2023-05-08 14:22:27 ET
Summary
- Medpace is one the largest Clinical Research Organisations in the market, and consistently winning market share.
- On April 24, Medpace presented its earnings for the first quarter of FY23, showing operative strength in a challenging market environment.
- Medpace's valuation is starting to offer new opportunities for long-term investors again as it cools off from its 2021 highs.
Medpace ( MEDP ) is one of the fastest growing CROs in the market, particularly benefiting from the biotech and biopharma boom in 2020/21. Due to the COVID-19 pandemic and the low interest rate environment, funding for small biotech start-ups was relatively easy as effective capital allocation wasn't required. Now, in 2023, interest rates remain high making it difficult for unprofitable and cost-intensive companies to raise capital. This development in the market environment was one of the concerns that was named by the management of Medpace during the earnings call for FY22 . Guidance for FY23 was therefore pessimistic, including higher pullback probabilities and funding risks.
Now Medpace has raised its outlook, confirming my investment in Medpace as one of the key positions in my portfolio. In this article, I want to discuss my investment thesis on Medpace and evaluate why the current weakness could be an opportunity for investors looking for long-term compounders.
Medpace's Business Model
Medpace is one of the world's leading Clinical Research Organizations (CROs), providing outsourced clinical development services to the biotechnology, pharmaceutical and medical device industries.
The company was founded in 1992 by Dr. August Troendle with the vision to offer a more innovative way to conduct clinical trials on behalf of biopharmaceutical sponsors.
Business Model of Full-Service CRO (Medpace IR)
Medpace fulfills this vision by offering a full-service approach, which means that Medpace supports its clients from the discovery of a potential drug to the post-marketing phase. According to August Troendle , this enables the company to maximise their services quality regarding time and efficiency. One major advantage of this approach for Medpace is the ability to accumulate data through the entire process and especially in the late phase, which can be used as real-world evidence (RWE in the diagram above) for future researching and decision making.
Therefore, Medpace generates its revenues by earning fees through the performance of services detailed in customer contracts. Most of these contracts are individually negotiated and priced, based on the anticipated complexity of the project and the performance risks inherent in the project. While Medpace often earns one part of the fees upfront at the signing of the contract, the majority is collected throughout the duration of the contract (e.g. if certain performance targets or milestones were achieved). Therefore, most of todays earned revenues are still depending on the individual performance obligation and aren't yet received as cash.
That said, Medpace provides two important metrics to track and review the underlying business performance, which I think are very appropriate and necessary to know for investors.
Backlog
The backlog of Medpace represents the anticipated revenue, resulting from net new business awards that have commenced, but haven't been completed. Since Q1/2019, Medpace has been able to more than double its backlog at a CAGR of 22% per year, resulting in $2.46 billion at the end of Q1/2023.
Ending Backlog, Q1 2019 - Q1 2023, in $ thousand (Quarterly Filings)
Net New Business Awards
In addition, net new business awards represent the expected revenue recognised in the backlog during the period, less the corresponding cancellations. In the first quarter of 2023, approximately $555.8 million entered the backlog, representing an increase of 31.4% YoY.
Net new Business Awards, Q1 2019 - Q1 2023, in $ thousand (Quarterly Filings)
Both KPIs show a very consistent growth over the last few years, which has driven Medpace's operational success. However, as the current market environment is difficult to predict, investors expected that the historical backlog growth would be tough to maintain. Therefore, the market was surprised by the latest results mentioned above and the improved outlook explained by CEO August Troendle during the recent earnings call :
Total pipeline cancellations were down over 50% on a sequential basis in Q1. The trends at this point look favorable. And we are cautiously optimistic about our backlog build toward 2024. We're raising 2023 guidance in line with our strong financial performance in Q1 and greater visibility we now have into the full year results.
Customer Composition and Market Prospects
Now that we've learned that Medpace created a strong business model by combining full-service support and therapeutical expertise, there's also another underlying factor that boosted Medpace's success in the past, namely the focus on small- and mid-sized biopharmaceutical companies.
These accounted for 79% and 17%, respectively, of total sales in Q1/2023, while large companies, defined as the top 20 pharmaceutical companies by prescription drug sales, contributed only 4%.
Medpace's Core Addressable Market, 2020 (Investor Presentation)
In their latest available investor presentation of 2020 , Medpace disclosed a total core market size of $16 billion, with them accumulating around 5% market share. And according to RBC , small players are likely to outperform the overall sector due to a more permissive regulatory environment. This current trend and the underlying forecast for the CRO market to grow at a CAGR of 12% should provide enough tailwind for Medpace to continue to expand its backlog. And in regard to the analysts' estimates, Medpace is likely to increase its market share in the coming years, thereby improving its track record and reputation in the industry.
Revenue Estimates, 2023-2025, in $ (Seeking Alpha)
Competitive Advantage
As mentioned above, Medpace is one of the largest players in the CRO market, while accumulating "only" around 5-10%, leading to the fact that this market is very segmented. I've compiled a list of the main competitors below:
Revenues ($ million) ((TTM)) | Gross Margin ((TTM)) | EBIT Margin ((TTM)) | Revenue CAGR (5 Years) | Revenue CAGR (2023-2025) | |
Medpace ( MEDP ) | 1,563 | 29.68% | 19.24% | 30.45% | 14.30% |
ICON PLC ( ICLR ) | 7,818 | 29.17% | 11.73% | 34.51% | 6.42% |
Syneos Health ( SYNH ) | 5,393 | 23.26% | 8.53% | 23.83% | -0.14% |
IQVIA ( IQV ) | 14,494 | 34.75% | 12.74% | 8.23% | 7.82% |
Although Medpace is by far the smallest in terms of revenue, it leads the competition with a significantly higher operating margin and compelling future prospects, while its peers lag in terms of growth and operating strength. Another indicator is a comparison based on return on invested capital ((ROIC)).
It appears that Medpace is overall more efficient in allocating its capital, although the latest ROIC is probably distorted by the share buyback throughout 2022.
Since 2022, Medpace has used almost all of its bank account to repurchase more than 5 million shares, or about 14% of the total shares outstanding. This has had the side effect of reducing the invested capital, resulting in higher returns.
From my perspective, these transactions demonstrate management's ability to drive shareholder value and confidence that future growth can be funded solely from operating cash flows. While the first deduction could probably be traced back to the fact that the CEO, August Troendle, owns 23% of the outstanding shares , which should definitely be enough to align his interests with those of the shareholders.
Cash Flows
In order to analyse a company's ability to generate cash from operations, I focus primarily on its free cash flow. Despite the usual calculation (OCF - CapEx = FCF), I adjust the operating cash flow for changes in net working capital and the expenses for stock-based compensation.
Using this approach, I try to get closer to the actual and sustainable cash generation of the business through the perspective of its owners.
For Medpace, the calculation (based on TTM) looks like this:
in $ million | |
Operating Cash Flow | 421.87 |
- Stock-based Compensation | 22.48 |
- Change in NWC | 127.54 |
= Adjusted Operating Cash Flow | 271.85 |
- Net CapEx | 37.13 |
= Free Cash Flow | 234.72 |
A closer look at the calculation reveals that the adjusted operating cash flow is significantly lower than before, due to normalised changes in net working capital. As one can expect, the NWC of Medpace differs from period to period, because of the individual contract and fee structure. Medpace itself explained this effect as follows in their 10-K :
Accounts receivable and unbilled, net, advanced billings and pre-funded liabilities fluctuate on a regular basis as we perform our services, bill our customers and ultimately collect on those receivables. We attempt to negotiate payment terms in order to provide for payments prior to or soon after the provision of services, but this timing of collection can vary significantly on a period by period comparative basis.
If we apply this to the last 5 years, we obtain a CAGR of 27% and an increasing FCF margin of previously 16.49% in Q1, demonstrating that Medpace became more profitable and cash-generating. As this calculation exclude any working capital changes, the resulting free cash flow also misses any advanced billings, which would otherwise significantly increase todays cash flow. As a result, I'm more than convinced of Medpace's ability to generate sustainable cash flows that will further enhance shareholder returns.
Free Cash Flow, 2017-2025e, in $ million (annual filings)
To estimate future cash flows of the company, I used the average cash-conversion of 72.75% and the analysts estimates on EBITDA for 2023 to 2025. The result is similar to the revenue estimates, which had been stated above, forecasting double-digit growth for the next two years and around 9% for 2025. In general, investors should avoid projecting the historical growth rates directly into the future, as the overall pharmaceutical industry cools down after the pandemic. However, if Medpace remains their level of profitability and cash-conversion, it will probably do fine in the coming years and will also be able to benefit from possible opportunities.
Headwinds and Risks
Having said that, I would like to briefly outline current headwinds and risks that could impact my views on future cash flows.
Industry Cool-Down
As briefly mentioned, the industry as a whole continues to be affected by increasing uncertainty about the customer sentiment. For B2B models, the more challenging biotech funding environment in particular is causing these companies to stay cautious with their guidance. When asked how Medpace CEO August Troendle felt about what other companies said, Troendle responded as follows during the recent earnings call:
We certainly have seen the funding difficulty and drop off of things. And I would characterize this quarter as less bad than we anticipated. [...] The clients that were kind of on a cash basis accrual. We thought they were going under and continue to pay us and have things have just seem to improve over the quarter. But there's certainly still a number of our clients that are having funding difficulty installed programs. And so [...] we think we've seen the low in the near term, things could always turn again. But things are in the right direction as far as we can see at this point.
Customer of Medpace and in particular small-sized companies seem to be more financially stable than previously expected, which confirmed my confidence in future expectations.
Higher Cost of Labor
Another challenge for the CRO market lies in the increased labor costs, which could hinder the estimated growth rates. As already obtained by comparing Medpace and its competitors, overall gross margins are relatively low for service offerings. Due to the complexity and difficulty of establishing patents and business contracts, the services of CRO's require employees with high level of expertise and a high-quality equipment. Therefore, the total direct costs are significantly depended on labor costs, which could increase even more in the future.
According to its 10-K , Medpace calculates its contracts based on the estimated costs of various factors. Therefore, I assume that Medpace will be able to pass on increasing labor costs through higher contract fees. However, this remains a risk to monitor in the future as cost efficiency returns to the forefront.
Valuation
In order to value Medpace, I'll use the free cash flow, as calculated above, in relation to the total enterprise value. My assumption for this approach is that I probably won't be able to calculate a comprehensive DCF model as accurately as Wall Street, therefore I'm following Warren Buffett's approach :
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
So let's see, what MEDP has to offer for us at the moment:
EV/FCF Ratios, 2017-2025e (annual filings)
After MEDP rallied on the first-quarter earnings surprise, the share price settled around $205 per share, resulting in a current market cap and enterprise value of $6.61 billion and $6.79 billion, respectively. Therefore, using the calculated free cash flow of $234.72 million ((TTM)), Investors are currently able to start a position at about 28.92x FCF.
That's certainly higher than most of Medpace's peers, but as I said at the beginning, I'm willing to pay a fair price for a premium company. And there is a reason for this difference in valuation, as we can see from the forward multiples and the comparison made earlier. Regarding the average guidance of the company and analysts estimates , Medpace trades at ratios of 27, 24 and 22 for 2023, 2024 and 2025, respectively. Medpace's valuation just estimates higher growth rates than its competitors, which I think is accurate. Therefore the current valuation of Medpace seems to have normalised from highs during 2021, while the underlying business continues to deliver - from my perspective a promising mix.
Conclusion
In conclusion, Medpace has proven its quality as one of the key players in the CRO industry over the last few years by focusing on the fastest growing segment and strong execution. In addition, tailwinds during the pandemic and the low interest rate environment boosted Medpace's success and reputation in the market. Now that the industry is more challenging, Medpace will have the opportunity to further convince shareholders of its long-term prospects and management qualities. Therefore, the first quarter of 2023 has been a solid start to the year, as it demonstrates the quality of Medpace's contracts and customers, and its ability to gain market share in an uncertain environment.
From my point of view, long-term investors can currently take a position and thus participate in the sustainable growth of Medpace. In the short run, however, it is a hold due to the current uncertain market environment and the relatively high valuation. As Medpace already accounts for about 6% of my portfolio, I would only buy if the uncertainty leads to short-term discounts.
For further details see:
Medpace: Gaining Market Share While Others Struggle