2023-07-20 09:00:05 ET
Summary
- Medpace Holdings, a Clinical Research Organisation (CRO), has outperformed in the stock market with a return of 429% in the last five years compared to 62% for SPY.
- CROs, which develop clinical studies for pharma companies, have benefited from increased funding for clinical studies, particularly during the search for COVID vaccines.
- Despite a drop in biotech funding in 2021 and 2022, recent months have seen a sharp increase in funding levels, indicating a positive outlook for the industry and companies like Medpace.
- Medpace has taken market share during the down cycle.
Medpace Holdings (MEDP) has been an outperformer in the recent past. In just the last five years, the stock returned 429% versus just 62% for SPY. Medpace is a Clinical Research Organisation ("CRO") with good momentum in the last few months as the market rallied again. Let's see what makes the company stand out and if it is likely to continue its performance.
CRO environment
CROs are companies that develop clinical studies for pharma companies. These studies are required for any medicine that is expected to be eventually consumed by humans. The below slide from Sartorius (SARTF) shows the immense capital and time investment needed to bring a drug into the market. Four stages, each taking 1-7 years, are required to pass. Sartorius estimates the average cost of developing a successful drug to be above $2.24 billion (if we convert from Euro) with just a 10% probability (note that a drug that fails in Phase 1, for example, will have a much lower cost of course than the $2.24 billion). This immense capital investment is why I do not feel comfortable investing in pharma companies. On the other hand, two sectors are large beneficiaries of this situation: CROs and Life Sciences tool companies.
I covered both Sartorius and Danaher (DHR) intensely on Seeking Alpha if you want to learn more about the Life Sciences tool industry.
Clinical Studies and probability of success (Sartorius Investor Relations)
2020 saw a sharp increase in funding for clinical studies, driven by the search for COVID vaccines and general excitement about new methods to develop drugs like MRNA. The chart below shows that biotech funding is very volatile, with swings of ~40% in both directions on an annual basis often occurring. After the massive $87 billion in funding in 2020, we saw a hangover in 2021 and 2022, dropping to $44 billion. This concerned CRO and life sciences companies, as they rely on funding for their customers. These studies are decade-long investments that need to be maintained. In the last few months, we've seen a sharp comeback in funding levels, a good sign for the industry.
Biotech funding (Jeffries Research)
Medpace - an impressive growth story
Below we can see that Medpace performed well, despite the lousy funding levels of the last years. Keep in mind that they have other clients than just biotech, but it's a good indicator, in my opinion. The company grew new business awards sequentially each quarter (except Q4 2021) and continued expanding its backlog. I expect this trend to continue in Q2, too. We can also see the book-to-bill ratio. While this has been trending a little lower, it is still very healthy, again a trend which we will likely see in Q2. According to Investopedia , a bill to book above 1 is a good sign of high demand in an industry.
Backlog and new award trends (Medpace Investor Presentation)
Medpace has taken market share during the funding slowdown and has shown a stellar performance over the last few years. The company grew Revenue at a 20% CAGR and EBITDA as well. Net income even grew close to 30% and EPS over 30% due to share repurchases (15% decline in shares outstanding).
CRO is a service industry where customers book the scientists of the CRO to perform studies. These contracts are often paid upfront, so Medpace has a strong cash conversion. Medpace has had FCF far exceed Net income each year as a public company. On the balance sheet, we can see a $466 million position in unearned revenues and the company has negative Net Working Capital of $426 million. Medpace is in a very favorable position where they are getting paid before they have to perform the service and can reinvest this money into the business. The preferred way for reinvestment has been Share buybacks, retiring 15% of shares over the last five years, with the majority of the buybacks in 2022 during the bear market. The company doesn't pay a dividend and doesn't do M&A.
Medpace looks well priced
To value Medpace, I'm using an inverse DCF model. I use a 10% discount rate and a 3% perpetual growth rate; I also calculate Owner Earnings besides normal Free cash flows. I believe that Owner Earnings are a better representation of the cash flows to owners than normal free cash flow, which several factors can easily distort:
- Stock-based compensation is paid out in shares and replaces cash expenses, but it is a cost to shareholders.
- Often not all of the CapEx spend is going towards maintaining the business, but rather to grow it. These investments could be cut, returned to owners and thus added back to Owner Earnings.
- Changes in Net working capital can distort cash flows, so I adjust them out.
Owner Earnings = FCF - SBC + Growth Capex +/- NWC changes
We can see that Medpace looks to be reasonably valued. On a FCF basis, the company needs to grow between 6-8%, while they guide for FY2023 with 7-15% EPS growth. Given the long track record of growth, I believe that high single digits are very achievable for the company. For owner earnings, we can see that the unearned revenues push Owner earnings down. One could argue that in the case of Medpace, this is a structural trend and not just a short-term movement; thus, we could decide not to adjust it. To be conservative, I included it. Still, the stock looks well priced at a 10% required growth rate. I rate Medpace a buy due to its market share taking and resilience during a down cycle.
For further details see:
Medpace: Resilience During The Down Cycle