Description

The market is currently valuing PDI Inc.'s operating business as a liability and expects that management will burn away the almost $70 million (or $5 per share) in cash that currently resides on the company's balance sheet.  The company is a CSO to the pharmaceutical industry that has been mismanaged for years, and revenues and market share have declined significantly as a result.  But the Board has hired a new CEO who has slashed costs and appears to be revitalizing the company's business development function.  The burn rate is down considerably, and management is hoping to break even by the end of 2010 by growing its revenue base. 

The pharmaceutical industry is desperately trying to reduce its fixed costs; as a result, the market for outsourced pharmaceutical salespeople should increase significantly over the next five years.  With a 15-20% share of this quickly growing market, PDI's execution has been absolutely abysmal over the past few years, and the company has lost its market leadership position to Inventiv Health as a result.  A year ago the Board hired Nancy Lurker to run the company and gave her 24 months to turn the company around. Since she arrived, she has reduced headcount, moved the company to a lower cost facility, and restructured a disastrous contract with Novartis.  She also brought in new sales talent to help the company land new accounts.  Sales progress has been admittedly slow due to industry consolidation and healthcare reform uncertainty, but the company just announced a strategic contract with a top 5 pharmaceutical company which should generate $24 million in annual revenue during 2010. 

If management can grow revenues, the market will change its mind about the value of PDI's business.  If management cannot grow revenues, I expect the Board will put the company up for sale.  Either way, investors should come out well in my opinion.  PDII to me appears to be an undervalued cigar butt.

Company Overview

PDI began as a contract sales organization (CSO) in 1987, so it has a long track record of providing outsourced sales services to pharmaceutical companies, and particularly to large pharmaceutical companies.  PDI's CSO organization focuses on "product detailing," which involves a sales representative meeting face-to-face with physicians and other healthcare decision makers to provide a technical review of the product being promoted.  PDI's sales teams can be hired on a dedicated basis or on a shared basis, depending on the particular needs of the client.  The typical term of a contract is between one and two years and may be renewed upon mutual agreement.  The company also has a marketing services segment, but looking forward the sales services segment will be the company's driver of growth.

If a pharmaceutical company launches a new product and wants to put forward a concentrated effort during the launch, a CSO such as PDI might be hired as augmentation.  Also, if a product is in the middle to end of its product life cycle, and all that is required is product detailing, and the company wants to focus its sales force on growth opportunities, PDI might be hired. 

With $86 million in trailing twelve month revenues, PDI has a fair amount of customer concentration risk.  In 2008, the company's largest customers were Pfizer (28.2% of revenues), Hoffmann-La Roche (13.6% of revenues), and Abbott Labs (10.7% of revenues), and this customer concentration risk has hurt the company over the past few years.  PDI has experienced a sharp decline in revenues since 2006, which is entirely attributable to the termination of several large customer contracts representing $150.9 million of revenue during 2006, $15.9 million of revenue during 2007, and $10.7 million in 2008.  These contracts were terminated because the project ended or because a client decided to move their sales force in-house; not a single contract was terminated due to competitive reasons.  Unfortunately, management was not able to find replacement revenues from new business, which is why the company hired a new CEO in November 2008.

CSO Industry Growth

Pharmaceutical companies are working diligently to become more efficient in the way that they both develop and market their drugs, for a number of reasons.  First, patent expirations are looming across the industry; more than $100 billion in annual branded revenues are going off-patent between now and 2012.  Second, due to FDA challenges and an already crowded marketplace, new drugs are not being introduced at a fast enough rate to replace the revenues lost from patent expirations.  Third, managed care organizations and PBM managers are consolidating and demanding greater rebates.  The recent acquisition of the WellPoint PBM business by Express Scripts is a perfect example of this phenomenon.  Fourth, Medicare rebates will be increasing.  All of these factors will create enormous pricing pressure on the pharmaceutical industry in the United States, and pharmaceutical companies are responding by cutting costs.

Outside of R&D, the major expense area that a large pharmaceutical company can cut is the sales force.  To boost margins, I expect large pharmaceutical companies to cut the size of their sales forces, to cut the compensation they pay their sales forces, and to move to a more variable cost sales force model.  All of these industry changes are likely to benefit the CSO industry, whose sales reps cost 30% less on average compared to an internally hired sales rep.

In addition, many start-up biotech companies and foreign owned pharmaceutical companies are looking to commercialize products themselves with an outsourced solution rather than give the product away to large company for a royalty fee.

Competition

In 2004 PDI had a #1 market share position among CSO companies with 40% of the market.  Today PDI's market share has declined to 15-20% of the total market.  PDI competes with other CSO organizations, namely inVentive Health, Innovex, and Publicis Groupe SA.  These three companies, along with PDI, accounted for a majority of the U.S. CSO market share in 2008. 

• InVentive is probably the market leader today with approximately a 33% share of the market. InVentive grew in size by focusing on emerging pharmaceutical companies.
• Innovex has increased market share due to its financial arm which invests in new pharmaceutical products, and those investments in turn help Innovex acquire CSO contracts. Innovex represents about 15% of the market.
• Publicis also represents about 15% of the market.

Again, PDI has lost market share because contracts have expired or been terminated, while at the same time management has done a poor job of signing on new clients.  Based on conversations I have had with management, the company's sales failures were a result of poor leadership, management disengagement, a poor business development team, and a poor head of sales.  This year PDI hired a new VP of Sales and a new VP of Business Development, and the recent contract win was probably the result in part of a better BD team.

2010 Forecast

Due to the fact that the company's sales base is not large enough to cover fixed costs, the company is still burning through cash, and I expect the company to continue burning through cash in 2010.  The cost side of the equation is the easiest to predict - right now expenses are running at a rate around $9 million.  Management has suggested that they may find some additional areas where it can save money, but I do not think investors should expect anything.  Based on these expenses, the company is likely to break even at somewhere between $34mm and $36mm in quarterly revenues and a 25% gross margin.

The revenue side is more difficult to forecast, because it is dependent on pipeline wins.  This is where the investment risk lies.  We know that PDI has several contracts set to expire during the fourth quarter which are not expected to renew.  These expiring contracts represent annualized revenue in the $5 to $7 million range.  As mentioned earlier, the company signed another contract worth $24 million in annual revenue.  Adding $18mm in net revenue to a base of $86mm in annual revenues, I get an estimate of $104mm in 2010 revenues without any further pipeline wins. 

Getting to the sales pipeline, in the Q3 call management claimed a sales pipeline of $200mm in annual revenues.  Let's assume $175mm in sales pipeline today.  If PDI can land 20% of this business during 2010, PDI gets to a break even run rate by the end of the year with a sales run rate of $139mm.  It seems like an attainable goal to me.  If PDI does not get to break even, they should at least come close.  And if PDII can grow revenues from current levels to they should burn less than $10mm in cash before the company starts to generate positive free cash flow again.

Valuation

Getting to a break even run rate by the end of 2010 seems like an attainable but challenging goal.  Clearly if this happens, investors should do well, because the company will have burned less cash and the market will start to value the ongoing business as an asset rather than a liability.  

But what if management fails to grow its revenue base?  If the company generates no additional revenues from closing new accounts, I would forecast that the company will have $58.4 million in cash at the end of 2010.  In this downside scenario, the Board would likely give up and sell the business to one of PDI's competitors for the value of the company's cash plus the value of PDI's customer base.  But what is the value of PDI's customer base?  Inventiv, the most similar comp for PDI, is currently trading at an EV/Revenue ratio of 0.74x.  At the value of the company's cash plus the value of PDI's customer base at 0.37x (half of Inventiv's ratio) sales, I estimate a 2010 year end intrinsic value of $96.4 million, or $6.78 per share.  This fairly conservative valuation still represents more than 50% upside from the current stock price.

If the company were to generate additional revenue and burn less cash than my worst case scenario, or if the market or a buyer decides to give PDI a larger EV/Sales multiple than 0.37x, or both, PDI could be valued at more than $10 per share.

Given the scenarios I laid out in the table above, I see limited downside and a lot of upside in an investment in PDI.  The biggest risk I suppose is that the business gets worse and the Board does nothing about it.  But John Dugan, the company's founder, is on the Board and owns 34% of the company's shares.  Granted, his governance record is far from stellar given where the company is today, but I don't think he is going to let the company run itself into the ground.

Catalyst

• New account wins
• Sale of the company