Investing in stock spin-offs is a great way to generate alpha. The Bloomberg spin-off index has generated annual returns of 13.99% since inception in 2002, beating the S&P 500 by 4.22% per year, observes Rich Howe, editor of the specialized advisory service, Spin-Off Stock Investing.

What is less well known is that investing in the parent of the spin-off can also be a profitable strategy. Recro Pharma (REPH), an outsourced manufacturer of pharmaceutical drugs, is a perfect example of why.

In November 2019, Recro Pharma Inc. spun off its money losing Acute Care Drug business, in a taxable transaction. This Acute Care Drug business was expensive to operate and masked the strong fundamentals of REPH’s remaining business — an outsource manufacturing and development organization (CDMO).

Recro Pharma’s remaining business is defensive, on pace to grow revenue 34% in 2019, and generates a 39% EBITDA margin. Despite robust fundamentals, REPH trades at 8.9x 2020 EBITDA and 15.3x 2020 EPS, a massive discount to peers.

The secular trend of pharmaceutical companies outsourcing manufacturing in ordre to cut costs is driving continued growth for CDMO companies. The industry is fragmented and M&A activity has been very strong.

With Recro Pharma, we have three ways to win.

First, REPH is a defensive, high margin business that will grow earnings 15% to 20% in 2020. Thus, even without multiple expansion, the stock should generate a 15% to 20% return.

Second, earnings estimates (both EBITDA and EPS) are way too low for 2020. Consensus EPS is $0.58, but I believe the company will earn $1.13. If REPH beats EPS estimates, the Street will have no choice but to re-rate the stock higher.

Third, REPH is an excellent acquisition candidate. 5 out of 7 peers that REPH lists in its 10-k have recently been acquired. The median acquisition EV/EBITDA multiple of 16.5x is significantly above REPH’s current valuation of 8.9x. In an acquisition scenario, there could be 50% to 100% upside. Buy Recro Pharma to take advantage of significant upside optionality.

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