Harrow Health: The Market Is Missing the Forest for the Trees (NASDAQ:HROW)

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The following segment is extracted from this letter from the fund.

Harrow Health (NASDAQ: HROW)

I have written about Harrow Health in my previous two letters to you, but I find it necessary to continue to explain my thought process to convey my belief in the company.

During periods of negative performance, I believe it is more important than ever that our partners understand my thought process so that you can adequately understand what I am doing as your manager. HROW is our biggest position, our biggest critique year to date, and the opportunity I’m most excited about over the next six months.

Harrow Health is a healthcare company focused on ophthalmology. The core business, ImprimisRx, is a compounding pharmacy that customizes medications to the needs of eye doctors and their patients. It is estimated that north of 90% of ophthalmologists and optometrists use complex formulations in their practice.

Physicians choose to work with ImprimisRx because they are the largest and most trusted compounding pharmacy in the eye care market and have achieved this by solving pain points for physicians and their patients where others cannot meet their needs. An example of how ImprimisRx was able to solve a pain point was related to cataract surgery and the dosing regimen required after the surgery.

This dosing regimen is usually for 30 days and requires three sets of eye drops with different doses, different duration of dosing, and if not followed properly, can lead to inflammation and infection. This can be a complex and confusing process, especially for an elderly individual with reduced cognitive abilities. ImprimisRx has been able to simplify this process by combining the three separate solutions into one bottle with a much easier dosing regimen for the patient to follow.

This alternative comes for about $75 out of pocket compared to an insurance copay of about $150-300 on average for the three separate solutions. It also eliminates the burden placed on the practice to obtain prior authorization from insurance companies for the three separate solutions and the expenditure of additional time educating patients on dosing regimens. This allowed ImprimisRx to rapidly expand into this market, becoming a trusted partner to the optometric industry and creating a lucrative market for the company, resulting in a return on invested capital of over 100%.

If this is such a lucrative business for ImprimisRx, why isn’t capital pouring in to eat into their margins? This is the first question you should ask yourself when analyzing any growing business that earns a high return on invested capital. The most important reason is that the industry’s regulatory framework has created a barrier to entry that has allowed ImprimisRx to create a moat around this business that the competition will have trouble catching up to if they want to dethrone them. Compounding pharmacies are categorized into two segments, 503A and 503B.

503A pharmacies can only fill orders for each individual patient (the pharmacy must then receive patient information, payment, and mail the prescription). 503B pharmacies are able to manufacture products in bulk before a doctor prescribes to a patient, allowing them to sell their products directly to doctors’ offices, hospitals and ambulatory surgery centers (the patient receives their prescription before leaving the office).

In order for a compounding pharmacy to obtain 503B status, it must invest significant capital in its operations to meet FDA guidelines, inspections, and cGMP (current Good Manufacturing Practices) guidelines, just like big pharmaceutical companies. ImprimisRx was the first mover focused on the optometry market to become a 503B pharmacy. This first-mover advantage has allowed them to outpace any competition and become a respected source for ophthalmologists and their patients.

At this point, the only practical way for a competitor to gain share would be to invest significant dollars to become 503B compliant, undercut costs, incur significant losses, and gain the same status that ImprimisRx has earned. Most doctors are unlikely to put their reputation and practice on the line to switch to a competitor for a cheaper alternative from a lesser-known source.

In 2021, Harrow Health began expanding into branded pharmaceuticals (BPP), acquiring the rights to several new products. Their goal with this expansion is to leverage their knowledge, relationships and customer trust they have established with the ImprimisRx platform to provide FDA-approved products to physicians and their patients that complement the compounded pharmaceutical products (CPP) they already offer. The most promising of the newly acquired drugs is AMP-100.

AMP-100 is a proprietary topical intraoperative anesthetic drug that Harrow believes will be a great product to use with the 4 million cataract procedures and nearly 6 million intravitreal injection procedures performed annually in the United States. The product has completed its Phase 3 trial and is scheduled for an FDA approval decision with a PDUFA date of October 16, 2022. Harrow estimates that AMP-100 has the potential to double the company’s revenue by 2024 based on their already 20% market share share of product use in cataract surgery.

The expansion in BPP has led to increased costs as the company ramps up its marketing and sales to introduce FDA-approved products, but has clouded the profitability of the core CPP business. The expansion of FDA-approved products will further serve to strengthen the ImprimisRx platform as a pharmacy access for ophthalmologists and their patients. By giving up profits today, the company is expanding its business to increase the likelihood of long-term success.

With the stock down roughly 45% from its highs, I think the market is missing the forest for the trees. To get a sense of the disconnect between market price and business value, we can separate the BPP expansion and its costs from ImprimisRx’s core CPP business. In the first half of 2022, revenue grew 35% year over year and is on track to surpass $85 million for the year with a 74% gross profit margin. Stripping out the increased start-up costs of the BPP business, the current G&A rate for the CPP business approaches $37 million per year.

ImprimisRx’s CPP business will produce about $0.90-$1.00 per share in operating cash flow in fiscal 2022. The stock recently traded below $7.00 per share. At this price, expansion into BPP is a free growth option that has the potential to double earnings by 2024. Management is excited about what the future holds for HROW and they are incentivized to follow through on their plans. Members of the senior management team have been issued a significant cash value of performance share units (PSUs) that are tied to specified stock price targets of $11.70, $15.60, $19.50 and $21.45.

Harrow Health is a largely recession-proof business, trading at a deep discount to fair value with years of significant growth ahead of it. As the company continues to execute on its plan and further strengthen its competitive advantage, investors will begin to realize the value being created.

Editor’s note: The summary points for this article were selected by the editors of Seeking Alpha.

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