Description

This is a very simple pitch. I would bullet point as thus:

• ·       ICLR is a well managed company in a structurally attractive industry
• ·       Valuation is very low for the level of growth / FCF, particularly in today’s environment
• ·       There is one idiosyncratic overhang that I think will eventually resolve

Icon (ICLR) is a large late stage CRO. Essentially, they help biotechs and pharmas conduct Phase I – IV clinical trials. They will go out and find doctors (investigators) willing to help with trials, help recruit patients, make sure the trial protocols are being followed, collect data, help with data preparation and analysis, help with trial design, handle the logistics for testing kits and drug samples, and so on. ICLR competes with the likes of Q, Covance, PRAH, INCR, PPD, inVentiv, PRXL, and so on.

This is a good industry:

• ·       Clients are rather risk averse. Risking a late stage clinical trial to save a few bucks is a big no-no. Clients are willing to pay for quality, speed, expertise, and reliability.
• ·       Relationships count for a lot. This is a rather sticky industry in my experience. A lot of companies have “strategic relationships” with large clients.
• ·       Switching costs are high. You will never switch a CRO mid-trial. Since phase II-III trials take so long, it takes a LONG time for business to roll off even if a client ditches you.
• ·       The cost structure is rather variable (people), and FCF generation is very robust.

Thus, despite being a somewhat fragmented industry, the degree of rivalry and price competition is much lower than you might expect. Look across the entire industry and you will find that most players generate consistently high margins and ROICs. In my research, the level of price competition and client price sensitivity has NOT increased in recent years.

I have also followed ICLR and the industry for a long time. Personally, I think they are one of the better managed companies in the space, with very consistent execution and a very good reputation. (You can’t say the same for some others, like PRXL).

Growth for the industry is driven by the amount of R&D dollars available, and the rate of outsourcing. R&D goes up 2-3% pretty consistently per year. Outsourcing has moved up significantly in recent years but the runway is maturing. I expect the entire industry to grow about 5% per year. Market shares are relatively steady.

ICLR’s growth rate has lagged in the last 2 years and will likely lag in 2017. The history of the firm is that they got a massive contract from Pfizer in 2011, as one of 2 “strategic partners” that will handle the bulk of PFE’s outsourced work. This turned into a huge success and drove robust growth in subsequent years. Unfortunately, they were TOO SUCCESSFUL and way overshot the revenue goals set out at the beginning of the contract. PFE at one point made up 35%+ of ICLR revenues.

A few years ago, PFE started to diversify their book, eventually bringing in 2 new partners. PFE revenues turned into a material headwind. Although ICLR had a ton of success selling outside of PFE, with 1.4-1.5x book to bill ratios, overall revenue growth was muted.

After signing a new PFE contract last year, this headwind was supposed to fade. Then, all of a sudden, PFE cancelled its pivotal PCSK9 trial due to poor market conditions (the entire drug class is not successful). This was a huge contract, and forced ICLR to pull down 2017 guide significantly. So what was supposed to be an “inflection year” turned into a “transition year”. The bright side though is that PFE will now be below 20% of revenues, and could even grow in the future.

Another potential overhang is that as an Irish company ICLR’s tax rates are very low. People view this as a risk. But after watching the Trump administration flail, I’m not too concerned about this for the next several years.

The last threat is that people are worried about drug pricing. The idea is that some structural regression of drug pricing will impact R&D spending. This is obviously a big hairy unknown, but I’m personally not too concerned. You need to make your own judgment call here though. I will point out:

• 1.       My feeling is that this whole drug pricing issue will take a really long time to evolve.
• 2.       Maybe competition is increasing in particular drug classes, and payors/PBMs are taking advantage… but there is also tremendous innovation and new classes of drugs will be found as well. The overall pie will grow.
• 3.       My personal feeling is that R&D will be more resilient even in face of slower pharma industry growth… Marketing budgets will be cut first as payors flex their muscles. If payors will now only pay for true innovation / health outcomes, you might argue that R&D becomes more important than ever.
• 4.       This is primarily a U.S. phenomenon. There is plenty of growth outside of the U.S.

So, my estimates are based on a picture where you have modest (2-5%?) global pharma/biotech spending growth. R&D goes up maybe 3% per year, and increasing outsourcing gives the industry 5% type revenue growth.

For ICLR, I think they will grow AT LEAST as fast as the industry. Frankly, they should have grown faster this year, except for this out of the blue trial cancellation. This is a lumpy industry, so I’ve come to expect stuff like this. But I think the longer term picture is very much intact.

Anyway, at 14.7x NTM, and very robust FCF generation, there is limited downside here I think. Barring a dramatic change in industry competitive or growth landscape, I’m not too worried. In today’s high valuation market, this is one of the more compelling bargains I see.

Catalyst

None. Just need to avoid blowing up.