Quintiles' Joint Venture With Quest For Clinical Lab Services Will Provide Long-Term Synergies

| About: Quintiles IMS (Q)

Summary

Quintiles has announced its intention to form a JV venture with Quest Diagnostics that appears to be an attempt to replicate the revenue synergies of the LabCorp deal.

Product development TTM net book-to-bill ratio of 1.41x is supporting a reacceleration in organic growth, which should build throughout 2015.

Considering the breadth of Quintiles' global client base and the combined CRO/CSO offering, the total addressable market opportunity is estimated to be around $68B and a significant growth potential for the company.

Business description

Quintiles (NYSE:Q) is the world's largest Contract Research Organization (CRO), and offers one of the most comprehensive suites of outsourced biopharmaceutical commercial services. Q's Product Development (CRO) segment provides management and monitoring of Phase I through Phase IV clinical research, lab, data and analytical support services, portfolio and trial strategic planning, design and consulting. Q's Integrated Healthcare Services (IHS) segment includes contract sales and marketing (CSO) and late-phase studies and support, including market access, observational studies, health economics and outcomes assessments, analytics and consulting. The company has 27,000 employees in approximately 100 countries, and has helped develop or commercialize all of the top 50 best-selling drugs on the market.

Fundamentals

Quintiles Transnational Holdings Inc. announced on March 31 its intention to form a joint venture with Quest Diagnostics (NYSE:DGX) that appears to be an attempt to replicate the revenue synergies of LabCorp's (NYSE:LH) recent acquisition of Covance (NYSE:CVD). The JV will aggregate Q's and DGX's central laboratories - Q will also contribute its genomics and bioanalytical operations, and will own a majority (60%) stake in the JV. The combined entity will solidify Q's position as the second-largest central laboratory provider behind Covance in a business where economies of scale are important. The JV is intended to operate as a standalone company with its own independent board, management and clientele. The JV will also include a number of multi-year service agreements between Q and DGX to allow for greater collaboration in the areas of clinical trial recruiting, the commercialization of companion diagnostics, observational/late-stage research and population health management.

JV Details

  • Structure: Both companies will combine their clinical trial labs (e.g. central lab, genomic lab, bioanalytical lab).
  • Synergies: Near-term, primarily from costs - facilities consolidation, procurement (e.g. lab supplies, reagents) and logistics.
  • Management: Q executive (Costa Panagos) will be CEO of the JV, while DGX will chair the board (John Haydon).

Moat Trend

  • Product Development reaccelerating: The segment's TTM (trailing twelve months) NBB (net book-to-bill) of 1.41x is supporting a reacceleration in organic growth, which should build throughout 2015. Q has healthy CRO revenue visibility, and organic growth is expected to pick up in 2015, although some cancellation activity clouds the backlog burn rate picture slightly.
  • IHS continues recent momentum: The strong TTM NBB of 1.15x is supporting robust organic revenue growth, which has averaged 25% y/y for the last three quarters, while on the margin front, long-term segment OM (operating margin) potential and Q's upper-single digits target is possible over time (Q4'14 segment OM was 8.4%).
  • Strong technical attributes: Q's size significantly broadens the potential investor base relative to peers, and as a newly public entity, the company brings potential incremental upside from indexing and also broadens the institutional relevance of CROs.

Major Risks

  • Customer challenges: Q provides mission-critical services to a large marketplace, yet the client base faces many challenges. While the environment has improved in recent years, the ongoing risks of pipeline reprioritizations, M&A, financing hurdles, restricted budgets, price pressures and potential disruptions remains from rapidly changing outsourcing models.
  • Competitive forces: Q is a differentiated share-taker in clinical outsourcing; however, this is a crowded field, where some peers occasionally offer exceptionally aggressive deals to regain market share. There exist many large non-traditional firms offering niche services to pharma that can eat into the market opportunity.
  • Contract risks: Expectations of more fixed-fee and risk-sharing contracting, along with slower payment terms by customers seeking leverage on consolidated procurement. While Q is highly diversified, contract termination risk is prevalent in the sector and remains a risk for the company's IHS segment.
  • Ownership: Q's board should comprise a majority of independent directors by November 2015 as part of its transition to non-controlled company status. With around 32% of shares outstanding in the hands of the major private equityholders (Bain, TPG and 3i), investors can expect additional liquidation events over the next few years.
  • Global risks: Given the breadth of Q's offering, the company is exposed to global political, economic and regulatory risks, along with forex and tax considerations.

Outlook

An enormous market and strong potential opportunity: Clients don't have to choose Q, but the tools and testing done are highly scripted in law, regulation and practice. Given average 10-15 year lifecycles for development, ever-expanding testing requirements and the pace of change, Q's solution set are expected to be viable for decades to come. Considering the breadth of Q's global client base and combined CRO/CSO offering, the total addressable market opportunity is estimated to be around $68B. Quintiles reported margin expansion in both its Product Development and IHS business segments, with $3.1B revenues (20.8% margin) from product development and $1.1B (6.1% margin) from IHS in FY2014.

Experiencing a cyclical recovery within a secular bull market for CROs: From 2H'08 through most of 2011, healthcare R&D support providers broadly experienced choppy and generally below-average demand, cancellations and delays, along with pricing pressure. In addition to global events, including a strained economic landscape, political turmoil and regulatory uncertainties, client reimbursement pressures and profit erosion from the generics wave, major influences have included biopharmaceutical M&A, pipeline restructurings, reduced biotech financing and excess capacity. However, recent strong biotech financing, an improved drug approval profile for large pharmaceutical players and relatively stable economy and regulatory environment bode well for CROs

Investment Rationale

Quintiles is the largest and one of the best-positioned vendor in both contract biopharmaceutical research and commercialization support, and brings several technical merits that make it investable to the largest audience. The JV (versus an outright central lab asset purchase) trades more material near-term accretion for optionality to pursue additional CRO/lab strategic objectives going forward. This results in favorable risk/reward on the deal, and shouldn't distract from accelerating core CRO performance in 2015. Management expects constant currency revenue growth of 7.5-9.0% for 2015, and expects to deliver 12-16% EPS growth ($3.02-3.13 in adjusted EPS). The firm's cash balance sits at nearly $900M, and hence, it has room to use tuck-in acquisitions or share repurchases to drive additional earnings growth.

Conclusion

Industry fundamental remain strong for both the early- and late-stage CROs, as they will continue to benefit from pharma and biotech R&D growth, increasing outsourcing penetration and expanded use of strategic partnerships, resulting in enhanced market share gains by the larger CROs. Quintiles currently trades at $66.46 (closing price as on April 7), with its 52-week range of $46.27-69.97, and looks attractive with strong potential upside over the medium to long term -

  • Quintiles' market share leadership in late-stage clinical trials, its diversified customer base and its strength in informatics will help in improving the company's financial performance.
    • With over 1000 PhDs, it is way ahead of other smaller CROs in terms of delivering value to its clients and global reach.
    • Book-to-bill ratio of 1.41 for FY2014 for the company's product development unit is the highest in the past 6 years, and augurs well for its performance in 2015.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: (Sources: Company Annual Reports, Company Press Releases, Investor presentations, SEC Filings -Form 10-K, 10-Q, Morningstar, Outsourcing-Pharma, Reuters, Yahoo Finance)

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