Woodford Patient Capital Trust

Friday, March 29, 2019 - 14:49

Neil WoodfordWoodford Patient Capital (WPCT) is a concentrated portfolio of early stage unquoted and quoted companies, focused on technology and healthcare, with high return potential and high levels of stock-specific risk. It is run by Neil Woodford, one of the most high-profile fund managers in the country.

Whilst the trust has had its share of difficult periods, NAV returns in 2018 were strong, with the trust’s NAV up 7% while the FTSE All Share fell 9.5%. Undoubtedly the high level of unquoted assets held (66%) helped the trust outperform in a falling market. However, there were also valuation increases on some stocks which hit milestones, as well a successful IPO of Autolus - a major holding at 10.9% of NAV.

On 1 March the trust announced it had agreed to purchase £72.9m of stock in unquoted companies held by the Woodford Equity Income Focus fund (WEIF) with new shares issued at NAV in a tap issue, and also received £6m to fund those companies from WEIF in the deal. This allows the trust to increase its exposure to stocks Neil thinks are some of the most promising in the portfolio: Atom Bank, Carrick Therapeutics, Cell Medica, RateSetter and Spin Memory.

Prior to the announcement we spoke with the team to get an update on the progress of the portfolio companies, which we discuss in detail below. The team believe that there is scope for 2019 to be even better than 2018 in performance terms, with the portfolio companies largely at more mature, less risky stages of development and a number of significant milestones on the horizon, which we analyse later.

Although the greatest contributor to performance in recent months since our last review has been Industrial Heat, written up by 357%, there have been interesting developments in other portfolio companies which could prove more significant in the longer run, such as with Oxford Nanopore (see portfolio section). Proton Partners’ listing on the NEX Exchange in February 2019 at a substantial uplift to WPCT’s initial investment could also prove to be a significant step for that company.

The discount has narrowed since we first highlighted the trust, coming in to 12.8% from the wider range of 15-20% through much of 2018.

WPCT has no annual management fee. Although there is a performance fee, after the March tap issue it won’t be payable until the NAV reaches 146p, a 50% uplift to its current level. This means that investors will only pay the 0.18% ongoing charges until that mark has been passed.

Portfolio

WPCT owns a portfolio made up of early-stage businesses, with a mixture of quoted and unquoted positions. The goal of the trust is to take advantage of the outsized returns that can be made from investing in quoted and unquoted businesses at the early stages of their development and following them through listing to a more mature stage. The ambitious aim is to generate a greater than 10% NAV return per annum, and although returns have been disappointing so far, the manager, Neil Woodford, remains convinced this growth potential is in the portfolio and that there are a number of positions held by the company which will be larger than the entire portfolio in the fullness of time.

Neil focuses on picking business that he believes have the chance to be successful through the use of new technologies and in whose management teams he has faith. The largest area of concentration is in pharmaceuticals and healthcare technology, as this is where Neil sees the greatest number of attractive ideas and innovations in the UK and globally, with demand well-supported by demographic trends.

Woodford Patient Capital

Source: WIM

We spoke to the team recently to get an update on the progress in the portfolio. Both Paul Lamacraft (technology) and Saku Saha (healthcare) are very optimistic for 2019, foreseeing a number of milestones and developments. Since our latest update in August the NAV is up 5.8%, and did briefly rise above 100p.

The most significant development for NAV during the period was Industrial Heat completing a successful funding round leading to the value of Woodford’s holding to be written up by 357%. This was based on calculations by the AIFM (Link Fund Solutions) and is discussed in detail in the performance section. Industrial Heat makes up 9.74% of the portfolio after the revaluation, in four lines of stock.

In our opinion, however, the most promising developments regard Oxford Nanopore. This company has developed long-read gene sequencing devices and has been a major holding since launch. It received a £50m investment from US biotech giant Amgen during the second half of last year.

We would argue that more important was the decision by its main competitor, the £32bn market cap Illumina, to purchase Pacific Biosciences in order to acquire its long-read gene sequencing technology. Previously, Illumina had insisted that short-read was the way to go, but this acquisition is a recognition that there are huge advantages to the long-read approach and they are now playing catch-up in this market, which they assess to be worth £540m in annual revenues. Clearly, their purchase of a competitor is a significant validation of Oxford Nanopore’s approach. In conjunction with Amgen’s investment, the team is bullish for the company’s prospects.

Saku says that he expects to see the company hit profitability in 2019 which would be a huge boost to the trust in our view, not only for the potential gains to NAV – Oxford Nanopore is 7.5% of the trust – but as validation of the stock-picking abilities of the team in this area. Oxford Nanopore was valued at $1.5bn in the last full year accounts, and the IRR since investment has been 9% a year.

Oxford Nanopore’s size as a proportion of the portfolio means it is potentially the most significant success story this year. However, there are a number of other unquoted stocks with potentially transformative periods coming up.

Kind Consumer, for example, has developed a smoking cessation cigarette which has recently become the first NHRA approved such treatment. The product should finally come to market in 2019. This is a long-term holding, which has been revalued downwards since Woodford invested, for an annual IRR of -21%. Should this product come to market and the company be revalued upwards as Paul expects, it would be a validation of the patient approach taken by the team since launch. It is a 1.35% position in two lines of stock.

This year could also be an exciting one for Federated Wireless. The company has developed technology which facilitates the sharing of the spectrum of frequencies used for transmitting wireless signals. This is potentially a highly useful service in a world which is increasingly connected online in real time but with a finite spectrum capable of carrying transmissions. Federated Wireless has submitted an application to the Federal Communications Commission for a license allowing them to launch. A decision would have been expected by now, but the shutdown of the US Federal Government has caused delays. Both the managers of WPCT and the company themselves are confident that the regulatory application will be successful, which could lead to an uplift in the valuation, which has been static since the position was first taken. The company makes up 1.3% of WPCT.

Lignia Wood (formerly Fibre 7) could also have an exciting 2019. The company has developed a modified timber product which has been successfully piloted. The task for the coming year is to go into commercial production, and WPCT has funded them to that end. The current market leader in this space has a £200m market cap and in the opinion of the Woodford team Lignia has a better, cheaper product. The holding has already been significantly written up, generating a 40% annual IRR for investors since initiation. Lignia is a good example of the sort of potential lurking in the tail of the WPCT portfolio. Overall, WPCT owns circa 50% of the company, representing 0.89% of WPCT, or roughly £9m. Should the company grow to the £200m size of its peer that would imply a gain of £91m, or 10 times the current carrying value. Of course, the mathematics is not so simple as that given the likelihood of capital raises on the way, but this is an indication of the types of rewards on offer for successful investments. On the other hand, ultimately some of the larger holdings need to make good returns for an investment in the trust to be a success over the long run.

Other unquoted stocks are developing more slowly than desired and perhaps foreseen, which is par for the course with this type of investment. That has proven the case for some of the trust’s largest holdings. Benevolent AI (8.89% of the trust) is making strides at integrating the research and development stages of drug development following the purchase of laboratories last March, however there are still probably 12 to 18 months before they bear fruit, according to Saku. For the investment to have real success this integration needs to be successful. Benevolent AI has generated a 20% annual IRR since the team first invested, but it will take further developments for that value to be realised in a sale.

Proton Partners (6.66%) saw its Wales centre approved by the NHS to treat cancer patients and has also started building a diagnostic centre in Liverpool. However, the NHS opening its own Proton Therapy Centre in Manchester, as well as a further one in 2020 in London, could be seen as a blow to the company given it implies that it will receive fewer NHS patients. Saku says, however, that even if the NHS maintains its belief that only 1% of cancer patients should receive the therapy it will be reliant on Proton Partners in the near future. On the other hand, it would need 20 centres to treat 20% of cancer patients with the therapy should it move its recommendations in line with those of other EU countries. The stock has generated an IR of 21% for the trust, but like Benevolent AI, future developments will be critical to whether that value can be realised. On 28 February the company listed on the NEX Exchange at a valuation of £347m, which represents a significant gain to WPCT on its initial investment.

Immunocore (5.11%) has entered into a co-development deal with Genentech, which will give it greater economic rights than in a normal license deal. It also has a trial ongoing with Glaxo of another asset, showing it is not a one drug business. However, both drugs are at early stages. In the long run, Saku sees the business growing to mid-single digit billions from its current $1.3bn, but patience will be required in the meantime. The annualised IRR to the end of December 2018 was 10% per annum.

Turning to the major quoted stocks, performance has been a headwind in recent months. One of the major disappointments of the last year has been PurpleBricks. The company lost almost two thirds of its value in 2018 and suffered a further blow in February 2019 as it cut revenue guidance for the financial year by 20%. Particularly disappointing are the poor results from the US business, where the board does not expect to meet targets. However, Neil and the team continue to prefer to take a long-term perspective on their investment and believe their initial investment thesis is still intact. From their initial investment (prior to flotation) to the end of 2018, the investment had generated an annual IRR of 57%. For the future, they believe that the unique and profitable UK business is its key advantage. Autolus has been flat in share price terms since IPO, but has shown promising data on its programmes targeting leukemia, lymphoma and myeloma, with its therapies so far passing safety standards. Key dates will come in March and November, when fuller results on trials will be presented. Only then will final stage trials be possible, so there is still a substantial time to wait for these treatments to come to market and prove profitable. Autolus makes up 10.93% of the portfolio. Sensyne Health (1.66% of the portfolio) has also been dull since IPO, although the team believes that the long-term investment case is strengthening.

Overall, Paul says that he believes the portfolio is at a de-risking stage when there is greater clarity about the potential of many of the holdings and increasing prospects for commercialisation in the coming year.

Gearing

The company can add gearing up to 20% of NAV, and is currently using the facility to the full through an overdraft, paying LIBOR plus 135bps. In March 2016 the trust started to use the facility, and over the past year has been consistently close to being fully drawn. The managers do not view this as structural though, as they foresee circumstances in which they could reduce the gearing relatively quickly. Nonetheless, we understand current levels of gearing should be expected to remain for some time. Clearly this adds to the risks of investing in the trust as well as the potential rewards

Woodford Patient Capital

Source: Morningstar

Performance

WPCT’s NAV is up 5.5% over the past 12 months, a good result in a year when the FTSE ended down 9.5%. Clearly, unquoted companies are not as subject to swings in sentiment as quoted ones are, and it is worth noting that private equity trusts on average also posted rising NAVs over the same period. However, the good results reflect the improving outlook for some unquoteds which were written up, frequently in the eyes of new investors who took part in later funding rounds. The trust has also benefited from holding some dollar-quoted equities. Most significantly, Autolus, which IPO-d last June and is the trust’s largest holding, is up fractionally since its debut in dollars, but dollars have gained 5% in sterling terms since then (WPCT also booked a gain on the IPO price within the period).

Woodford Patient Capital

Source: Morningstar

The most significant contributor since we wrote our last note was Industrial Heat. The NAV of the trust spiked by 9% in September 2018 following the upwards revaluation by Link Fund Solutions, the AIFM of WPCT. This followed a successful fundraising and represents a write-up of 357% to the previous carrying value. Industrial Heat is a controversial holding due to its research into cold fusion, considered impossible by most scientists due to the huge amounts of energy believed necessary to generate the fusion of atoms which it depends on (the sun generates energy through fusion reactions, but at a temperature of 27 million degrees Fahrenheit). It is worth noting that the revaluation was based on the funding raised from investors not an assessment of the science, although (presumably) the investors based their decisions on their understanding of the scientific developments. Industrial Heat is a secretive company, and it is also noteworthy that it is not entirely focused on cold fusion, so it is hard for third parties to properly assess its prospects.

The trust aims to generate NAV returns in excess of 10% a year over the long run and will charge a performance fee once the NAV has surpassed that hurdle rate. However, performance since launch means that is still some way away: NAV is down 2.4% since launch and the share price down 15.6%.

Woodford Patient Capital

Source: Morningstar

This trust is all about stock-picking and there have been a handful of companies with poor results that have hurt returns. The concentrated nature of the portfolio compounds the damage to investors just as it would magnify gains.

One of the most difficult periods for the trust was after a US short-seller targeted Prothena in November 2017. At the time, it was the largest holding in the trust, and Woodford Investment Mangagement (WIM) is the largest shareholder in the company. When the company’s amyloidosis drug failed phase three trials in April 2018, the trust took another hit. Neil remains convinced in the potential in the stock and has held onto his position. Share price falls in Purplebricks also hurt returns during 2017 and 2018. The stock sold off from August 2017 and helped push the NAV below 100p. However, overall the company has been a major contributor to the trust since launch. Neil believes the market is discounting the growth opportunities in Australia and the US too much, and retains 20% of the company, making WIM the largest shareholder.

Earlier problems came from Circassia, which saw its cat allergy drug fail phase three trials, and Allied Minds, a target in 2015 of a shorting attack by the same outfit which took aim at Prothena. In 2017 it saw significant share price falls after it discontinued funding to seven portfolio companies.

Woodford Patient Capital

Source: Morningstar

Dividend

According to the most recent report and accounts, the board will not be paying a dividend this year. The aim of the trust is to grow capital and there is no mandate to generate a dividend. There was a 0.16p payout in 2015 paid out due to regulatory rules requiring 85% of an investment trust’s income to be paid out to shareholders. This was from a number of mature businesses which were held in the portfolio before it was fully invested in early stage businesses. As such, reflecting the growth strategy employed by the managers, we think it fair to expect little in the way of dividends going forward.

Management

Neil Woodford is one of the most high profile fund managers in the UK, having generated an impressive track record over 25 years managing the Invesco Perpetual Income and High Income funds. His success was built on making contrarian calls on the stock market, most notably by staying out of the 2000 dotcom bubble and avoiding banks prior to the 2008 crisis. Investments in the tobacco and pharmaceutical sectors made when they were out of favour were also particularly successful. Neil’s success in the past has therefore been built on making unpopular calls and sticking to his guns when criticised intensely, a pattern which we may be seeing once again.

Woodford Patient Capital is a very different product to the income-focused funds he has previously run. However, Neil’s involvement in early stage companies dates back to the early 2000s when he invested in IP commercialisation companies, some of which form part of the network of contacts he currently uses to generate ideas. After investing in these ‘incubator’ stocks he then branched out into investing directly into the portfolio companies as they sought further funding, and these two types of investment together made up almost 10% of his Income and High Income funds when he left Invesco in 2014. This means that he has had many years’ experience of following early stage companies through from gestation to listing and beyond.

Neil has full control of investment decisions on this trust, but is supported by a team with a mixture of competencies and backgrounds. Paul Lamacraft came over with him from Invesco, where he used to work with Neil on the smaller companies in his income funds; his main responsibility is the ongoing research on the early stage technology companies in Woodford’s funds, including WPCT. Other key team members include Saku Saha and Lucinda Crabtree, who are responsible for ongoing research on the healthcare and bio-science holdings. Lucinda has a PhD in neuroscience from UCL and a background in the pharmaceutical industry, also covering it as a sell-side analyst.

The trust leans heavily on the strength of its network of contacts in the IP commercialisation industry, and the Woodford team are in constant contact with IP commercialisation companies and other private owners looking for co-investors. This means that their ideas come with a level of diligence already done, although the task then for the team is to verify and further that research.

Although he also runs the multi-billion pound equity income products, most of the team’s time is spent on this portfolio given that the nature of these companies demands greater research (and the fact there is around 20% crossover with the equity income portfolios). Of the seven individuals in the team, two are devoted to FTSE 350 companies, which mostly means they do not work on this trust, and five on WPCT or early stage companies.

Discount

The trust currently trades on a 12.8% discount. As the graph below shows, thanks to Neil Woodford’s reputation and popularity amongst retail investors, the trust launched on a premium which swiftly rose to 15%. Enthusiasm dwindled, and the trust swung onto a discount during 2016.

Woodford Patient Capital

Source: Morningstar

Some poor results from portfolio companies, discussed in the portfolio section, helped the discount widen. We would note the differing fortunes of the mainstream UK and global equity trusts however: since the Brexit vote to leave the EU, global trusts have seen their share prices move close to par while UK trusts have slipped onto a wide average discount. This gives some credence to Neil’s contention that the macro-economic environment and investor sentiment have had a significant part to play in the disappointing recent fortunes of the trust.

We would suggest that the 12.8% discount makes some sense in the context of the 8% average discount on the UK All Companies trusts tracked by Morningstar and the higher 16% discount on the average private equity trust. However, should strong results start to come through from portfolio companies we think it possible the trust will again trade on a significant premium to these comparators given its unique mandate.

The board has the authority to buy back shares, although it has not used it. The board currently believes that the cash reserves are better used investing in the portfolio, but has not ruled out using the authority in future.

Charges

The trust has no management fee, with the OCF of 0.18% covering only the administrative costs. Woodford IM will only be paid a performance fee once the trust has achieved its hurdle rate of 10 per cent returns per annum. This hurdle rate is cumulative, so for the manager to be paid a fee would require the NAV to rise from its current 96p to over 146p in the current financial year. The manager will be owed 15% of the NAV returns above the hurdle rate, subject to a high watermark. This is a highly attractive fee structure in our view, particularly for investors looking to invest now, who could see 35% returns on NAV charged at only 0.18% a year before they had to pay any performance fee.

March 2019

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