Description

SUMMARY THESIS:

ICON plc is recommendend as a long.

DISCLOSURE: PLEASE VERIFY ALL THE INCLUDED INFORMATION. DO YOU OWN WORK. I DON'T HAVE A POSITION CURRENTLY BUT THAT MAY CHANGE WITHOUT NOTICE. 

• ICON is a Top Outsourcing Vendor Driven by Healthcare Innovation and Medical Product Pipeline Growth.
  • Leading CRO: ICON PLC (“ICON”) is one of the top five global contract research organizations (“CRO”), which means it is a provider of outsourcing services to the pharmaceutical, biotechnology and medical device industries.  It facilitates the research and development process for new drugs and devices and hence its fortunes are tied to the funding and demand for such innovative products. 
  • A Bet on Pipeline Growth: An investment in ICON is a bet on the size and growth of the aggregate medical product pipeline and not the success of a single drug or device. As such we view it as a relatively lower risk way of participating in the healthcare industry innovation more than a company whose survival depends on a one or two products.  
  • Strong Secular Tailwinds Benefiting ICON and its Peers.
    • Cost Pressures:  Years of profligate spending in the healthcare industry have produced limited productivity results and have brought costs to unsustainable levels. In the current age of low economic growth and financial austerity, the medical industry has intensified its efforts to reduce expenditures. 
    • CROs –Efficient Operators:  Outsourcing services to specialized third-party providers, such as CROs, accomplishes the goal of cost containment. CROs have lower costs and operate more efficiently which has made them an increasingly important part of the healthcare research and development process.  
    • Rapid Growth Industry: In the decade before the Lehman crisis, the CRO industry grew rapidly benefiting from high healthcare spending and an increasing rate of outsourcing.  Some of the leading providers, such as ICON, grew revenues at 30%+ p.a. during that period and correspondingly their valuation and stock prices skyrocketed.  The financial crisis brought them back down to earth as growth decelerated and multiples contracted.
    • Renewed Recent Interest in the CROs As Industry is Transforming.
      • Improved Investor Sentiment: Over the last year, there has been renewed interest in the CRO sector.  ICON has appreciated 45% year-to-date. The driver behind the improved investor sentiment is an industry transformation benefiting the leading global CRO providers. 
      • Supplier Base Consolidation: In order to improve the consistency, efficiency and quality of the outsourcing process, the big pharmaceutical companies are consolidating their vendor base around the larger providers. While we expect that healthcare expenditures to most likely remain flat in the foreseeable future, we believe that continuing growth for the top global outsourcing suppliers will come from deeper penetration into the medical product development process as well as further market share gains. 
      • ICON Has Both Attractive Top Line Growth and Margin Expansion Opportunity.
        • Attractive Fundamentals: Our analysis suggests that it is reasonable to assume that companies like ICON will manage to achieve 10-15% top line growth over the next five-year cycle.  Furthermore, given recent upfront investments associated with the vendor consolidation, there is room for margin improvement, which should provide further boosts to profitability and earnings growth. 
        • Attractive Valuation: We find the fundamentals of ICON and the CRO industry to be more attractive than a number of other healthcare subsectors and we believe that the current valuation is undemanding - we believe that upside to the stock is to the $33-35 in the next 12 months and higher beyond.

COMPANY DESCRIPTION:

ICON is a global contract research organization, which offers to its clients a diverse set of outsourced development services. Its customers include companies from the pharmaceutical, biotechnology and medical device industries. ICON provides strategic development, management and analysis that support all phases of the clinical development process, effectively facilitating a medical drug or device go from a compound / concept stage through clinical and regulatory approval and ultimately reach the global marketplace.  More specifically, the provided services include pre-clinical development, clinical trials management, clinical data management, study design, biostatistical analysis, post marketing surveillance, regulatory affairs services and central laboratory services. ICON was founded in 1990 by two Irish physicians, Dr. Ronan Lambe and Dr. John Climax, who are still involved with the company as members of the Board.  ICON is incorporated in Ireland but operates globally and is listed on the NASDAQ. At the end of the last fiscal year, the company had 8,470 employees, in 81 locations in 40 countries, and its $945mm FY 2011 net revenues were derived in the United States (42%), Europe (46%) and Rest of World (12%).

INDUSTRY OVERVIEW:

Our analysis of ICON has led us to believe that while there is some differentiation among the various publicly-traded players in the CRO industry, the investment thesis is driven to a greater extent by the industry dynamics rather than the individual companies[1]. Therefore we will devote this section to an overview of the industry, its size, drivers, structure, players and overall value proposition.

1. I.               The CRO Value Proposition

The drug development process has proved to be very costly – a single approved drug brought to market can require $800mm to $1billion over the course of 10-15 years[2]. The returns and profitability of these massive investments have been, for the most part, undesirably low.  As a result, the medical industry has sought various ways to reduce costs. Clearly, outsourcing part of the development process to a CRO accomplishes that, because by doing so, pharma companies effectively transform their fixed costs into variable ones. Most big pharma companies have maintained a large and relatively expensive R&D staff, which are not fully utilized 100% of the time.  Through outsourcing parts of the drug development process, managements can opt to turn off the payment tap almost instantaneously, effectively removing the employees’ fixed costs overhang.  The CROs are estimated to have 20% lower cost base than the pharma companies and reduce the duration of the process by one third compared to in-house efforts, therefore they can pass on a portion of these savings back to their customers.  Therefore the trend towards outsourcing is likely irreversible. Pharma companies are choosing to control the IP portion of the value chain by focusing on core competencies, i.e. pure science and discovery as well as customer relations, i.e. sales and marketing. 

From the perspective of a CRO company, the benefit arises from the diversity of its client base, which reduces the risk of reliance on a few drugs becoming successful and provides the basis for operational leverage and future growth as scale becomes a competitive edge. Therefore the CRO business model is driven more by backlog growth, i.e. procuring additional outsourcing drug development projects, and less so by the success of each individual compound becoming a commercial drug.  In other words, an investor in the CRO industry is betting on the process and volume of drug development rather than the outcome. Of course, successful commercial development of drugs ensures the health of the CRO’s customers but that becomes a secondary driver.

1. II.              Industry Trends – Tailwinds and Headwinds

There are a number of trends that are impacting the development of the CRO industry. Some of the key tailwinds include: (1) Patent expiration and the need to develop innovative drugs leads to increased demand for development; (2) Pharma companies’ desire to reduce costs is driving a greater shift towards outsourcing as discussed in the section above; (3) Explosive growth of the biotechnology sector, which is leading drug innovation, yet lacks the in-house development capabilities;  (4) Globalization of the marketplace and the need to access pools of new patients leads to conducting clinical trials in “emerging markets” and hence the greater demand for global outsourcing vendors; (5) Increased focus on product safety together with heightened global regulatory complexity is driving the demand for large, highly-specialized CROs.

There are also some negative headwinds impacting the industry (1) R&D budget growth is plateauing; (2) Economic weakness is hindering venture capital raising for biotech companies; (3) Complexity of clinical trials and formation of long-tail strategic partnerships is putting pressure on costs; (4) Vendor consolidation is leading to heightened client concentration. Despite the existence of both negative and positive trends, the rapid growth of the industry is a testament to the fact that the tailwinds outweigh the headwinds.

1. III.            CRO Products and Services

Before a new drug or a device may be marketed it must undergo extensive testing and regulatory review in order to determine that it is safe and effective. The process is broadly divided in early-stage and late-stage. The early-stage includes Pre-clinical (in vitro and animal testing) and Phase I (basic safety and pharmacology testing in a limited number of humans) with a duration of 3 to 5 years. The later-stage includes Phase II-IV studies (safety, efficacy, dosage, and additional drug uses) and typically involves hundreds or thousands of patients globally and could last an additional 5 to 7 years. Specific services include: investigator recruitment, site selection, patient sourcing, protocol preparation, case report form preparation, study monitoring, patient safety monitoring, data collection, medical reporting, medical imaging, and others.

The size and scope of the test trials varies depending on the underlying characteristics of the disease that the investigational drug is intended to treat. Patient enrollment can range from a few hundred (e.g., oncology trials) to several thousand (e.g., cardiovascular trials). Accordingly, the number of sites can range from a few dozen to a few thousand. The length of Phase III trials also varies depending on whether the drug being tested is for a chronic indication such as depression, which requires long-term treatment data or an acute indication, such as bacterial infections, which necessitate shorter trial duration.

In addition to early and late-stage clinical services, most CROs offer central lab services, which provide a unified way of reviewing the test data. To achieve that, central labs analyze samples (blood, urine, and other body fluids) to determine efficacy and safety of drugs being evaluated in the clinical trials. According to Thomson CenterWatch, more than 70% of clinical trials rely on central labs, and 100% of this work is outsourced to CROs, large reference labs, hospitals labs, or academic institutions. Central Lab services are more closely tied to late-stage development work, however due to over-capacity in this area, their profitability has seen higher volatility.

Lastly, CROs provide incremental value-added services such as investigator training, market scope and pricing research, electronic data capture, clinical trial management systems, electronic patient reported outcomes, image processing, randomization and trial supply management services.  The benefit of these value-added services flows aids incremental revenue generation and/or facilitates cost containment.

In terms of business characteristics – early-stage and central lab services have larger fixed costs component and therefore their profitability tends to be more volatile fluctuating with trial volumes. Late-stage services are more people intensive and therefore have a larger variable cost component. Late-stage services have longer duration, are larger in size and can generate $5-$20 million in revenues, depending on the scope. 

In the last couple of years, as part of the focus on greater cost reduction and productivity improvements, pharma companies have dedicated a larger portion of their budgets to late-stage drug development as the risk related to this work is substantially lower and the timing to commercialization is shorter.  As a result, CROs with greater exposure to late-stage drug development have fared a lot better than early-stage geared vendors.

1. IV.            Market Size, Penetration Rate and Growth Rate

CROs derive substantially all of their revenue from the R&D expenditures of pharmaceutical, biotechnology and medical device companies. In addition, some CROs provide R&D services to other industries including agriculture, tobacco, food, consumer staples, academic and non-for-profit research centers[3], albeit to a much smaller extent. As such, the total industry revenue pool is driven by two factors - first, the size of the aggregate R&D budgets of all end markets and second, the percentage of these budgets that is being outsourced to the CROs.

The overall spending by medical companies is in the range of $125 billion[4], however approximately 30-50% of that is dedicated to drug discovery or early animal testing in which CROs are presently not involved in. ICON and its peers derive their revenues from later stage research and/or development processes. There are a number of different sources[5] that provide estimates for this segment of medical R&D spending and they all range between $65 to $85 billion.  For the sake of conservatism we will base our analysis on an addressable market size of $65 billion. The CRO industry’s aggregate revenues are estimated to be in the range of $25 billion[6] and hence the current CRO outsourcing penetration rate is approximately 40%.[7] There is an academic study[8] that argues that the penetration rate is much higher but that would contradict with the estimates for the CRO industry’s overall revenue and those for the R&D spend, so for our analysis we will use the more prevalent penetration rates.

Historically, medical R&D budgets were on an upward-sloping trajectory, increasing nearly 85% from 2002-2008⁵, a CAGR of c.11%. Similarly CRO penetration rates increased from basically nil in the 1970s, when the industry started, to its current rate of c.40%. As a result, the CRO industry grew rather quickly during the last 10-15 years with some of its industry participants sustaining top line growth in the 25-30% per annum in that period. In fact, there has been only a quarter or two of flat/down backlog growth over the last 10-15 years and never a full down year even during the 2008 recession. Correspondingly, the stocks of the high growth CRO companies skyrocketed, appreciating substantially during the late 2003-mid 2008 period.

However, the situation has changed in the current age of austerity, with R&D budgets plateauing over the last couple of years. Some companies (e.g. Pfizer, Lilly) have reduced spending recently while others have added to it so for the last two years overall budgets have remained flat.  Our operating assumption is that aggregate budgets stay at current levels with any potential cuts offset by the demand for innovative new drugs and the growth of the global medical marketplace. Therefore we will assume that the broad market opportunity for CROs over the next 5-7 years will remain at $65 billion. 

We believe that the penetration rate has further upside. Currently there are services that are 100% outsourced (central lab) and those that are 10% outsourced (drug discovery). Given the CRO value proposition and current industry tailwinds, as described above, we believe that the trend towards greater outsourcing will continue. ICON’s management and a number of industry analysts expect the penetration rate to reach 70-80% in 5-7 years, i.e. the CRO industry’s aggregate revenues to nearly double to $40 - $50 billion. The implied industry growth rate is 10-15% over that period.

This is of course a base case scenario.  It is conceivable that medical spending enters a prolonged period of decline bringing that $65 billion figure down.  In this case, while the industry pie would be shrinking, the largest companies could continue to gain market share as their global scale, broader therapeutic experience and solid reputation gives them a competitive edge (please see the next section). Currently, the top global players account for $9+ billion of the c.$25 billion CRO industry revenues i.e. an approximately 36% market share. If we make some negative assumptions about R&D budgets, say down 15% over the next 5 to 7 years, with penetration rate rising from 40% to 60%, instead of 80%, then this implies that CRO industry revenues grow to c.$33 billion by 2017-2019.  Assuming further, that the large companies’ market share grows from the current 36% to 56%, would lead to their respective revenue slice expanding to c.$18 billion, i.e. nearly double the current revenues.  Although this is an illustrative example, it points out the fact that even in a declining medical spending environment, ICON and its large global peers could sustain growth rates in the 10-15% over the next 5-7 years. We have provided in the model appendix various sensitivities to growth, size and penetration rate, market share gains and the impact on the company’s financials.

1. V.             Market Structure and Company Differentiation

The CRO industry is fairly fragmented with a large number of small players and a limited number of global players.  ICON’s management estimates that there are several hundreds CRO providers, while some industry research papers² maintain that the participants’ number is in the low thousands.  Regardless, this is a fragmented industry. Historically the big pharma companies were not particularly selective in their use of CROs which fed the proliferation within the industry.  As a result of this multitude of suppliers, customers experienced inconsistencies in results, quality, costs and timelines. Therefore, during the last decade, clients pared down the number of their approved outsourcing vendors significantly. Pfizer for instance went from dealing with 160 CROs in 2004, to 17 in 2010 and down to 2 currently. There is a clear tendency towards the big getting bigger while the small CROs are getting squeezed and forced to deal with sub-scale, less stable clients.

We conducted a call with a former CRO relationship manager at Novartis and she highlighted some of the main criteria that large pharma companies rely on when selecting their preferred vendors. They are as follows: 1) Well-established global scale and infrastructure – this is important as trials are getting increasingly global in scope. For instance, most Phase III studies require testing on non-US populations (Asia in particular has become a very important market) in order to establish product commercialization in the global marketplace, 2) Operational excellence – given the huge risks and liabilities in dealing with human tests, reputation for reliability, quality, integrity, on-time/on-budget execution has become a key factor 3) Broad therapeutic competence – the capability to conduct studies on a wide array of diseases is also very important 4) Solid global regulatory experience – ability to handle different complex regulatory environment and their idiosyncrasies 5) Financial stability to efficiently handle multiple trials 6) Value-added services that lead to further cost containment. Clearly, these selection criteria favor the larger, global players allowing them to grow their market share both organically and via tuck-in acquisitions.

According to ICON’s 20-F and a research paper by Jeffries, the CRO industry generated $25 billion of combined revenues in 2011.  The top 10 leading CROs generated close to $9.1 billion during that period, thus representing 36% of the market.  The leading players are Quintiles with c.10% market share, Covance with 9%, Parexel with 6%, Charles River Labs and ICON with 4% each and Wuxi Pharma with 1%.

Quintiles and Covance are the two “big gorillas” in the segment offering the full plethora of early-stage and late-stage services in addition to clinical labs, consulting services and a host of technology based solutions.  The benefit of offering both early-stage and late-stage services is that early-stage contracts often lead to late-stage work.  Parexel is known for its extensive global network, with particular strength in Asia, and its strong technology product offering.  Charles River Labs is known for its pre-clinical early stage strength and solid technological experience, while Wuxi Pharma has significant Asian presence and offers drug-manufacturing capabilities.  ICON is not particularly differentiated from its competitors – it offers global scale and mostly late-stage clinical services, with some limited exposure to central lab. In addition, analysts praise its reputation for high quality output and strong management (please see Icon Analysis section).

1. VI.            Client Relationships, Contracts and Pricing

We have discussed already that CROs target primarily the pharmaceutical, biotechnological and medical device industries with a few players casting a broader end-market net. Historically, the relationship between the outsourcing vendors and their clients was a transactional one. What that meant was that medical companies would announce an RFP for certain drug development and various CROs will bid for the work.  The process was competitive and there was limited precedent for long-term partnerships between clients and suppliers. The awarded contracts lasted from a few months to a few years.  They were cancellable either immediately with cause or within 30-90 days without cause.  The contracts were either fee-for-service based or fixed-price in nature with a 10-15% upfront payment and the balance amortized over the life of the contract or based on achievement of milestones. Pricing seemed to be consistent across the industry as most publicly-traded players had comparable operating margins prior to the crisis.

As described earlier, this scattershot way of selecting CROs led to inconsistencies and inefficiencies within the drug development process and therefore big pharma companies sought improvements. That led to consolidation of the supplier base and the formation of a number of strategic relationships.  These partnerships included the transfer of employees from the pharma companies to the CROs, the creation of governance committees with members from both parties, the establishment of homogenized operational procedures and performance measures. 

From the perspective of the pharma companies, such partnerships meant greater efficiency, standardized and reliable quality, direct cost control and assured access to CRO capabilities at any time.  From the perspective of the CROs, this arrangement ensured reliable revenue flow (e.g. guaranteed minimum take-or-pay), greater scale, ability to sell value-added services and less competition. 

Given the long-term, locked-up nature of these partnerships and the limited number of large pharma and biotech companies striking such relationships, the CROs have engaged in a “land grab” over the last 12-18 months to sign up as many strategic partners as possible.  This has resulted in margin pressures in fiscal 2011 for most of the CROs as they took in pharma employees and made IT investments without an immediate corresponding top line growth.  The solid backlog growth by a number of outsourcing vendors during the fist half of this year demonstrates that these strategic partnerships are starting to pay off.  It appears that these alliances are the predominant driver of top-line growth in the industry. However, CROs’ managements have disclosed very limited information on pricing and expected profitability of these partnerships, so the ultimate impact to the bottom line remains to be seen.  Despite the lack of fully disclosed information on the structure of these partnerships, most industry observers view these strategic alliances as transformational for the industry.

1. VII.          Backlog, Book-to-Bill, Burn Rate and Cancellations

The analytical community uses a few metrics to prognosticate and evaluate CRO companies’ performance.  These measures include backlog, book-to-bill ratio, backlog burn ratio and cancellation rate. The backlog represents pending contract work to be earned from projects awarded by clients. However, given that CRO contracts are cancellable (please see section above), such backlogs are not always a great predictor of future results.  The book-to-bill ratio is the ratio of the dollar volume of new business that a CRO books in a period to the amount of business that it bills in the same period. If this ratio is greater than 1, business is expanding, conversely it is contracting.  The backlog burn rate is the rate at which a company burns through the backlog in a quarter.  High burn rates mean that contracts are of shorter duration, low burn rates imply more complex, longer-tail contracts. Cancellation rates measure the ratio of cancelled project to existing backlog. Clearly, the lower the cancellation rate – the greater the retention among the client base.

ANALYSIS OF ICON:

Our analysis of the CRO industry indicates that drug development outsourcing experienced significant growth during the last two decades fueled by continuous rise of R&D spending and increasing penetration.   Within this expansionary environment ICON grew at above-industry rate, driven by market share gains, favorable business mix and a successful acquisition strategy. The following table summarizes the five-year revenue and EBITDA CAGR over the last decade as well as actual EPS for each of the years listed below.

Not surprisingly ICON’s stock attracted the attention of a number of growth investors and appreciated 800% during the late-2003 to mid-2008 period. During the Lehman crisis, with funding for drug development adversely impacted by the economic slowdown, growth decelerated and P/ E multiples collapsed from highs of 35x to 10x.  ICON’s stock price was down 65% from its peak within a matter of months. 

Over the last 12 months, however, the ongoing industry transformation has resulted in rising backlogs at the leading global CRO players. This has led to renewed interest in the name by some well-regarded large investors such as Artisan Partners, Neuberger Berman and Earnest Partners. Year to date, ICON’s stock price has appreciated 45%, outpacing its peers and the broader markets. In the following paragraphs we will present our views as to what we believe the company has attracted investors’ attention:

1. I.               Justifications for Purchase of ICON’s stock

ICON offers a broad range of pre-clinical, clinical and central lab services that most CROs provide to their clients.  Our analysis of company suggests that it also has all the characteristics that medical companies look for in a trusted global CRO partner.  Furthermore it benefits from favorable business mix and improving fundamentals:

1. Global Scale, Infrastructure and Regulatory Expertise – ICON is a very global company with 81 offices in 40 countries around the world. It has been growing very rapidly both in the developed world (at a 10-year CAGR of 20%) and in the emerging world (at a 10-year CAGR of 56%). Only its closest peer Parexel Intl. has greater global scale. It has a dedicated staff that handles all the complexity of the relevant regulatory regimes.
2. Operational Excellence and Reputation for High Quality – ICON’s has the second highest book-to-bill ratios in the industry of 1.48 (after Parexel at 1.65) and the lowest cancellation rate (2-4% vs 5+% for some if its peers). This is an indication that its customers are very satisfied with the quality of its work.  Furthermore it has one of the lowest bad debt allowances in the industry (1.0-1.5% of AR), indicating that its customer base is also of high quality. It has a well-regarded management and staff that is 36% comprised of PhD, MDs and MA degree graduates.
3. Broad Therapeutic Competence – ICON has broad capabilities to handle all major therapeutic areas (oncology, CNS, cardiovascular, dermatology, respiratory etc.). In fact its current backlog is very closely aligned with the pharma industry’s drug development pipeline an indication that it is an active, well-represented outsourcing vendor.
4. Financial Stability – ICON’s balance sheet is solid – it has no debt and $168 million in cash, equal to 17% of 2011 sales and 12% of the current market cap. It has low capital requirements and has been free-cash-flow-positive over the last five years. In fact, as a testament of its financial strength, ICON’s management announced a $50 million buyback last year (equivalent to 5% of the market cap at announcement), an infrequent corporate activity in the world of high-growth CROs.
5. Value-Added Services – ICON has invested heavily in value-added IT services (iCONIK knowledge information base) and best in-class medical imaging. Furthermore, ICON’s has made some attractive acquisitions that have added complimentary services, e.g. Firecrest - a leader in investigator training and site selection services, which add both to revenues and cost reduction efforts.
6. Favorable Business Mix – ICON’s business mix is geared predominantly toward clinical research (92% of LTM revenues) with little exposure to the volatile central lab services business (8% of LTM revenues).  Furthermore, within its clinical research division, the company has over 90% exposure to the more profitable, higher-growth and less volatile late-stage clinical services area, which has been an important contributor to backlog expansion. Parexel, its closest peer, has similar business mix and as such has also enjoyed good stock performance year-to-date. Covance and Charles River Labs, with more exposure to early-stage services, have lagged.
7. Strategic Partnerships – ICON has signed a few high-profile strategic partnerships. It was one of the two global CROs (together with Parexel) selected as partners to Pfizer and Bristol-Myers Squibb and at the last conference call announced two new alliances. Clearly it is being competitive in the strategic partnerships’ “land grab” game and rewarded for its high quality work.
8. Improving Performance – ICON has seen improving performance in the last few quarter. Year-over-year revenues and backlogs are up c.20%-25% (5-10% up sequentially) driven primarily by the strength in late-stage services and new partnerships. The company’s book-to-bill ratio at 1.48 is the highest since the trough of 2009 and its burn rate has stabilized at 11-12%. Central lab services announced two consecutive profitable quarters (YTD EBIT margin of 5%), first time in 3 years, as some capacity has been removed from the industry and the company implemented cost controls. Central lab services tend to lag late-stage services by 3-6 months, hence the strength in performance should continue.  Lastly, the hit to margins that the company experienced last year due to strategic partnership investments has started to reverse with EBIT margins recovering from 2011’s c.4% to c. 7% in Q3’12.
9. Disciplined Capital Allocator – ICON’s has shown discipline in its capital use. Despite the number of available acquisition candidates it has shown restraints, making small acquisitions (3-5% of annual revenues) at valuations of around 1.5-2.0x sales. It has funded these purchases using highly priced stock with tiers of earn-out incentive payments.  It has also bought back stock during periods of stock underperformance. In terms of ROIC – it has averaged 15-20% over the last decade.

1. II.              Risk factors

There are two potential areas of risks associated with an investment in ICON. The first is related to the CRO industry and the second is company specific.

1. Industry Risks – The main risks associated with CRO industry are: 1) Uncertainty surrounding the size and trajectory of the medical industry R&D expenditure budgets; 2) Some debate around the level of penetration of CRO services within the medical industry development process; 3) Further consolidation either within the medical industry or within the outsourcing vendor sector; 4) Potential adverse regulatory changes; 5) Changes in the competitive environment.
2. Company-Specific Risks – The main risks associated with ICON include: 1) Rising concentration – with the signing up of strategic partnerships, ICON’s top client accounts for 13% of revenues and the top 5 clients in aggregate represent over 35% of sales; 2) Potential cost overruns will have an adverse margin impact due to fixed-fee structure of the company’s contracts; 3) Limited disclosure on contracts – business model is a somewhat of a “black box” when it comes to financial forecasting; 4) Various operational risks including inability to recruit patients or investigators, potential safety/liability issues, acquisition risks, and employee retention; 5) Client cancellations; 6) Currency risks given international operations.
3. 
   
4. 
   
5. III.            ICON Management

ICON’s management appears well regarded in the industry. The two founders, Dr. Ronan Lambe and Dr. John Climax, are still involved as members of the board.  They still receive consulting fees for their involvement (some argue these fees may be somewhat higher than industry standards).  There were some recent management changes.  The former CEO, Peter Gray, retired last year (now Vice Chairman of the Board), and Ciarran Murray, the former CFO, was elected to replace him.  The transition appears to be proceeding smoothly as both have been long-standing employees of the company.

In terms of management compensation, they appear to be inline with other publicly-traded CROs or companies of this size.  The incentive packages include cash, restricted stock and at-the-money options. Historically ICON management did have issues with high management compensation but that has been corrected.

In terms of shareholders’ capital stewardship, the management acts prudently. They are not focused on building big empires and have in fact eschewed large acquisitions.  They have used high priced stock and cash to make small purchases with earn-out incentives. Despite the strength of its balance sheet, ICON does not pay a dividend but has bought back shares opportunistically.  Despite acquisitions and share compensation, the share count has been flat over the last 5 years.

1. IV.            ICON Valuation Analysis

We have approached our valuation analysis on ICON both from a top-down and bottom-up perspective. We have developed a model for medical R&D expenditures, CRO penetration rate and market share gains by the leading global CROs.  As described earlier, we are assuming that the addressable market opportunity amounts to $65 billion with no growth over the next five years.  In our base case we are further assuming that the penetration rate rises at 2% a year (it has risen to c. 40% over a period of 20 years, so we are extrapolating) and also that the leading global CROs increase market share at 4% a year (it has risen to c.36-40% over a period of 10 years).  Here is a summary of the market model with these assumptions and implied industry CAGRs.

We have run sensitivities to our model and have established that the CRO industry growth is less sensitive to R&D spending growth and more sensitive to market share gains and penetration increases.  Furthermore, the size of the assumed total market opportunity (i.e. the $65bn figure above) has very limited impact on the model and growth rates.

The main drivers of our ICON financial model are 1) top-line growth – based on our market growth model and 2) EBIT margins – management is providing guidance that they will reach 12% (its pre-crisis run-rate) by end of 2013. 

Looking at the company’s margins there has been some volatility.  This is almost entirely explained by the ups-and-downs of the sub-scale central lab business. In the model we have highlighted the operating margins of the core clinical services business (92% of revenues).  Its margins have consistently been in the 10-12% range for the last decade with the average and median margins almost coinciding at 11% and a very small standard deviation of 3%.  There has been a little bit of volatility in the core margins with the transition to strategic partnerships last year but that is normalizing. Central lab, on the other hand has been volatile with an average margin of -8%, median of 0% and standard deviation of 31%.  Clearly operating a fixed cost business with limited scale in an under-utilized industry has had its impact.  The management is focusing on cost control and with the benefit of some capacity leaving the industry, central lab services achieved 5% margin year-to-date.

The company has limited operating leverage at the gross profit level (the business is labor-intensive), however it has achieved SG&A operational leverage by controlling fixed costs, so the model reflects that. The company’s long-term tax rate is targeted to be 18-20%, inline with other peers in the industry (please refer to the worksheet called Quarterly Income Model in the model for assumptions).  The company fundamentals are not impacted by inflation as the majority of the costs are labor-related, which fortunately for ICON have seen limited, upward pressures.

Our valuation analysis was based on various sensitivities to the main two drivers - top line growth and operating margins.  As you can see in the table below, the range of potential 5-year estimated 2017 earnings range broadly from $2.22 to $5.27.  The high-end estimates will occur in a situation where the industry and ICON are growing strong, either because of rising R&D budgets, or faster penetration and/or market gains. In such a scenario, the outsourcing market will become quite saturated and as such the industry prospects beyond 2017 will be more limited. Therefore we have assigned lower terminal multiples in this case.  Conversely, the case of lower industry growth and penetration yields lower estimates but leaves potential future growth opportunities and as such we have assigned higher terminal multiples. 

After applying the appropriate multiples, we have used the WACC to discount back to the present the 2017 stock price to arrive at a current price range of c.$28-$34 (weighted average of c.$33).  ICON is trading at present at around $27 which, based on the table below, implies 5-year top line growth of 10% and EBIT margin of also 10% in 2014. Coincidentally these are the levels that most analysts are assuming and hence current price reflects consensus. Therefore, our range of $28-$34 reflects an industry growth of c. 10-15% and margins of 10-12% in 2014, respectively.

For information purposes, we present below current multiples of the comparable companies. They are 19x for 2012E EPS and 15x for 2013E EPS, with ICON and Parexel trading at a premium.  We have focused on P/E multiples as this seems to be the preferred metric among the analytical community, however the results will be similar if we use other measures. 

We have also run a DCF analysis and have established that the weighted average implied current price by this valuation method is c.$33.  We believe that given the growth prospects in the industry, the price target is likely higher for investors with longer horizons.

Catalyst