2023-09-09 00:42:46 ET
Summary
- Medpace is a Contract Research Organization (CRO) that provides outsourced clinical development services to the biotech, pharma, and medical device industries.
- The business model is simpler than it seems and has shown great resilience in complicated macroeconomic environments.
- Although the current valuation is not attractive enough, Medpace seems like a must to add to any watchlist.
Investment Thesis
Medpace (MEDP) is the kind of company I often refer to as a 'clean growth' company. These are businesses that achieve significant, sustainable, and profitable growth within sectors characterized by robust trends and minimal cyclicality. Medpace, in this regard, can serve as a foundational stock upon which you can construct your portfolio.
This thesis is to explain this business that at first glance may seem complex, which is why it often goes under the radar, but, as can be seen in the following image, it has been a stock that has consistently beaten the S&P500.
Price Return vs S&P500 (Seeking Alpha)
Business Model
The company is a Contract Research Organization ((CRO)), so its business model is focused on providing outsourced clinical development services to the biotechnology, pharmaceutical, and medical device industries.
Before a new drug can be brought to market, it often must undergo extensive preclinical and clinical testing, as well as regulatory review, to verify safety and efficacy. As you can guess, this is not cheap; in fact, it is estimated that the cost of getting a new drug approved is around $2.5 billion, and it takes about an average of 10 years.
Phases of a new drug (Cancer NSW Gov)
This is why small and medium-sized companies often face challenges when developing their medicines and drugs independently. This is where companies like Medpace come into play, as they can efficiently handle these tasks and guide the successful progression through the development process, from Phase I to Phase IV.
This is primarily attributed to two key factors:
- Medpace's established professional infrastructure.
- Their know-how in conducting these therapeutic trials.
Revenue is generated through fees outlined in the contracts for services provided. The contract duration and pricing are generally based on a fixed fee, which takes into account activities performed by third parties and the associated ancillary costs necessary to fulfill the contract's scope (which are reimbursable).
These contracts can vary in duration, spanning from a few months to several years, and are negotiated based on the projected project scope, including complexity and inherent performance risks. They are structured with an initial fee due at contract signing, with the remaining fee paid over the contract's duration, either according to an agreed-upon billing schedule or upon achieving specific performance milestones.
As a result, it becomes evident that income tends to be stable and predictable, thanks to the structure of contracts and the manner in which income is received. Additionally, the importance of these services to Medpace's clients makes it challenging for them to abruptly halt their orders, regardless of the prevailing macroeconomic conditions.
Sales Distribution
Despite having a global presence, 98% of sales are generated in the United States, indicating that the international segment contributes significantly less to the company's revenue.
In terms of market segments, the majority of sales originate from Oncology, a field that focuses on the study and treatment of neoplasms, with a particular emphasis on malignant cancer tumors. In 2022, Oncology accounted for 32% of total sales.
Revenue Segments (Author's Representation)
Approximately 80% of the income is derived from small biopharmaceutical companies, and the top 5 clients account for only 23% of total sales, so the risk of customer concentration is low and the opportunity to gain reputation among the largest pharmaceutical companies is an interesting growth driver.
Revenue Distribution (Medpace)
Market Overview
Competition
The CRO industry remains highly fragmented, with several hundred smaller, narrow-focused service providers and a small number of full-service companies with global capabilities.
This is due to the existence of significant barriers to entry, including the costs and expertise required for developing therapeutic areas, managing complex clinical programs, establishing infrastructure to support large global projects, delivering high-quality services, and handling regulatory filings across multiple jurisdictions.
Major global competitors in the CRO industry include
- Laboratory Corporation of America.
- ICON plc.
- Syneos Health.
- PAREXEL International.
- PPD (now part of Thermo Fisher Scientific Inc.)
- IQVIA Holdings.
Oncology - Main Segment
As could be seen in the distribution of sales, a significant portion of the revenue is attributed to oncological tests. This is a substantial market, with 6,504 (29%) of the 22,684 drugs in the development pipeline in 2020 dedicated to cancer treatment. It is projected that by 2026, the Oncology sector will see an allocation of over $300 billion , maintaining double-digit growth in most geographic regions.
Medpace is well-positioned to meet the anticipated demand in its core segment, and currently, its sales from this segment represent just 0.2% of the 2022 Total Addressable Market ((TAM)). So there is significant growth potential within this segment alone.
CRO Industry
Furthermore, the global CRO market had a total expenditure of $60 billion in 2022 and is projected to maintain a steady growth rate of 12% CAGR through 2030. This expansion is driven by the growing demands placed on pharmaceutical developers, pushing them to enhance the management of clinical data, effectively navigate intricate regulatory landscapes, and maintain rigorous security protocols
In this context, it's noteworthy that Medpace currently holds a global market share of only 3%. There is ample room for further expansion as the company continues to establish its reputation through successful collaborations with small pharmaceutical firms and gains the trust of larger pharmaceutical companies, potentially leading to more lucrative projects.
Market Growth (Verified Market Research)
The company is just a drop in a vast ocean and growth opportunities are attractive.
In addition to this, personally, I like the idea of investing in a company that is dedicated to finding a cure for diseases that affect millions of people. Something like an 'ethical investment'
Key Ratios
Sales have impressively grown at a rate of 22% annually, and Free Cash Flow has also seen accompanying growth at 23% annually. This is the type of high-growth that I prefer - a company that achieves 20% annual growth while not neglecting its cash flow generation.
Revenue and Profitability (Author's Representation)
This growth has been coupled with strong returns on its capital employed (ROCE) and return on its Free Cash Flow used (FCF ROCE), averaging 17% and 23%, respectively. These ratios indicate how efficiently Medpace generates profits from its invested capital.
However, it's worth noting that in 2022, there was an artificial growth in ROCE due to the calculation method, as I consider ROCE as Total Assets minus Current Liabilities. It's important to delve into this further.
ROCE (Author's Representation)
If we examine the current liabilities, we observe an increase of $246 million (44%), while total assets decreased by $307 million (-18%). However, $170 million of the $246 million increase was attributed to accrued expenses and advanced billings.
Accrued expenses represent obligations to pay for goods and services that have been provided but not yet invoiced or paid for. Advanced billings , on the other hand, reflect cash received from customers in advance of services being performed or revenue being recognized, as explained in the company's 10-K.
Rather than constituting an increase in liabilities, this appears to signify an advance payment for work that Medpace will perform. Such advanced invoicing is often used to enhance cash flow and enable clients to plan and establish recurring payments, which benefits the predictability of Medpace's income.
If we only consider the debt that generates interest, the company's Net Debt / EBITDA ratio would be approximately 0. In other words, the company could fully repay all of its net debt with the EBITDA it generated this year.
Net Debt /EBITDA (Author's Representation)
Management Team
August James Troendle is the founder and still serves as CEO. He has extensive knowledge of the CRO and biopharmaceutical industries, as prior to founding Medpace (1987-1992), Dr. Troendle served as Assistant Director and Associate Director for Sandoz (Novartis).
He still owns 21% of the company, which is almost $2B compared to his base salary of $700K, which is more than 2500 times his annual salary.
Also, August's total compensation in FY2022 ($1.9M) is below average for companies of similar size in the US market ($8M). This means that the majority of his equity is in Medpace, so his best interest lies in the company performing well, and he has enough 'skin in the game' to be aligned with us, the shareholders.
Capital Allocation
Medpace acquires most of its funding from its own generated cash from operations and uses this capital to return to shareholders through share buybacks.
During 2022 the stock fell sharply, so the board opted to repurchase 10% of the outstanding shares and in this first half of FY2023 they have already repurchased another 5%. I like to see a determined board of directors that knows how to bring value to the shareholder when the price warrants it.
Another 30% of the capital is used to pay down debt, which is mostly ($158M) in leases of office space, five laboratories and a logistics warehouse.
Capital Allocation (Author's Representation)
Valuation
For the valuation I'll take into account the following data:
- Revenues have grown more than 30% CAGR in the last 5 years.
- FCF's margins have been 22% on average.
- The average EV/FCF for the past few years has been 25x.
For FY2023, the management team expects to generate around $1.85B in revenue, which represents a growth of 27%. For subsequent years I will assume 20% growth.
I will maintain the average EBITDA and FCF margin of 20% and expect an exit multiple of 15x EBITDA and 20x FCF. It could be argued that the company could justify a higher multiple due to its growth and the quality of the business, but I feel more comfortable making a conservative valuation.
With these assumptions the expected CAGR return would be 10% from the current price of $270. It may be enough for someone, although I would rather wait for a slight correction to expect returns closer to 15%.
For example, if the stock fell 15% towards $230, the expected return would already be around 14%, which is much more attractive.
Valuation (Author's Representation)
Risks
Regulatory Compliance: Ensuring compliance with ever-changing and complex regulations is a significant challenge. Any failure to meet regulatory requirements can result in delays, fines, or even suspension of operations.
Data Integrity: Maintaining the integrity and accuracy of clinical trial data is vital. Data discrepancies or manipulation can lead to serious consequences, including the rejection of trial results or regulatory penalties, so Medpace must be extremely careful with the way it handles and protects its trial and client data.
Recruitment and Retention: Enrolling and retaining qualified participants in clinical trials can be challenging, particularly in competitive therapeutic areas or for rare diseases. Delays in patient recruitment can extend trial timelines and increase costs. If Medpace fails to retain its talent, project completion times would be lengthened, so the company would cease to be an alternative for its clients.
Final Thoughts
While Medpace is undoubtedly a high-quality company, I'm hesitant to assign it a 'buy' rating at its present valuation. I'd prefer to wait until its stock approaches values around $230, as I mentioned earlier.
Looking at the valuation multiples, the company is currently trading near its recent-year average of a Price-to-Earnings Ratio (P/E) of 30x. Although this could be justified given its rapid growth and earnings quality, it's also worth considering that the recent increase in the risk-free rate due to rising interest rates might make such valuation levels less common in the market. Consequently, the current price may not provide a sufficient margin of safety.
Valuation Metrics (Seeking Alpha)
For further details see:
Medpace: A Great Anchor For A Long-Term Portfolio