Is IMS Health a Good Investment?

Below is our investment analysis for IMS Health (RX).

Executive Summary

• Attractive and sustainable return on invested capital
• Exceeded 100% over the past ten years
• High customer switching costs should help sustain returns on invested capital over a long time period
• Management team focused on delivering value to shareholders
• CEO has meaningful equity ownership in t he company
• The company has consistently delivered excess cash flow back to shareholders through dividends, stock buybacks, and paying down debt
• Attractive valuation
• Current stock price implies an 18% normalized free cash flow yield
• Market is mistaking the impact from the recession with a long-term secular decline in the company’s free cash flow

Is IMS Health a Good Company?

The IMS Health, Inc. (“IMS”, “RX”, or the “company”) provides mission critical information to pharmaceutical companies globally, such as sales territory reporting and prescription tracking.

In other words, the company tells pharmaceutical companies where their products are being sold. The company was founded in 1954, and is headquartered in Norwalk, Connecticut.

Information and Analytics (77% of 2008 Revenue)

IMS gathers data from pharmacies, wholesalers, prescription benefit managers (“PBM”s), and doctors to determine which doctors prescribe particular drugs. Pharmaceutical companies pay millions of dollars each year for this data to:

(i) compensate their sales force,

(ii) allocate resources (advertising dollars, sales force members, etc.) appropriately to optimize sales, and

(iii) and provide information to Wall Street analysts regarding market share and unit sales data.

Consulting (23% of 2008 Revenue)

IMS uses the above referenced data to provide consulting services, such as forecasting demand for particular drugs, advice for optimizing marketing spend, and selling reports to healthcare industry analysts. Economic downturns and other events that negatively impact the pharmaceutical industry’s profitability impact this portion of the business more than the information and analytics business, as these services are normally not as critical to pharmaceutical companies.

As of December 31, 2008, IMS employed approximately 7,500 people. None of the employees are represented by a union. The company’s capital expenditures are primarily related to developing software tools and upgrading information technology to better gather and analyze prescription data.

Over the past 10 years, the company has earned excellent returns on capital, exceeding 100% every year. Below I will discuss the factors that drive such high returns on invested capital, and why I believe those returns can be preserved over long periods of time.

The prescription information and analytics market is characterized by limited competition from the following major companies:

(i) IMS Health,

(ii) SDI,

(iii) Taylor Nelson,

(iv) Cegedim, and

(v) Wolters Kluwer.

Note that IMS is the only company that offers pharmaceutical sales information globally. The market possesses relatively high barriers to entry with only one company attempting to compete globally during the past 10 years.

Based on conversations with former employees and customers, the company’s global footprint provides a critical benefit to customers, as data is consistent across geographic territories and pricing is lower buying a single global solution versus buying several individual market reports from IMS’s competitors.

Further, once a customer subscribes to data from a particular provider, the pharmaceutical company will not likely to switch to an alternate provider, because the customers’ sales force is compensated based on that data, and therefore customers need to make sure the data is consistent and accurate to avoid compensation disputes with the sales force.

Since customers are unlikely to switch, IMS buys more data than its competitors at higher prices from its data suppliers, as IMS can spread those costs over several large pharmaceutical company budgets, which allows them to obtain 70% of all prescription related data globally. Further, IMS signs supplier agreements that include most favored nation (“MFN”) clauses that stipulate that IMS receives the lowest price for the information it buys.

These clauses effectively make it more difficult for smaller competitors to compete. For example, let’s say IMS pays $10MM to a pharmaceutical chain in Italy for its prescription drug sales data. A competitor would need to offer at least $5MM to the same chain to make selling data to it worthwhile, as IMS would reduce its payments from $10MM to $5MM under the MFN clause of the contract.

This example does not account for the administration burden of providing the information to two providers. The competitor may not be able to offer $5MM, because it has fewer and smaller customers.

Lastly, IMS possesses the largest and longest historical set of pharmaceutical sales data in the industry, which has enabled it to create superior algorithms (100+ patented algorithms) that help estimate the remaining 30% of prescriptions written where IMS does not receive the actual data. The company is also able to utilize its algorithms for other commercial purposes, such as projecting future drug sales.

Risks to Cash Flows

There are several risks to the company’s cash flows, including:

(i) the increasing prevalence of generic drugs, as generic manufacturers do not use the company’s services, because marketing is deemphasized by these companies in order to maintain a cost advantage over branded drugs,

(ii) potential future consolidation of the pharmaceutical industry would create less customers, which could increase customer bargaining power over time, and

(iii) any healthcare reforms that would decrease the profitability of the drug companies in the future could put pressure on the company’s consulting business, as pharmaceutical companies tighten selling expense budgets.

While large pharmaceutical companies’ pipeline of new drugs is dwindling, and their existing drugs are increasingly coming off patent (and therefore subject to generic competition), I view this development as a temporary phenomenon. Over the long-term, new drugs will be invented by both large pharmaceutical companies and smaller biotechnology firms that will fuel the new drug pipeline, and increase demand for IMS’s services.

In my opinion, most Wall Street analysts are focused on this issue, because their time horizon is less than mine. Further, given the lack of alternatives for global data and the high customer switching costs, IMS should be able to maintain its pricing power despite pharmaceutical industry consolidation.

While single-payor reform in the U.S. would likely negatively impact pharmaceutical profits, the amount of selling expense spent on IMS products is relatively small (under 2% of large pharmaceutical companies’ budgets), and IMS’s market position should allow them to maintain pricing.

Additionally, it is important to note that 60%+ of the company’s revenues are generated outside the United States (including several countries with state run healthcare). Further, some Wall Street analysts seem focused on the fact that New Hampshire recently passed a law banning linking prescriptions written to the doctors who wrote them.

However, the New Hampshire decision has not impacted the price IMS charges for those sales territories, as companies like IMS are still able to link back sales data to the sales representatives’ territory. Further, the movement to pass these laws is dwindling with only three states still considering this type of law compared to 23 at the beginning of the year.

Does IMS Have a Good Management Team?

The IMS management team is lead by David Carlucci. He has been Chief Executive Officer since January 2005. Prior to becoming CEO, he was COO of IMS. Prior to IMS, David held senior management roles at IBM.

David has grown ROIC consistently since he became CEO, and has returned substantially all free cash flow to shareholders through dividends, share buybacks, and paying down debt, as the company does not require large amounts of capital to grow.

David owns $5.2MM worth of IMS common stock or ~6x his base salary, ensuring that he will continue to keep a shareholder mindset.

Can IMS Be Bought at a Cheap Price?

After examining the past 10 years of financial information, I believe that normalized pre-tax equity free cash flow is ~$430MM. At Wednesday’s closing per share price of $13.08, IMS’s market capitalization is ~$2,386MM, which means the stock has an 18% pre-tax equity free cash flow yield.

If IMS trades at a 7% pre-tax equity free cash flow yield, which would be appropriate for this high quality company with a potential emerging markets growth story, the stock will rise to ~$34 without any earnings growth, making the stock a compelling buy at $13.08.

Please note that Wall Street appears to be assuming that the company’s free cash flow is in secular decline, rather than just going through a cyclical decline.

However, due to tightening budgets in the healthcare industry during times of extreme economic duress, the company has always lost consulting revenue during recessions, and I believe the company will return to pre-recession free cash flow levels, as the company has historically done after prior periods of economic difficulty.

As always, please feel free to contact with any questions, or if you would like to discuss my research further.

Comments

[Graham Jervis:]

on top of that, check out their share count over the years. Just wait till their debt is paid off, this wide moat company will surely fly. i am glad no one is paying attention to it so that i can quietly accumulate it.

Aug 20 11:27 AM