasoned industry vets.

The promise of Sonoma has been to reach the tipping point where product sales outweigh costs associated with building an in-house sales force and launching new products.  This process can only be expedited with cash, which can be quite difficult to come by for a small specialty pharma, especially with a broad negative bias towards the healthcare sector in general for the last year.  Sonoma previously guided that it would need another $6 -$8 million to achieve commercial breakeven.

The sale of the Latin American assets not only relieves the company of the burden of trying to grow sales in a difficult market climate, but also provides the capital necessary for Sonoma to reach breakeven. Importantly, it was done in a non-dilutive fashion, without impeding new product development, launches or expansion of the sales team, which should have investors cheering.

Impact on Top and Bottom Lines

In selling the assets, Sonoma is giving up about $1.1-$1.2 million per quarter in product revenue.  That translates to about $1 million annually in earnings before interest taxes depreciation and amortization (EBITDA).  The EBITDA loss is trimmed by the $250,000 (at the minimum) royalty from Invekra, as well as interest gained on the banked portion of the $19.5 million in cash. When factoring in the potential for increased U.S. revenue due to the influx of new sales people in concentrated derm markets, the effect on EBITDA is further marginalized and eventually overcome.  

If It Walks Like It's Undervalued and Talks Like Its Undervalued…

Unexplainable disconnects in market valuations abound in the small and microcap markets.  There may not be a better example of this than with Sonoma.  As Sonoma CEO Jim Schutz explained in a shareholder call on the Invekra news, the company sold 30 percent of its lowest margin revenue for $19.5 million in cash plus royalties.  Extrapolating from that data, the other 70 percent of the company should be worth at least $45.5 million.  Without splitting hairs on that thesis, it’s easy to further argue that the company’s U.S. derm business in its present state, with a steeper growth curve, is even more valuable than the Latin America business.

Wall Street is all about forward-looking valuations, but that doesn’t seem to be the case with Sonoma.  In fact, investors are overlooking the obvious in that the company isn’t even valued fairly compared to the cash it has on hand.  The sale amount was greater than the total market capitalization of Sonoma at the time of the news. It is foreseeable that as Sonoma continues to fulfill its promises, the market could correct to a forward-looking valuation.