PRA Health Sciences (PRAH)
By Jeremy Butler, Editorial Analyst
PRA Health Sciences (PRAH) is a global contract research organization (CRO). These are entities that provide outsourced clinical development services to the biotechnology and pharmaceutical industries. The company has 75 facilities across North America, Europe, Asia, Latin America, South Africa, Australia, and the Middle East. Since 2000, PRAH has participated in approximately 3,550 clinical trials worldwide, leading to the domestic and international regulatory approval of 72 drugs. In the March quarter, the company derived 66% of its revenues from drugmakers and 34% from biotechnology creators. PRA Health Sciences has over 13,000 employees and is headquartered in Raleigh, North Carolina.
PRA Holdings was created by three physicians in 1982. In 2013 it was incorporated in Delaware and adopted the name PRA Health Sciences in 2014. In November, 2014, the company undertook an initial public offering of 60 million shares at $21.00 a share. The stock is listed on the NASDAQ under the ticker symbol PRAH.
The CRO Industry: A Primer
The CRO industry was conceived in the 1970s in order to save drug and biotech companies medication development expenses. CROs create the drug testing infrastructure, acquire the expertise (by hiring pharmacists and doctors), and seek the relevant patient bases (both animal and human) to test their clients’ drugs. By doing this with a greater quantity of products (economies of scale), they can typically get results in a less expensive manner than clients could if they performed the tests on their own. In addition, CROs maintain licenses and registrations to develop and market products in multiple countries. It is complicated, bothersome, and expensive for an individual drug company to do all of this on its own. Some drug companies try to skirt the use of CROs by pairing up and sharing testing services and facilities with peers. However, many of these arrangements end up becoming more expensive and complex than expected. Indeed, these R&D sharing arrangements can create unforeseen acrimony regarding which company has the rights to which patent. Lawsuits can ensue, costs often rise, and the co-marketing process can get messy.
CROs have become very sophisticated as clinical trials for more complex products have increased.Most CROs position themselves as generalists, but with a niche specialization. This enables them to cast a wide net, even if they are best known for their work in a few fields.
However, this strategy is a double-edged sword. Taking on more business than a CRO can handle often leads to a decline in reliability, efficiency, speed, and accuracy. This quickly destroys reputations, since inaccurate test results can easily occur in these situations. As a result, CROs walk a fine line by trying to increase their share of the pie without biting off more than they can chew. Annual revenue growth in the CRO industry has been averaging in the mid-single digits, but we expect that to increase to the high single digits over the next three to five years.
What Differentiates PRA Health Sciences From Other CROs?
PRA’s business model isn’t that different from the majority of players in the industry. It provides drug development services for biotech and pharmaceutical companies spanning clinical phases I through IV. It has therapeutic expertise in oncology, the central nervous system, inflammation, and infectious diseases. However, the two areas where PRA stands out are in medical informatics technology (see below) and clinical trials for diseases associated with infants and children. Rising demand for treatments for child populations in developing countries has increased the need for these services. Moreover, infants and children require slightly different medicines (and dosages) to treat the same diseases. Consequently, many trials are often needed for a single treatment. Medical informatics technology is the advanced collection and processing of data about patients, which leads to an increase in the efficiency of patient enrollment for specific trials and the distribution of trial results to the client. Essentially, it boils down to harnessing technology to produce better, more accurate data that are easier for clients to use. Other CROs are developing expanded IT capabilities, but PRAH is currently ahead of the pack.
Since its IPO in 2014, PRA Health Sciences’ top line has been growing at an approximate 11% average annual clip. Its bottom line has risen from a loss of $0.83 a share in 2014 (as a result of heavy R&D and marketing expenses, which have since moderated), to a profit of $1.29 in 2015 and $1.90 in 2016. Sales and share earnings are expected to tally $2 billion and $3.05, respectively, in 2017. Share net should reach $3.55 in 2018.
The company ought to generate free cash flow per share (net income plus depreciation less dividends and capital spending) of almost $3 in 2017. As of March 31st, the long-term debt-to-total capital ratio stood at 50%, a reasonable figure for a fast-growing company in the Medical Services industry. Cash on the books stood at $124 million, and working capital was $91 million. No dividend is paid, nor is one expected to be.
The CRO industry is consolidating, and we expect to see more deals like Laboratory Corp.’s $5.6 billion acquisition of Covance in 2015 and PAREXEL’s recent agreement to be bought out by private equity firm Pamplona Capital Partners for roughly $5 billion (this deal is expected to close in the fourth quarter). PRA’s specialties are attractive, as is its leading position in medical informatics, and since it is relatively small, there is a possibility it could be acquired by a larger CRO. The company’s good reputation for high-quality service, pediatric expertise, and quick turnaround times (due to its enhanced IT capabilities), has resulted in a strong backlog of business. Our estimates suggest that its sales and share earnings should grow at an 8% and 16% average annual clip, respectively, over the next couple of years. Despite the stock’s impressive run-up since it went public in 2014, we think it still has room to move higher.
At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.
Innophos Holdings, Inc. (IPHS)
By Kevin Downing, Editorial Analyst
Innophos Holdings (IPHS) is a leading manufacturer of specialty ingredients for the food, health, nutrition, and industrial markets. It uses a wide variety of inputs (phosphates, minerals, enzymes, botanical ingredients, etc.) to make custom compounds important to the taste, texture, and nutritional content of foods, beverages, pharmaceuticals, and oral care products. The company’s chemicals are used as flavor enhancers in beverages; electrolytes in sports drinks; texture additives in cheeses; leavening agents in baked goods; fillers in pharmaceutical pills; and cleaning agents in toothpaste. Some products also provide nutritional fortification for food, beverages, and supplements. The company also derives purified phosphoric acid, the primary ingredient in many of its downstream specialty products, from raw materials (such as phosphate rock). With more than 900 customers in 70 countries, the customer base is well diversified, with around 40% of sales coming from overseas.
On April 5th at the annual analyst day, management laid out the growth plan for the next several years. Dubbed Vision 2022, Innophos expects to reach $1.25 billion in revenue over the next five years, reflecting an increase of over 80% from Wall Street’s consensus 2017 top-line forecast of $693 million.
Much of that potential growth will likely stem from acquisitions. The company has narrowed down a list of more than 800 targets to just a handful currently. Screening criteria include a revenue growth rate between 4% and 6% at the lowest; the attractiveness of the industry served; market share penetration; degree of product innovation; and estimated profitability. The potential for revenue synergies originating from customer portfolio overlap is another desired quality. Too, any M&A targets IPHS ends up buying will likely be accretive to earnings per share within the first two years after closing. All told, the company is looking to add up to $475 million to the top line via acquisitions over the pull to 2022.
Notably, management recently reinforced its capital allocation strategy, prioritizing Vision 2022 initiatives first, followed by continuing the generous dividend payout (this equity’s yield was recently over 4%), since it “believes that our shareholders see value in [the dividend].” Finally, share repurchases come in at a distant third. The company paid $9 million in dividends during the first quarter, making the dividend payout ratio 87%. Although significant acquisitions are likely on the horizon, we are optimistic that the dividend payment will remain largely intact, but this is not certain.
In addition to buying up chemical makers in attractive growth markets, Innophos has recently revamped its sales model to better service long-standing relationships, which the company believes will continue to provide a competitive advantage. Efforts have been made to align the global sales force with the highest growing end markets and sales channels. Further, IPHS has joined marketing, sales, and technical professionals into three-person teams to better understand customer needs and develop new products that meet those unique requirements.
Long term, Innophos hopes to realize organic growth of approximately 5% per year. It looks to accomplish this by focusing less on the mature phosphate business and more on opportunities in the $70 billion specialty food ingredient markets and the $28 billion specialty health and nutrition market, which require value-added products, not just basic purified phosphoric acid. These areas are expected to grow in the mid- to high-single digit range over the next five years. Part of that will likely stem from what the company calls “megatrends,” including an increase in the number of health-conscious consumers and the corresponding rise in demand for “clean labels,” i.e., products with ingredients that are naturally derived, minimally processed, and/or organic. An aging baby-boomer population also augurs well for the long-term internal revenue growth rate, especially in regard to pharmaceuticals and fortified foods.
The other side of the Vision 2022 plan involves cost cutting. The first phase should net $16 million in savings from better negotiating on input costs. Much of this opportunity has already been realized as of the first quarter. The second stage will likely come from streamlining the supply chain through faster processes, better forecasting, and inventory optimization. These efforts are expected to yield $13 million in savings, $5 million of which is anticipated to come in the second half of 2017. Overall, the company hopes to widen the adjusted operating margin by 250 basis points over the next five years.
Recent Results and Guidance
Innophos has pegged 2017 as a “transition year,” owing to the investments and efforts to right size the product suite. Several underperforming product categories are being pruned, which contributed to sales falling 12% year over year in the first quarter. A little less than two-thirds of the drop came from lower volumes, with the rest stemming from competitive pricing pressure in certain product lines. The Food, Health, and Nutrition unit experienced a decrease in relatively high-margined export sales, owing to currency exchange restrictions in Venezuela and increased import tariffs into China. Both of those trends are likely to persist for the foreseeable future, but are fully accounted for in guidance. Meanwhile, sales in India were also somewhat weak due to a slowdown at a few pharmaceutical customers. We think deal timing was more to blame than an industrywide headwind, as the generic drug market in India has been strong in recent years. Meanwhile, we expect the impact from prior company-initiated product exits to abate in the third quarter.
Although the top line has come under pressure somewhat, the gross margin expanded 55 basis points in the first period and the operating margin grew 21 basis points. This was partly due to the pruning of unprofitable businesses, as well as cost-cutting activity. The company is currently calling for sales comparisons to improve sequentially in the second quarter, but still be down 5% year over year. For the full year, earnings are expected to be flat versus 2016. At present, Wall Street’s consensus 2018 earnings estimate calls for the bottom line to expand roughly 16%.
Investors willing to look past near-term weakness will likely be rewarded over the long haul. Many of the least profitable products will likely be weeded out by this time next year. We like the company’s efforts to improve the sales mix and have a favorable view of the growing food and nutrition markets in which IPHS is expanding its presence. This, coupled with acquisitions, should be enough to offset the legacy phosphate business, which will likely grow at a pace equivalent to GDP for the foreseeable future. The rich dividend payout, although not assured, may help convince income-oriented investors. The reasonable forward P/E ratio make the shares worth consideration from a value perspective, in our view.
At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.
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