For those not familiar with PPDI, it is a leading Contract Research Organization [CRO] focused on late-stage development. Its closest and largest competitors are privately-held Quintiles and Covance (CVD), the latter of which I discussed earlier this year (ironically when PPDI last reported). PPDI has a strategy that is quite unique: It partners occasionally with companies to develop compounds. The company has had considerably high ROIC on these projects, fueled by “wins” with dapoxetine (JNJ) and alogliptin (Takeda). While the strategy has sometimes proven controversial, it has often impacted the projected EPS of the company enough to move the stock significantly more than justified. While I favor CVD over PPDI for longer time-frames (primarily due to scalability of the central lab business), PPDI is too cheap to ignore.
Before I go into the details about why I expect to add a long position, allow me first to address a few issues. First, the company has experienced some turnover of key executives. Over the past year, the President, the CFO and the SVP of Global Operations have all left the firm. The latter two joined PRA International (PRAI). I met with all of these executives over the past year and am not that surprised to see them go, as their “boss” apparently is a tough employer. CEO Fred Eshelman, who owns about 7% of the company, is one of my favorite healthcare industry executives. He is a straight-shooter who is extremely demanding. He has had problems with key executive retention in the past. I don’t mean to diminish the importance of other senior executives, but PPDI is Dr. Eshelman. I do hope that he understands how uncomfortable it makes investors to see this type of ship-jumping, even if it has no impact upon the firm’s ability to continue to lead the industry in operating margins.
The second issue to nail down is the compound partnering. When we first bought PPDI in late 2003 at my former firm, the company embarked on this strategy in a “louder and clearer” way. At the time, if I recall properly, the company was plowing about 10% of its earnings into these deals (it absorbs the costs of development in exchange for royalties, milestones, etc. if successful). Perhaps because the “services” analysts covering the name and industry were ill-equipped to ascertain the potential value of these ventures, they ascribed “no value”. Indeed, as they lowered estimates to account for the R&D spending, one could argue that they ascribed a negative value. The company recovered the gap over the following years, partially because investors understood it better and partially because the value turned out to be quite high. So, fast-forwarding almost 5 years later, it does appear again that investors are being too negative about the potential R&D spending. In this case, the .10 that the company mentioned amounts to about 7.5% of 2007 EPS. Importantly, CEO and big-time owner Eshelman is no fool – he won’t throw money down the drain. The company will continue to invest in this Ranbaxy drug only to the extent that it is justified by the clinical results. So, when I see the stock drop $4 on a reduction in guidance that appears to be mainly a “one-time” event, I get excited.
Longer-term, PPDI (and the other CROs) is leveraged to biotech development, increased outsourcing by Big Pharma and an increased focus on safety (post-marketing studies). PPDI is one of the few CROs that can run a global trial on three continents. The company maintains the highest margins in the industry and very satisfied customers. The backlog has grown significantly over the past few years. Yes, the quarters can be lumpy, especially given the potential for drugs under development to be pulled or delayed. With that said, though, the improvements in target identification and in initial safety evaluations (due to technology) should ultimately allow the drug developers to be more confident about spending on late-stage trials, as the chance of failure for safety reasons is theoretically much lower. So, I’ll take some lumps with that higher long-term growth potential.
The stock dropped as low as 33 when the company reported in April, and I expect that level to hold again (though 34 might be the low). Adjusting for the lower EPS, the stock trades at about 22X forward EPS at 34. Its peers, including CVD, ICLR and PRXL trade at higher valuations. Assuming the company can earn at least $2 in 2009, I expect the stock could see a price of 50 by the end of next year. The company’s dapoxetine and alogliptin compound partnerships represent upside to the earnings. Each addresses a large market, as does the Ranbaxy statin. By the way, the balance sheet is stellar - $400mm net cash. For those curious about the big increase in capital spending, it is related to their new HQ. So, I will be listening to the call in the morning, hoping to get this one on sale near $34 a share. Maybe it gets CVD down to 66, which would be a good entry there in my opinion.