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 3^rd 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 3^rd 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.

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