Medpace Holdings Facing Some Challenges To A Model That Has Worked Well

Summary

• Once a double-digit grower with well-above-average margins, Medpace is seeing pressure as larger rivals move into its core market segment.
• Engaging with clients earlier in their business development needs could restore some of the growth, but there are risks and up-front costs involved.
• The ongoing trend of increased outsourcing should continue to benefit Medpace, as should the ongoing growth of biopharma start-ups in response to less early-stage research activity from Big Pharma.
• MEDP shares look priced for a high-single-digit/low-double-digit return on the basis of mid-single-digit long-term growth, and reaccelerating growth or margins offer upside.

Medpace (NASDAQ:MEDP) had some challenges in its first year as a publicly-traded company, as this full-service contract research organization (or CRO) saw revenue growth and margins weaken through 2017. Compounding those issues is a greater effort on the part of Medpace's larger rivals to target its core business - smaller biotechs that have historically been ill-served by the larger players in the CRO market.

Valuation is an interesting dilemma right now. It would seem that Medpace could generate high-single-digit to low-double-digit annual returns to shareholders even if it can't reaccelerate growth beyond peer/industry norms and has to absorb some additional margin pressure. While I don't expect it to be a quick (or certain) process, if management were to succeed with its efforts to reignite revenue growth there would be enough incremental return to make this a more interesting idea.

Committed To A Model That Has Worked

Although I wouldn't call Medpace's model unique, it's definitely not the model that its other publicly-traded peers use. While other players in the space like IQVIA (IQV), Lab Corp (LH), and Icon plc (ICLR) offer a wide range of services and try to get their clients to use as many of these as possible, they also allow and support customers to do partial or functional outsourcing. Medpace, in contrast, is an all-or-nothing proposition, as they don't do partial outsourcing.

On the plus side, this has allowed Medpace to create a consistent and efficient operating model that has worked very well for the company - to the tune of around 10 points of EBITDA margin outperformance versus its peers. On the negative side, that committed focus to its model costs Medpace customers, as not all biopharma clients want to outsource all of their needs (or outsource them all to a single provider).

Medpace has also done well by focusing on the under-served segments of the CRO market, and most particularly with smaller biopharmas. Some of this is a function of the model (smaller clients are more willing to outsource all of their needs), and some of it is function of the reality that larger CROs have historically not served smaller clients well - the contracts are smaller and many CROs have typically preferred to deal with larger companies that can generate substantially more revenue.

Rivals Starting To Come Into Medpace's Kitchen

When larger CROs like IQVIA, Icon, Lab Corp, and PRA Health Sciences (PRAH) were more content to focus on the larger opportunities in CRO outsourcing, Medpace's foremost concern was the funding environment for biotechs. In recent years Medpace has done around two-thirds of its business with pre-revenue biotechs, and these companies are critically dependent upon funding sources like the IPO/secondary market and venture funding to advance their clinical programs.

Market sentiment for biotech can change rapidly, and has been quite volatile since the last election, but overall funding does not appear to be a big problem. While biotech IPO amounts were down 25% in 2017, it was a drop from a high level and 2017's figure was still well above the norms of recent years. Follow-on offerings were quite a bit stronger (up 113%) and though growth in venture funding was more modest (up 5%), it reached an all-time high for 2017.

So, I don't think you can blame weak funding for the sharp deceleration from double-digit growth to just 4% growth in service revenue in 2017. Instead, I believe Medpace is facing more competition for its services. While larger CRO providers like IQVIA, Lab Corp (and others) have traditionally generated two-thirds or more of their revenue from Big Biopharma clients (which contribute about 11%-12% of Medpace's revenue), these companies are actively moving downstream and attempting to recruit smaller customers.

There's nothing mysterious about this process. The outsourcing opportunity for large biopharmas isn't fully exploited, but the low-hanging fruit has largely been picked, and larger companies seem more interested in funding buybacks and mergers than numerous new development programs. The larger CRO's have also learned from their past mistakes in servicing smaller biopharma clients, and they're often creating special units and teams that are tasked with address the customer service deficiencies that alienated this customer base in the past.

Medspace's response at this point has been to try to go smaller, building out business development capabilities and approaching potential biotech clients earlier in their development process. While that could, in theory, lead to long-lasting relationships that are harder for rivals to dislodge, it means a larger number of smaller contracts and a greater risk of clients disappearing as they lose access to funding and/or early-stage research doesn't pan out.

Outsourcing Is Still Growing, But The Challenges Will Be Different

On balance the CRO industry is still a growth opportunity. Different third parties present different figures, but there's general agreement that somewhere around 45% to 55% of eligible work is currently being outsourced and that the number continues to increase. While that's a positive figure on balance, Medpace's core market (small biopharma) already outsources 70% or more of their post-discovery development work.

Consequently, Medpace may need to step up its offerings in areas like discovery, pre-clinical, and central lab to take advantage of the comparative underpenetration of outsourcing at these earlier stages (around 40%). Lab-based work is already about 17% of Medpace's revenue base, so they do at least have a leverageable staring point here.

Medpace has also been stepping up its efforts in more demanding and complex therapeutic areas like oncology and CNS. As oncology is far and away the area of greatest focus for biopharma (roughly 30% of the industry pipeline), I consider this an essential move. Even so, Medpace doesn't try to be all things to all clients - the company isn't really involved in areas like respiratory or dermatology.

One challenge to note is the possible growth in master protocols. Master protocols involve a break from the historical practice of stand-alone clinical trials and instead consider multiple therapies for a single disease, a single therapy for multiple diseases, or a combination of the two. Master protocols are often better for patients, as they're screened once and matched with potential trials (instead of searching for specific trials, attempting to enroll, and then starting over if they don't meet the criteria), and they are likely to grow in conjunction with precision medicine (including medications that target very specific mutations). While master protocols are complicated (which is good for outsourcing providers), they are likely to lead to fewer individual trials, which would on balance be bad for the industry. On a relative basis I would expect this to impact Medpace less than some of its rivals, as it is likely larger biopharmas that will be embrace master protocols first.

The Opportunity

On the whole, I like Medpace's more conservative approach to the business. Management has created an operating model that works well, and they stand behind that model even if it means losing some partial outsourcing business. That model has supported above-average margins historically, but as bookings and revenue have underwhelmed, the company has found itself with underutilized staff and operating inefficiencies that have hurt margins.

Management is also rather conservative with respect to bookings compared to its peers. Management won't book business unless the project is funded and it only includes the revenue it expects to collect within three years. Management also generally requires upfront payment for services, and the company has a strong record with respect to both backlog conversion and working capital management.

Medpace is clearly facing some challenges in its business, but I believe it can still generate good growth. In addition to capturing more of the available outsource-able work in its core market (small biopharma), I believe Medpace can benefit from ongoing growth in the number of biopharma companies starting up - as larger pharma deprioritizes early stage discovery/development and continues on with M&A, scientists and executives are starting up their own businesses to pursue new research opportunities. History has shown that funding for these start-ups can disappear quickly when the markets turn risk-averse, but on the whole I'm comfortable betting that the number of small biopharmas will continue to increase.

I'm not as sanguine about margins. I think the company's efforts to pursue earlier-stage relationships is going to impact margins and I don't believe increased competition with larger CRO players is going to help the margin picture either. To that end, I expect EBITDA margins to head toward the mid-20%'s - still stronger than the peer group, but by a smaller margin. Likewise, I think future FCF margins will be lower than the last few years, though still attractive on balance (high teens / low 20%'s).

My modeling estimates lead to a long-term revenue growth figure of around 7% (annualized), which is in the middle of the range of what I expect for the industry, and slightly lower FCF growth. With those assumptions, I think the shares can still generate annual returns of around 10% for shareholders, which isn't too bad. If Medpace can reassert its dominance in the pre-revenue biotech space (and/or if larger CROs once again alienate the companies) and/or if this margin compression proves transitory as management starts to leverage these investments into business development, there would be upside to those numbers. By the same token, Medpace could lose more share in the space than I believe and suffer even greater margin erosion, so there is down-side risk as well.

The Bottom Line

Given that the stock is just below its 52-week high, I can't really say that these challenges in the business have created a table-pounding opportunity. I do believe there is room for the company to do better than currently expected, leading to higher estimates and higher multiples, and the returns on offer aren't bad now, but this would have more appeal as a buy-on-a-pullback idea.

Analyst’s 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.