Life Sciences Research LSR
January 13, 2008 - 2:04pm EST by
utah1009
2008 2009
Price: 20.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 310 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

This might be the first VIC writeup that requires a safety warning.  Life Sciences Research (LSR) is an animal testing lab with improving and sustainable fundamentals, high operating leverage, barriers to entry, and industry trends that support +15% revenue growth for the foreseeable future.  For all that it’s trading at 7.9x EV/EBITDA and 14.5x EPS (2007) while comps trade at lofty 17x and 35x multiples, respectively.

 

Company

 

LSR is a contract research organization (CRO) that specializes in preclinical testing for large pharmaceutical companies.  They have 3 labs (2 UK, 1 US) that mostly run toxicology, safety, and dosage studies on primates, rabbits and dogs to determine whether a particular compound is safe for human (clinical) trials.  Their labs are ~275k square feet of animal cages, instrumentation, lab equipment, and corporate offices.  I haven’t been to the UK labs, but the Princeton lab was a rather unique office visit.  Razor wire, security checkpoints, and the inescapable smell of monkey feces…actually, I think I  visited a couple banks like this.

 

Preclinical CRO Industry

 

There are a number of trends favorably affecting the preclinical CRO industry.  It’s estimated that the annual market is about $10 billion, while between 20-30% of it is outsourced (LSR is 3rd in market share with about 6-8%).  However, the outsourcing model is becoming much more popular, so not only are CRO’s benefitting from overall spending growth, but also from the outsourcing shift.  Data about penetration isn’t precise, but we believe CRO penetration has increased ~5% in the last 5 years.  I believe that the relatively low penetration by CRO’s means there’s a lot of growth left.  Two of the biggest competitors are Covance and Charles River Labs, so if you know those guys you’re probably already familiar with this part of the story.

 

Basically, the environment for major pharmas has been very challenging in the last 5-7 years.  Drug development costs are rising, more drugs are coming off patent, there’s been a drop-off in new blockbuster drugs, and the drug approval process is longer.  These companies just aren’t able to increase earnings like they used to, and most of their 5 year stock charts reflect it.  So they do what most companies do in that situation – they cut costs.  Labs can be relatively large fixed cost centers, so by outsourcing they simply move to a variable cost model.  Merck, Pfizer, GSK, AstraZeneca, Eli Lilly, et al, have closed or sold labs (sometimes multiple labs) in the last couple years as part of cost cutting initiatives.  It’s probable that M&A amongst these firms will further drive outsourcing, as cost synergies will be required.  Plus there are smaller drug companies and biotechs who can’t support their own captive labs and need to outsource.  The result is that growth in the CRO market is accelerating. 

 

The CRO business itself has some nice economics and strategic appeal.  First, preclinical contracts are usually fixed-price and range from $100k up to $1m.  Clinical trials on the other hand can range anywhere from $5m up to $100m , so pharmas end up being less price sensitive and more time/quality sensitive for preclinical work.  Second, labs are becoming increasingly large (some > 400k sqft) and can be quite expensive, costing in some cases $500m.  They can also take at least 3 years to build, so bringing on new capacity has significant lead times.  Third, there are technical people needed to do the analysis.  Veterinary pathologists aren’t exactly a dime a dozen, so it’s not always as simple as having deep pockets.  Fourth, pharmas value established relationships with CRO’s, which must be good lab practice (GLP) certified.  Finally, there is the ick-factor associated with animal testing that keeps people away.  Animal testing isn’t exactly highly publicized, and the industry likes to use all sorts of euphemisms to disguise the fact that their business involves doing unpleasant, albeit necessary things to animals.  I should note that these companies are not performing tests for cosmetic products, this is strictly for drug development.

 

History

 

LSR was originally a UK company that ended up buying a lab in Princeton, where they are currently headquartered.  In 1997, a PETA member went “under cover” and got hired by LSR.  This guy snuck a video camera into the lab and caught some of the technicians smacking and yelling at a couple beagles [insert Michael Vick joke here].  The video made the rounds on the UK Hard Copy, and while House of Commons launches an investigation into the abuse, LSR’s order flow came to a near standstill and institutions decided it wasn’t worth the hassle of owning it because of pressure from animal rights activists.  It was quite the story at the time.  The company and stock got crushed and LSR was forced to do a couple recaps, which is how the current management got in.  They own about 30% of the stock, by the way.  Anyway, here’s the rub.

 

Now 10 years later, there are still activists who campaign against LSR…actually they’ve mostly shifted towards protesting affiliates of LSR.  Equipment suppliers, drug companies, stock exchanges, , service providers, and yes, shareholders are regularly targeted by activists.  Their protests are laughably inconsequential and usually never amount to more than a dozen militant vegan dorks with megaphones and placards.  Check out their website (www.shac.net) for details…the “diary” section shows how frivolous they really are.  Unfortunately, there have been more serious incidents of threatening, you can Wiki “SHAC” for a quick rundown.  This eventually led to one of the quirks about the stock – no one has to file their ownership, the SEC allows exemptions (out of 15 million shares, a mere 70k of non-insiders are registered holders).  Nor does LSR disclose who their lenders are.  And their conference calls are hysterical.

 

CEO: “Why don’t we open the call for questions.”

[crickets chirping]

CEO: “Ok, well, you all know my number.”

 

These activists are completely insane in a way you and I couldn’t even begin to comprehend, and they’re obviously willing to go to baffling lengths to interfere with LSR’s business.  In a bunch of ways they’ve been successful.  LSR is the 3rd largest preclinical testing company in the world, they aren’t listed on an exchange, and the sell-side barely mentions LSR, let alone covers them.  In 2006, LSR decided to list the stock on the NYSE and after going through all the hoopla of getting listed, the NYSE (in a totally pathetic and spineless move) indefinitely postponed the listing without publicly citing a reason.  One can certainly speculate.  For now, it is banished to the NYSE ArcaEx anonymous electronic trading platform.  Hell, LSR was actually delisted from the OTC Bulletin Board after no one would make a market.  Can’t say I’ve ever seen that happen to a profitable company before.  On the other hand, LSR’s stock is up ten-fold in the last four years and business has never been better.

 

The activism against LSR has died down in recent years.  The problems that existed in the 1990’s have long since been corrected and the chances of history repeating itself are slim.  So why don’t Covance, Charles River, et al have these problems?  The video footage really stuck in peoples’ minds, and for whatever reason, the UK/EU is one of the bigger hotspots for militant animal rights activists.  I’ve got to hand it to the activists for their persistence, the video incident was 10 years ago for crying out loud.

 

Financials

 

2007 has been a great year for LSR, and I think business will continue to improve.  I’m forecasting slower revenue growth offset by sustained gross margins ~29%.  The revenue growth will slow as a number of new labs are brought online, but I think that until some of these events in 2009-2010, my gross margin assumption might even be too low.  If they can properly manage expenses I think their EBIT margin can start moving closer to 16%, essentially inline with Covance and Charles River Labs.  They pay virtually no taxes thanks to $45m in NOL’s and UK research tax credits, and they don’t foresee paying taxes any time soon.  New contract signings and book/bill are both solid.

 

 

(millions) 2005 2006 2007E 2008E 2009E 2010E
Revenue      172.0      192.3      236.9      274.7      316.0      358.6
Growth 9.1% 11.8% 23.2% 16.0% 15.0% 13.5%
             
Gross Profit        47.2        49.6        69.3        82.2        92.4      104.0
% 27.4% 25.8% 29.2% 29.9% 29.2% 29.0%
             
SG&A        26.2        29.5        38.0        41.4        43.9        47.8
             
EBIT        21.0        20.1        31.3        40.8        48.5        56.2
% 12.2% 10.5% 13.2% 14.9% 15.3% 15.7%
             
EBITDA        33.9        43.5        43.8        54.3        62.7        71.5
             
Interest, etc      (19.5)      (14.4)      (10.1)         (9.8)         (8.2)      (10.2)
             
Net Income          1.5          5.7        21.2        31.0        40.3        46.0
EPS        0.10        0.39        1.41        2.05        2.65        3.00
             
Signings      184.9      233.0      277.8      322.0      354.0      390.0
Backlog      122.0      175.0      206.5      253.7      291.8      323.2
Book/Bill        1.08        1.21        1.17        1.17        1.12        1.09
             
Debt        77.3        90.0        75.8        75.8        75.8        65.8
Capex        16.0        13.1        16.5        16.4        16.8        18.0
FCF          2.5          9.2        16.6        28.1        37.7        43.2
Growth   268% 81% 69% 34% 15%
             
EV/EBITDA     7.9x 5.7x 4.3x 3.1x
P/FCF     18.6x 11.0x 8.2x 7.2x
P/E     14.5x 10.0x 7.7x 6.8x

 

Valuation

 

To me, a cheap stock is like that famous Potter Stewart quote about porn: I know it when I see it.  My research leads me to believe that FCF will increase almost 70% in 2008 because of operating leverage and flat capex.  Therefore, LSR is trading for just 11.0x 2008 FCF, and 8.2x 2009 FCF.  I’ll let you decide what kind of FCF multiple you’d slap on a company with this kind of FCF growth and competitive position, but in my mind it’s significantly higher.  And you can see by the table above that it’s cheap by other metrics as well.  When you start comparing it to Covance and Charles River it’s really cheap.  These companies are wildly expensive and have been great stocks over the last few years.  The last major preclinical acquisition was Charles River Labs purchase of Inveresk in 2004 which was a lofty 4.9x revenue.  Most other transactions are ~2.0x revenue, which would put LSR north of $30/share.

Catalyst

Earnings improvement;
Exchange listing;
Activists back off;
Sale of company
    sort by    

    Description

    This might be the first VIC writeup that requires a safety warning.  Life Sciences Research (LSR) is an animal testing lab with improving and sustainable fundamentals, high operating leverage, barriers to entry, and industry trends that support +15% revenue growth for the foreseeable future.  For all that it’s trading at 7.9x EV/EBITDA and 14.5x EPS (2007) while comps trade at lofty 17x and 35x multiples, respectively.

     

    Company

     

    LSR is a contract research organization (CRO) that specializes in preclinical testing for large pharmaceutical companies.  They have 3 labs (2 UK, 1 US) that mostly run toxicology, safety, and dosage studies on primates, rabbits and dogs to determine whether a particular compound is safe for human (clinical) trials.  Their labs are ~275k square feet of animal cages, instrumentation, lab equipment, and corporate offices.  I haven’t been to the UK labs, but the Princeton lab was a rather unique office visit.  Razor wire, security checkpoints, and the inescapable smell of monkey feces…actually, I think I  visited a couple banks like this.

     

    Preclinical CRO Industry

     

    There are a number of trends favorably affecting the preclinical CRO industry.  It’s estimated that the annual market is about $10 billion, while between 20-30% of it is outsourced (LSR is 3rd in market share with about 6-8%).  However, the outsourcing model is becoming much more popular, so not only are CRO’s benefitting from overall spending growth, but also from the outsourcing shift.  Data about penetration isn’t precise, but we believe CRO penetration has increased ~5% in the last 5 years.  I believe that the relatively low penetration by CRO’s means there’s a lot of growth left.  Two of the biggest competitors are Covance and Charles River Labs, so if you know those guys you’re probably already familiar with this part of the story.

     

    Basically, the environment for major pharmas has been very challenging in the last 5-7 years.  Drug development costs are rising, more drugs are coming off patent, there’s been a drop-off in new blockbuster drugs, and the drug approval process is longer.  These companies just aren’t able to increase earnings like they used to, and most of their 5 year stock charts reflect it.  So they do what most companies do in that situation – they cut costs.  Labs can be relatively large fixed cost centers, so by outsourcing they simply move to a variable cost model.  Merck, Pfizer, GSK, AstraZeneca, Eli Lilly, et al, have closed or sold labs (sometimes multiple labs) in the last couple years as part of cost cutting initiatives.  It’s probable that M&A amongst these firms will further drive outsourcing, as cost synergies will be required.  Plus there are smaller drug companies and biotechs who can’t support their own captive labs and need to outsource.  The result is that growth in the CRO market is accelerating. 

     

    The CRO business itself has some nice economics and strategic appeal.  First, preclinical contracts are usually fixed-price and range from $100k up to $1m.  Clinical trials on the other hand can range anywhere from $5m up to $100m , so pharmas end up being less price sensitive and more time/quality sensitive for preclinical work.  Second, labs are becoming increasingly large (some > 400k sqft) and can be quite expensive, costing in some cases $500m.  They can also take at least 3 years to build, so bringing on new capacity has significant lead times.  Third, there are technical people needed to do the analysis.  Veterinary pathologists aren’t exactly a dime a dozen, so it’s not always as simple as having deep pockets.  Fourth, pharmas value established relationships with CRO’s, which must be good lab practice (GLP) certified.  Finally, there is the ick-factor associated with animal testing that keeps people away.  Animal testing isn’t exactly highly publicized, and the industry likes to use all sorts of euphemisms to disguise the fact that their business involves doing unpleasant, albeit necessary things to animals.  I should note that these companies are not performing tests for cosmetic products, this is strictly for drug development.

     

    History

     

    LSR was originally a UK company that ended up buying a lab in Princeton, where they are currently headquartered.  In 1997, a PETA member went “under cover” and got hired by LSR.  This guy snuck a video camera into the lab and caught some of the technicians smacking and yelling at a couple beagles [insert Michael Vick joke here].  The video made the rounds on the UK Hard Copy, and while House of Commons launches an investigation into the abuse, LSR’s order flow came to a near standstill and institutions decided it wasn’t worth the hassle of owning it because of pressure from animal rights activists.  It was quite the story at the time.  The company and stock got crushed and LSR was forced to do a couple recaps, which is how the current management got in.  They own about 30% of the stock, by the way.  Anyway, here’s the rub.

     

    Now 10 years later, there are still activists who campaign against LSR…actually they’ve mostly shifted towards protesting affiliates of LSR.  Equipment suppliers, drug companies, stock exchanges, , service providers, and yes, shareholders are regularly targeted by activists.  Their protests are laughably inconsequential and usually never amount to more than a dozen militant vegan dorks with megaphones and placards.  Check out their website (www.shac.net) for details…the “diary” section shows how frivolous they really are.  Unfortunately, there have been more serious incidents of threatening, you can Wiki “SHAC” for a quick rundown.  This eventually led to one of the quirks about the stock – no one has to file their ownership, the SEC allows exemptions (out of 15 million shares, a mere 70k of non-insiders are registered holders).  Nor does LSR disclose who their lenders are.  And their conference calls are hysterical.

     

    CEO: “Why don’t we open the call for questions.”

    [crickets chirping]

    CEO: “Ok, well, you all know my number.”

     

    These activists are completely insane in a way you and I couldn’t even begin to comprehend, and they’re obviously willing to go to baffling lengths to interfere with LSR’s business.  In a bunch of ways they’ve been successful.  LSR is the 3rd largest preclinical testing company in the world, they aren’t listed on an exchange, and the sell-side barely mentions LSR, let alone covers them.  In 2006, LSR decided to list the stock on the NYSE and after going through all the hoopla of getting listed, the NYSE (in a totally pathetic and spineless move) indefinitely postponed the listing without publicly citing a reason.  One can certainly speculate.  For now, it is banished to the NYSE ArcaEx anonymous electronic trading platform.  Hell, LSR was actually delisted from the OTC Bulletin Board after no one would make a market.  Can’t say I’ve ever seen that happen to a profitable company before.  On the other hand, LSR’s stock is up ten-fold in the last four years and business has never been better.

     

    The activism against LSR has died down in recent years.  The problems that existed in the 1990’s have long since been corrected and the chances of history repeating itself are slim.  So why don’t Covance, Charles River, et al have these problems?  The video footage really stuck in peoples’ minds, and for whatever reason, the UK/EU is one of the bigger hotspots for militant animal rights activists.  I’ve got to hand it to the activists for their persistence, the video incident was 10 years ago for crying out loud.

     

    Financials

     

    2007 has been a great year for LSR, and I think business will continue to improve.  I’m forecasting slower revenue growth offset by sustained gross margins ~29%.  The revenue growth will slow as a number of new labs are brought online, but I think that until some of these events in 2009-2010, my gross margin assumption might even be too low.  If they can properly manage expenses I think their EBIT margin can start moving closer to 16%, essentially inline with Covance and Charles River Labs.  They pay virtually no taxes thanks to $45m in NOL’s and UK research tax credits, and they don’t foresee paying taxes any time soon.  New contract signings and book/bill are both solid.

     

     

    (millions) 2005 2006 2007E 2008E 2009E 2010E
    Revenue      172.0      192.3      236.9      274.7      316.0      358.6
    Growth 9.1% 11.8% 23.2% 16.0% 15.0% 13.5%
                 
    Gross Profit        47.2        49.6        69.3        82.2        92.4      104.0
    % 27.4% 25.8% 29.2% 29.9% 29.2% 29.0%
                 
    SG&A        26.2        29.5        38.0        41.4        43.9        47.8
                 
    EBIT        21.0        20.1        31.3        40.8        48.5        56.2
    % 12.2% 10.5% 13.2% 14.9% 15.3% 15.7%
                 
    EBITDA        33.9        43.5        43.8        54.3        62.7        71.5
                 
    Interest, etc      (19.5)      (14.4)      (10.1)         (9.8)         (8.2)      (10.2)
                 
    Net Income          1.5          5.7        21.2        31.0        40.3        46.0
    EPS        0.10        0.39        1.41        2.05        2.65        3.00
                 
    Signings      184.9      233.0      277.8      322.0      354.0      390.0
    Backlog      122.0      175.0      206.5      253.7      291.8      323.2
    Book/Bill        1.08        1.21        1.17        1.17        1.12        1.09
                 
    Debt        77.3        90.0        75.8        75.8        75.8        65.8
    Capex        16.0        13.1        16.5        16.4        16.8        18.0
    FCF          2.5          9.2        16.6        28.1        37.7        43.2
    Growth   268% 81% 69% 34% 15%
                 
    EV/EBITDA     7.9x 5.7x 4.3x 3.1x
    P/FCF     18.6x 11.0x 8.2x 7.2x
    P/E     14.5x 10.0x 7.7x 6.8x

     

    Valuation

     

    To me, a cheap stock is like that famous Potter Stewart quote about porn: I know it when I see it.  My research leads me to believe that FCF will increase almost 70% in 2008 because of operating leverage and flat capex.  Therefore, LSR is trading for just 11.0x 2008 FCF, and 8.2x 2009 FCF.  I’ll let you decide what kind of FCF multiple you’d slap on a company with this kind of FCF growth and competitive position, but in my mind it’s significantly higher.  And you can see by the table above that it’s cheap by other metrics as well.  When you start comparing it to Covance and Charles River it’s really cheap.  These companies are wildly expensive and have been great stocks over the last few years.  The last major preclinical acquisition was Charles River Labs purchase of Inveresk in 2004 which was a lofty 4.9x revenue.  Most other transactions are ~2.0x revenue, which would put LSR north of $30/share.

    Catalyst

    Earnings improvement;
    Exchange listing;
    Activists back off;
    Sale of company

    Messages


    Subjectre: Rating of 1?
    Entry01/16/2008 12:30 PM
    Memberoscar1417
    Maybe it was from a vegan dork investor with a megaphone? Just kidding. It wasn't me, I have a T-shirt that says, "there's room for all of god's creatures, right here next to my mashed potatoes".
    Thank you for an interesting and, at times, very funny write-up. Just as a comment, I would say that the political incorrectness of the company is something that has to be given consideration. Over a year ago, I bought WMT, and almost immediately I got calls from clients who insisted that I sell it immediately. I can only imagine what would happen if I bought this stock, perhaps I'd find them super-glued to my car in the morning. WMT will probably find a way to improve its image, but I don't see anyone suddenly warming up to an animal testing lab. Even if it doesn't make sense from a purely financial perspective, this is going to keep institutions out of the stock indefinitely IMHO.

    SubjectTaxes
    Entry01/16/2008 06:01 PM
    Memberzzz007
    Thanks for the writeup. I notice that you have the company paying no taxes thru the end of of your projection period (2010). It appears to me that the company had gross loss carryforwards of roughly $87mm ($75mm UK, $12mm US) at year-end 2006, yet your projections show the company generating an aggregate of $139mm in pre-tax income between 2007 and 2010. Shouldn't they theoretically start paying taxes once their pre-tax income burns thru the gross carryforward amount? Am I missing something?

    Subjecttaxes
    Entry01/17/2008 09:53 AM
    Memberutah1009
    LSR qualifies for significant R&D tax credits in the UK. I dont fully understand the dynamics of the credits, but management has told me that because of the current structure, taxes wont be an issue for them for "many" years. I apologize if I cannot provide the full details about it, I tend to rely more on management for this type of forecast.

    SubjectQ4
    Entry02/27/2008 06:30 PM
    Memberutah1009
    if anyone out there is still interested in LSR they just turned in a great, albeit messy Q4. excluding a bunch of tax valuation adjustments and FX stuff (all non-cash) that flowed through earnings, they earned $.46 and did $4.7m in FCF. eps for 2007 were $1.46. yeah, i hate proforma numbers too, but margins continue to expand, revenues are growing +15%, orders/backlog are strong, and the operating leverage is really showing up with record EBIT margin of 15%

    Subject13F filings
    Entry05/19/2008 06:22 PM
    Memberutah1009
    this was really interesting. previously, only 70k shares of institutional holders had been registered publicly, as the SEC grants temporary confidential treatment for LSR. but for Q1, this is the first time in many years that a whole bunch of institutions chose not to seek confidential treatment...apparently they're comfortable attaching their name to the company.

    LSR is slowly losing its stigma in the investment community. i estimate 100% upside alone if it simply traded inline with CVD and CRL.

    Subjectstill follow?
    Entry02/05/2009 09:22 PM
    Memberfinn520

    Utah,

    Interested in your thoughts if you still follow.  Any default risk here or has this just been beat up with the rest of the CRO's?

    Thanks.


    SubjectRE: still follow?
    Entry02/06/2009 08:34 AM
    Memberutah1009

    Still follow closely.  Had sold some in the 30's but obviously not nearly enough...thought management was going to sell the company.  My original EPS estimates were obviously assuming a perfect alignment of the stars, and I now think they'll earn about $.90 in 2009.  CRO's in general have gotten blasted, even later stage ones where demand has accelerated.  Companies like KNDL have seen business pick up but the stocks just arent doing much.  One somewhat encouraging thing was the acquisition on Monday of PharmaNet Development Group (PDGI) by JLL Partners.  Unlike LSR, PDGI did have serious liquidity problems in the form of a putable convert.  I'm hesitant to use the takeout as a valuation benchmark though since it was a distressed sale and PDGI doesn't have nearly the reputation of LSR.

     

    No default risk (see pages 66-69 of the 10K) whatsoever.  LSR has $59m in a secured term loan due March 2011.  They are comfortably meeting their covenants and even assuming a really lousy 2009 and 2010 they are still FCF positive.  They have $30m in cash.  Management has turned this around marvelously once already and owns 20% and has essentially never sold a single share.  The main problem for LSR right now, other than new business, is that 2/3rd of the company is in the UK.  The Pound falling off a cliff is going to hurt.  The financing agreement is contained in the 8K dated March 6, 2006. 

     

    I think it's really, really, cheap right now but I lament about the total lack of catalysts to get the shares higher.  I think patience will pay off.

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