Value Investors Club / PAREXEL INTERNATIONAL CORP (PRXL)

Description

“[CROs] are the experts…in the regulatory landscape, the therapeutic area, and the database of patients and investigators” – Clinical Development at PRXL Customer

We’re long shares of Parexel International (PRXL), a leading clinical research organization (“CRO”) with a multi-decade track record of double-digit growth. Founder & CEO Josef von Rickenbach launched the business in 1982 and took it public in 1995. Over the past decade, von Rickenbach grew Parexel’s revenue from $545m to $2bn, EPS expanded from $0.36 to $2.70, and Parexel solidified its position as a top three CRO, all while maintaining an unlevered balance sheet and generating consistent free cash flow. Short-term market gyrations, triggered by a guidance reduction of NTM EPS growth from 20% to 17%, then aggravated by a broad-based healthcare selloff, have left Parexel with the undemanding valuation of 1.9x NTM EV/Revenue (peers are 2.3x – 3.5x) and 13x EBITDA.

Amongst the large public CROs, Parexel trades for an anomalously low EV/Revenue multiple, suggesting that operating margins have room to expand. We’re inclined to support that view for a few reasons: i) a recent hiring spree, in anticipation of a growth uptick and move towards later-stage trials; ii) management recently introduced a $50-60m cost reduction plan, to be realized by FY17; and iii) PRXL operates with a 35% tax rate, but believes it can decline to 20-30% over time. Quotes paraphrased from our calls with customers indicate there’s room to reduce overall costs: “[PRXL] staffs with one Senior Director, one Director, but only one contract Analyst on the ground”; “[PRXL has a] ‘clubby,’ ‘Ivy League’ feel”; “Pfizer is very top-heavy, and Parexel is very top-heavy, so they go together.” We also heard that a shift towards junior employees wouldn’t impact service levels. Parexel has gone a step further by outsourcing staff abroad: its headcount in India grew from 500 in FY14 to about 1,000 today, with a March 2015 acquisition targeting the pharmacovigilance market (detection and collection of adverse events) staffed largely out of India. Parexel’s organic growth, cost reductions, and tax opportunities could lead to 100-120bps of margin expansion per year over the next few years.

A comparison of Parexel’s employee growth against recognized revenue (a trailing figure) also supports the notion of front-loaded hiring in anticipation of future growth – perhaps helping explain the lack of recent margin expansion.

PRXL Historical Revenue vs Employee Growth

Within its industry, Parexel stands out for the breadth and depth of its services. Parexel has worked with each of the top 50 companies in the biopharma space, with at least some degree of involvement on 95% of the top 200 biopharmaceutical products on the market. Further, a recent analysis of clinicaltrials.gov cited Parexel’s involvement in more clinical trials than all but one of its peers, the much larger Quintiles. One client told us, “Between Parexel and [a second retained clinical outsourcing partner] I expected Parexel to outperform, and they have.” That’s not to say that Parexel is without faults. Amongst the top five CROs, all adequately service a multi-national client. And over time the CRO group must become more cost efficient. But with recent hiring abroad, in addition to the cost-cutting plan, Parexel appears to have positioned itself ahead of these trends, with further evidence of outperformance apparent in Parexel’s hefty backlog.

Parexel possesses a business backlog of $5.4bn, or almost 2.5x LTM Revenue – or about 2x, factoring in expected cancellations. Offsetting this massive backlog is Parexel’s track record of cancellations, which compares poorly against margin-leading peers like ICON plc. Management attributes the historical cancellation rate to failed clinical trials, and believes the rate should fall: “the quality of molecules [in the pipeline] are better than 6 or 7 years ago.” But even amidst client product failures, Parexel’s new business wins (21%, 11%, and 46% growth) and backlog growth (9%, 6%, 11%) result in a book-to-bill of 1.3x through the last twelve months, positioning it well for future growth.

The business model is recurring – once a Phase I trial is begun with a CRO, the business is usually retained through the 10+ year testing phase. Cancellations result from failed early-stage trials, reallocated R&D budgets, or in rare instances, a consolidation of a client’s vendor base. The business is somewhat counter-cyclical since well-funded pharmaceutical companies tend to invest through the cycle. And Parexel’s client base skews towards large customers like Pfizer (PFE). Even in a recessionary environment, cash-rich companies like PFE are unlikely to pull mid-stage clinical trials.

We’ve constructed a DCF taking into account all of the aforementioned considerations. Over the next few years, we believe high-single digit growth will be supported by the CRS backlog, and assumed ~10% overall growth in 2016 slowly declining to mid-single digits over our 10-year projection period. As Parexel has demonstrated good operating margin expansion over the last two years (8% to 11%), we’ve modeled continued margin expansion through the projection period, combined with a reduction in tax rate. Under these assumptions, we arrived at a share price of $95-100, implying 45-50% upside.

Industry and Company Synopsis

Parexel’s long-term success springs from three primary growth drivers: i) global pharmaceutical R&D growth (c.2-4%/year); ii) increased outsourced penetration (currently c.50%); and iii) industry consolidation. Taken together, these three constituents can lead to 7-9% organic growth, with Parexel’s targeted growth reaching 10-12% after supplementary M&A.

Both our primary research and a medley of public studies approximate this rough math. Year-to-date sellside surveys of pharma staff predict high-single digit R&D growth through 2015.

Source: October 2015 Baird Survey

Source: May 2015 Jefferies Survey

The CRO industry has undergone a secular period of consolidation. The advent of strategic partnership agreements -- where pharmaceutical clients cull their vendor base from tens to three or fewer providers -- and ever-escalating regulatory complexity drove market share towards leaders like Parexel. In years prior, the top seven CROs (Quintiles, Covance, Parexel, PRA, PPD, Icon, and inVentiv) held less than 40% share. That figure climbed to 50% in 2014 and is expected to grow to 60% within the next few years, with no obvious regulator to stymie the trend.

The outsourcers also govern a larger proportion of the clinical budget at existing clients. A senior director at BMS told us, “I don’t foresee any changes to the CRO model…people are happy that they can do more work, so they outsource more.” Paraphrasing from another large pharma company, “[CRO] usage has grown over the last few years here, and it’s going to continue to grow.” A study of 148 senior-level executives, completed by a consulting group, but commissioned by Parexel, predicts high-single to double-digit growth for the sector.

Whatever the underlying growth rate, it’s clear that large CROs have amassed the expertise and sophistication to make their service indispensable to some clients. CROs dampen the volatility of internal budgets by converting fixed R&D capital costs (overhead, clinical staff, reporting infrastructure) into a variable cash expense. This allows research organization to focus on what they do best: drug discovery and, for the multi-nationals, selling and marketing.

Non-CRO Business Lines

Augmenting Parexel’s core CRO business are two directly related businesses: a 45-50% gross margin software business – pieces of which, like the data-monitoring tool Perceptive MyTrials, are used at all top 15 pharmaceutical companies -- and a consulting group that works to capture regulatory and commercialization business.

As expected for any standalone software company, Parexel is deeply committed to IT, “eClinical technology solutions are fundamentally reshaping the biopharma landscape…being a successful CRO increasingly also means being an eCRO” (Investor Day), and this IT expertise confers benefits to the entire organization. But Parexel’s software platforms are a profit center themselves. Products include ClinPhone RTSM (randomization and trial supply management) – it has randomized 2.4m patients for 3,300 unique clinical trials – a medical imaging group that has processed 2.5m examinations, a clinical trials management system, IMPACT, utilized by nine of the top 20 pharma companies, and Liquent InSight for regulatory information management. Some of these were acquired, such as Liquent, and retain the non-PRXL brand name, allowing unrestricted usage by competitors. Parexel competes both with other CROs and with more traditional software companies like Medidata.

Parexel’s Consulting group, seen as an industry leader and staffed by former FDA officials, advises on a wide variety of projects, including regulatory outsourcing, pharmacovigilance, and post-approval commercialization. The Consulting segment competes with other CROs like Quintiles and inVentiv – all are positioned to extend customer relationships to before and after the clinical-stage.

Taken together, these segments are about 25% of revenue and 30% of PRXL’s gross profits. Hampered by a significant Consulting contract delay in 2014, a mix shift in Informatics away from commoditized services like medical imaging, and YTD FX headwinds, trailing growth for these segments has underwhelmed. In spite of this, Parexel’s LTM consolidated bookings of 1.3x suggests improvement through the coming year, as does recent management commentary:

FQ4 2015 Call

In our consulting business, declined project delays that we experienced earlier in the year were not fully resolved at the year-end. These projects are beginning to move forward now, in addition, in our new regulatory outsourcing business, client demand is increasing. These dynamics bode well for the business. As we expected in PAREXEL Informatics, revenue growth continues to roughly mirror that of CRS, reflecting the increasing levels of integration, between those businesses.

FQ 2016 Report

The first quarter represented a solid step forward for PAREXEL Consulting. A number of client projects that were delayed last year started moving forward, yielding improved profitability…PAREXEL Consulting revenue came in at $39.3 million, growing sequentially by 4.4% on a constant-currency basis…

In PAREXEL Informatics or PI, quarterly revenue was $62.6 million, representing a year-over-year decline of 2.1% on a constant-currency basis. We expect PAREXEL Informatics to return into positive revenue growth territory in our second quarter of fiscal year '16 as we expect a more favorable business mix… We believe the first quarter marked a low point in the revenue cycle for PI, and we anticipate improving financial performance in PI for the balance of fiscal year 2016, driven by margin leverage on sales growth as the business scales…

Over the next five years, management thinks regulatory outsourcing will grow at a 15% annual rate, nearly twice the rate of traditional outsourcing.

Parexel is equally optimistic about the Pharmacovigilance (“PV”) market, whose rote reporting and data collection across countries lends itself to the outsourcing model.

Pfizer/Allergan

Pfizer is a key Parexel customer at 12%-15% of total sales. Subsequent to the Pfizer-Allergan announcement, the sellside reacted with trepidation, though this anxiety was muted in light of the added pipeline for Pfizer’s strategic clinical partners: PRXL and ICON. While banks continue to warn “the near-term risk of disruption to CROs is material,” management disagrees:

Once again, I would just make sure, we really don't expect any fallout from this certainly not negatively. I mean, if anything, as I said, this would be a net positive for us. – FQ4 2015 Call

Thus far, the deal logic doesn’t rest on R&D cuts. Pfizer projects some $2bn in synergies -- one-third would be related to R&D.

Conclusion

Parexel’s long-term growth targets are ambitious: 10-12% revenue growth, 100-120bps of margin expansion per annum, a 20%+ ROIC, and 15-20% earnings growth. But looking through Parexel’s long-term operating history, the growing penetration and acceptance of clinical outsourcing, and continued stewardship by management, led by founder Josef von Rickenbach, these objectives seem attainable. And if earnings can double over the next four years, through any cyclical correction, the current valuation of 2x EV/Revenue and 13x EBITDA seems too cheap.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Continued earnings growth

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			2015	2016
Price:	65.14	EPS	2.84	3.28
Shares Out. (in M):	55	P/E	23	19
Market Cap (in $M):	3,575	P/FCF	23	19
Net Debt (in $M):	333	EBIT	215	252
TEV (in $M):	3,902	TEV/EBIT	18	15