PRA Health Sciences: A Solid Investment Case But Watch Out For Signs Of Inertia

Investment Thesis

I last posted about PRA Health Sciences (NASDAQ:PRAH) in May 2019, after the company’s share price had slipped from late 2018 highs of $117 to trade at $90.

I suggested that the company’s days of sector and S&P beating growth – PRA’s share price gained 216% between 2016 and 2018 – were most likely behind it and that shareholders could still expect gains, albeit in the mid-double-digits, in 2019.

That proved to be the case – the stock is up 14% since my note, so I thought it would be a good time to evaluate what the rest of 2020 and early 2021 may have in store for the company.

Company Overview

PRA Health (PRAH) is one of the world’s leading contract research organizations (“CRO”), and one of the largest by revenues generated. Its focus is on helping biotechs and large pharma organizations conduct development and clinical trials of their drug candidates, from pre-clinical testing, through phase 1,2 and 3 clinical trials to commercialization, and post-marketing studies if required.

PRA’s areas of specialism include oncology, immunology, central nervous system, inflammation, respiratory, cardiometabolic and infectious diseases. The company has more than 75 offices, and 17,500 staff worldwide, and since 2000, has worked on more than 4,000 clinical trials, including more than 95 pivotal late-stage trials that have resulted in FDA or international marketing approval. PRA earns the bulk of its revenues (56% in Q220) from large pharma concerns, ~8% from mid-sized pharmas, 18% from larger biotechs, and the remainder (18%) from other biotechs.

PRA has 2 reportable segments – Clinical Research, which covers most of the company’s day-to-day operations and development and trial work, and accounts for ~92% of all revenues earned by the company, and Data Solutions, which is focused on leveraging data analytics and technology to provide consulting solutions to the life sciences market.

The company is led by an experienced management team and board – President, CEO and Director Colin Shannon has been with the company since 2007, whilst most of the rest of the management team have been in place for more than 5 years.

The company’s Board of Directors comprises a mix of private equity, investment banking and biotech experience, including James Momtazee, formerly Head of the Americas Health Care industry team at PE firm KKR, Glen Stettin, Senior Vice President and Chief Innovation Officer at Express Scripts & Cigna Services, and Matthew Young, Chief Operating Officer and Chief Financial Officer of GRAIL, the promising cancer diagnostics startup that has been in the news owing to a rumored $8bn acquisition bid by former owner Illumina (ILMN).

According to Fintel, PRA has ~50% institutional ownership, with its largest shareholders being Price T Rowe (11%), Vanguard Group (11%), Blackrock (10%) and Wellington Management (9%).

Recent Performance

With the exception of the market selloff in mid-March this year as traders reacted to the impact of coronavirus, and PRA’s share price dropped briefly to $66 – its lowest level since May 2017 – PRA has traded in a narrow range since 2019, typically between $85 and $115, which is some way below the fair value I have calculated for the company based on DCF analysis of >$127.

There are explanations for the lower trading price however. First of all, PRA is heavily indebted – its debt to equity ratio is ~3.2x, and the company reported $1.27bn of long term debt as at Q220, alongside near-term cash of just $168m.

The pandemic has also disrupted the company’s operations and its revenues have suffered – falling from an impressively high $800m in Q419 to $784m, and $730m in Q120 and Q220 respectively, while adjusted net income has fallen from $136m in Q419, to $99m in Q120 and $82m in Q220 – its lowest level since Q318.

On its Q220 earnings call, management reported that ~30% of its client’s studies had been put on hold owing to coronavirus, and that 65 – 80% of sites were subject to restrictions, causing billable hours to drop. On the plus side however, management noted that by the end of Q2 only 18% of studies remained on hold and more than 50% of sites were no longer subject to restrictions.

Management took the unusual step of issuing Q3, as well as full-year guidance, perhaps in an effort to dissuade analysts from cutting their price targets and ratings. Revenues of between $754 – $784m were forecast for Q3, and adjusted EPS of $1.09 – $1.19, whilst FY20 forecasts have been adjusted to $3.07 – $3.13bn, and adjusted EPS of $4.35 – $4.55 (GAAP EPS of $2.4 – $2.6).

At the midpoint of FY guidance, then, management is anticipating annual growth of 1%, which, if achieved, I would rate as an impressive achievement given the pandemic headwinds, although it will require a bumper last quarter of $800m+ – which PRA achieved in Q419, so investors ought to be hopeful.

The detailed guidance trick certainly seems to have satisfied analysts – whose consensus rates the stock a “strong buy” with a price target of $117 – and investors – who have helped PRA quickly recover from its March lows to trade at $103 at the time of writing. If PRA encounters more fair-weather market conditions in 2021, as seems likely, it may find itself in a strong position to buck the trend of recent stagnant share performance and push on towards $120.

Now let’s consider the state of PRA’s competition and market, and consider what the company must do in order to thrive.

Competition, Market & Strategy

The below 2 charts show how PRA’s performance has declined vs. the S&P 500 and key sector rivals over the past year after a period of sustained outperformance.

PRA Health 5-year share price performance vs S&P 500 plus sector rivals CRL, LH, SYNH, ICRL. Source: TradingView.

As we can see above PRAH stock is up 128% over a 5-year period – outperforming the S&P (+70%) by nearly 2x, and only bettered by Charles River Laboratories (CRL),+205%, whose gains have mainly been achieved in the past year.

PRA Health 1-year share price performance vs S&P 500 plus sector rivals CRL, LH, SYNH, ICRL. Source: TradingView.

As above, however, over a 1-year period PRA stock is down by 1.5%, behind the S&P 500 (+10%), and key sector rivals Laboratory Corp (LH), +7%, Icon Group (ICLR), (my note here), +17%, and Charles River (CRL), +62% – and only slightly ahead of Syneos Health (SYNH), -1.5%.

This might suggest that PRA is underperforming relative to its rivals, and a quick look at the investment fundamentals of the different companies adds some weight to this thesis, but also provides some positives.

Investment ratios of CRO sector rivals compared. Source: my table using company data.

PRA’s EBITDA multiple is one of the higher in the sector, at 18x, but is still competitive, with only Lab Corp’s significantly lower. PRA’s $3.1bn of revenues generated in FY19 is second only to Lab Corp, which is notably higher than the rest of the sector at $11.6bn, but PRA’s net profit margin of 7.9% is somewhat lower than Charles River and Icon plc (ICLR), at 9.6% and 13.3% respectively, and PRA’s price to free cash flow, at $41, is nearly double that of the rest of the sector, indicating the stock may be overvalued. The reason for this, I suspect, is PRA’s indebtedness -the second worst in the sector (behind Charles River) at 128%.

Still, looking at PE ratio, ROIC and price to sales, PRA scores slightly above average. Overall, based on analysis of more than 25 data points I award PRA a Haggerston BioHealth score of 3.20 out of 5, with 1 being best and 5 worst (more information on the HB scoring system and a rating for >1,000 biohealth stocks is available with a Haggerston BioHealth marketplace membership). This is the same as LabCorp, lower than Icon Plc and Charles River, and above Syneos Health.

I’d say this accurately reflects how I would rank the companies currently, but in truth, this is a closely matched sector, and I do not consider PRA to be overvalued or underperforming. Icon aside, and given Charles River’s recent share price surge, which looks unsustainable, I would rate PRA the strongest buy opportunity.

The specialist nature of the CRO market means that it would be hard for new competitors to gain a foothold in this market, which was estimated to be worth $39 billion in 2018 and growing at a 7.5% CAGR to reach $56 billion in 2023.

PRA had a healthy backlog of work as at June 30, 2020 of $4.9bn compared to $4.5 billion at the same time last year, and the company’s gross new business awards for H120 were $1.48bn, compared to $1.5bn in H119, with cancellations down to $172m, from $193m one year ago.

One area where I believe PRA has underperformed is within its Data Solutions business. The company spent $0.5bn in 2017 acquiring Symphony Health and its database of claims and prescriber information, but this hasn’t translated to tangible revenue growth – Data Solutions contributed just $120m in the first 6 months of 2020, compared to $116m in H119. All the acquisition seems to have done is added to PRA’s worrying debt burden.

It could also be argued that PRA has not taken advantage of an increase in clinical trials related to infectious diseases owing to COVID-19. CEO Shannon commented on the Q2 earnings call:

We have obviously a strong infectious disease franchise, but I mean we don’t have like a central lab where a lot of our clients were able to get work done there. I mean, we’ve just got bioanalytical labs, and that’s pretty much for our patients and their dependents in getting access to patients and all of the samples that get to that.

I suspect this is an area where PRA has lost ground to some of its rivals. When prompted on the earnings call, in response to a query about percentage of earnings from COVID-related trials – a figure that has been supplied by peer group rivals, Shannon responded:

I have to get back to you on that one. I don’t actually have that number on it just now. Maybe we’ll get it, when we speak to you later.

Nevertheless, COVID trials have to go down as a potential opportunity for PRA in the second half of 2020 and into 2021. Then, if the Symphony acquisition proves to be a slow-burner and begins to pay off in 2021, together with the company’s new business wins, backlog and tailwinds potentially created by a return to BAU plus additional COVID work, the next 18 months begin to look good for PRA – perhaps providing the impetus the company needs to finally break out beyond $100 and towards my target price of ~$127.

Fair Value

For my fair value price calculation I have decided to use free cash flow to equity, in other words, using EBIT minus interest expenses before subtracting tax (23% as per company guidance) and adding back depreciation (3.7% of revenues as per 2019 figure).

I assume that OPEX remains the same in 2020 as it was in 2019 – 88% of revenues, but give the company some leeway by reducing the figure down by 0.5% per annum between 2020 and 2025, and I am assuming that after 2020’s 1% growth (using the midpoint of current FY projections), PRA achieves a rate of 7% revenue growth per annum – just behind the projected 7.5% growth of the CRO market.

I calculate interest expense of ~$35m per annum, which is lower than the figures recorded in 2017-2019 of $47m, $57m and $52m. Interest expense in the first 6 months of 2020 are reportedly $25.3m, so I am being quite generous here, although if, as expected, pandemic pressures ease, PRA should have less recourse to use its line of credit.

With high CAPEX of $75m per annum I forecast PRA’s free cash flow to be down from $457m in 2019 (and $441m in 2018) to ~$315m, rising to $475m by 2025 at a CAGR of 6%. Using a WACC of 8.2% (expected market return of 9%, beta of 1.02, RFR of 1.6%), I forecast a present day firm value for PRA of $8.1bn – a 23.3% premium to current market cap, and a fair value price per share of $127.

Risks

PRA’s debt burden has to be the stand out risk in an otherwise positive – albeit limited – growth story. Despite its size – $1.3bn as at Q220, as we can see below the interest rate on the senior debt – which comprises ~$1bn of the whole portion – is a modest 1.68%.

PRA Health debt structure. Source: PRA Health Q220 earnings presentation.

PRA Health current maturities of long term debt. Source: Q220 10Q submission.

PRA is not under pressure to repay the debt quickly, with just $12.5m remaining due in 2020, $195m falling due in 2021 (PRA has a current cash position of $168m to net this off with), and after that, the vast majority falls due in 2024.

I don’t see any way that PRA can make this repayment in 2024 – even a huge share offering would not come close to raising sufficient funds – so I would expect the company to secure a new agreement from 2024. It is a shame that the cost of supporting the debt will be close to $50m per annum – which could be put to much better use – but it is not unusual either.

Charles River, for example, had long term debt of $1.8bn at the end of FY19, but the company’s share price has gained 62% nonetheless. Syneos Health has a more crippling debt position of $2.5bn, but its share price, if not performing optimally, is not suffering as a result.

Icon has just ~$0.3bn of debt, another reason I like the company – but on balance it would be fair to say that being highly leveraged does not necessarily correlate with underperformance for a CRO.

Another risk I believe PRA faces would be the competitive nature of the marketplace, with 5-10 companies of similar size and experience competing for the same contracts from the same pool of clients, with probably 15-20 companies – big pharmas e.g. Pfizer (PFE), Bristol Myers Squibb (BMY) or Merck (MRK) responsible for as much as 50% of all available business.

Competitors other than those mentioned already include IQVIA Holdings, and PAREXEL International Corporation, and Pharmaceutical Product Development, so there is a level of intense competition that requires company-wide performance to be at a high level at all times. Success rate in trials will be noted by clients, and it is easy to see how CROS can create either a virtuous or vicious circle through their actions that will either enhance or harm their reputation.

PRA also needs to avoid becoming too dependent on major firms for its revenues – the company’s top 5 clients generate ~39% of its total revenues, CEO Shannon revealed on the Q220 earnings call, although he also stated that no one client represents more than 10% of revenues which provides satisfactory diversification.

With reputation key in the CRO sector, the company’s recruitment strategy must augment the current strength of its staff, which includes roughly 850 PhDs, 600 medical doctors and 275 doctors of pharmacy worldwide. This is a balancing act given that PRA must manage costs and hire according to the amount of work it has, whilst making sure it hires to people who can do the job.

Conclusion

Will 2020 – 2021 be the year that PRA finally breaks a near 2-year period of share price stagnancy?

As I argued in my last note, I think PRA is capable of delivering upside for investors but as before, I would not expect gains to exceed a mid-to-high teen percentage in the next 12-18 months. The company does not pay a dividend and is unlikely to initiate a share buyback program owing to its debt, hence investors are reliant upon the share price alone to make a satisfactory ROI.

Personally, I preferred to add the CRO Icon Plc to my model portfolio at Haggerston BioHealth in mid-July, and its performance has been so-so to date, gaining 4%.

Icon trades at a significant premium to its pre-pandemic selloff peak, however, whereas PRA still trades at a discount, so although I pegged Icon as having the greater momentum at the time, if PRA delivers a solid second half to 2020, it may well reinvigorate analysts and investors and drag its share price significantly above $100 and towards its fair value price of >$125. That would be my hope – rather than my expectation – for PRA – but since I don’t see much case for downside with PRA, I would describe myself as bullish on the stock price.

A final thought – it strikes me that a congested sector with many companies of similar size in competition with one another has the potential for significant M&A activity, so I would also keep a close eye on that.

For PRA shareholders, a best case scenario would be an acquisition by a larger firm – LabCorp (LH) or Thermo Fisher (TMO) for example, who would pay a premium to whatever price PRA stock traded at the time a bid was made. A merger is another possibility, however this would require investors to be patient and may depress the share price in the medium term.

In the short term, I would keep a close eye on PRA and see how it responds to COVID and whether it can grow via its infectious disease segment by capturing more business from companies leading the coronavirus treatment/cure race.

If it can, it may be a sign that PRA is alert and gathering momentum. If not, it may be a sign that things really are stagnant at the company and management are suffering from inertia.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.