We like shares of PRA Health (PRAH), a top-tier clinical research organization (“CRO”). VIC members may remember and refer to our December 2015 writeup of Parexel (“PRXL”) for industry background and a few well-considered rebuttals to the CRO long thesis. The industry’s sensitivity to biotech spending, pharma consolidation, and competition remains, but we see PRAH well-placed to accelerate growth and generate attractive returns relative to the market. Against a market vacillating near its valuation highs, PRAH trades at a discount to its historical 20-21x P/E even after many years of 5-12% organic growth and consistent margin expansion. PRAH also holds one of the cleanest balance sheets in the industry, with leverage soon to decline below 2.0x after several years of debt reduction. A technical overhang melted away this September after long-time shareholder KKR sold its final 6.7m shares, the last of 39.9m position held since 2014. But against these positive developments, several transient factors drove softer revenue and billings growth in recent periods: currency-related demand shifts for the embedded solutions group, large pharma project deferrals, and management turnover in data solutions. As these factors are cycled in 2020 against easier comparisons, PRAH should return to HSD organic revenue and billings growth. As growth steadies, shares can appreciate to 22x 2021E EPS of $6.50, or a price of $145 for 35% upside, over the next year.  

PRA Health became publicly traded in November 2014 as a KKR-controlled CRO with a pedigree in oncology, CNS, inflammatory, and infectious diseases. It built an early following with biotechnology clients but grew into major partnerships with large pharma, competing toe-to-toe with larger incumbents like Quintiles, PPD, Parexel, and ICON. The CRO sector remains integral to the drug development process, administering the steps that take a drug from an IND (Investigational New Drug) to an NDA (New Drug Application) filing. Tasks like patient recruitment (we’ve been told it’s more difficult than it sounds), site feasibility, clinical record-keeping, and medical writing can be outsourced on behalf of the drug sponsor. According to industry-sponsored studies, CROs can identify and launch a new clinical site 6 weeks faster than a biopharma sponsor can on its own. With patent life ticking each day through a trial, time-to-completion becomes paramount. 

Source: Leerink Research, Parexel R&D Sourcebook (2018/2019)

While the top tier of CROs are largely interchangeable, our diligence suggests that PRAH’s competitive advantages are its brand and reputation for high-quality employees, its lineage with biotech clients, its therapeutic strengths in large fields like oncology and CNS, and its technological suite. PRA Health’s Data Solutions segment markets a suite of tools that handle everything from clinical management to physician targeting and commercial feasibility. 

We also see continued above-market growth for the CRO industry while economic conditions remain conducive. Biopharma R&D spend grows 5-8% annually and the CROs are 40-55% penetrated, creating high-single digit organic growth before market share gains. This growth is further buttressed by worldwide prescription drug growth of 6-8% annually through 2024 and a record number of biopharma companies with an active drug pipeline.

Source: Icon June 2019 Corporation Presentation

 
Source: Leerink Research

Within this accommodating backdrop, the CROs as a group have shown remarkable consistency. Contracted trials can be deferred or cancelled, but once a multi-year, multi-clinical clinical trial begins, the CRO usually owns the project through completion. Captive systems and integrated teams prevent clients from easily switching between providers. Some large pharma companies even create long-term partnerships with CROs, as Takeda did with PRA Health, to outsource entire pipeline programs. Revenue stickiness has been accompanied by steady organic (ex-FX) growth, with PRAH consistently tracking in the high-single-digits or low double digits since its public debut. 

The CROs most likely to succeed over the next five years are those with a strong technology stack. While no CRO has a complete solution, we think PRAH ranks well against its competitors. The Symphony Health ($530m) and Parallel 6 ($50m) acquisitions in 2017 formed the base of PRAH’s $250m Data Solutions segment. This suite of products improves trial design and recruitment, offers real-time clinical data collection, and measures the commercial market through systems like Symphony’s Metys. 

The cornerstone of the technology stack, Symphony Health, collects and harmonizes prescription and claims data on 280 million lives and 10bn claims, second only to IMS Health. Symphony has sued IMS in the past for cornering the market, but today both seem to have viable datasets and clients can switch between providers (Daiichi Sankyo switched from IMS to Symphony, for example). The Symphony platform grew 20% in 2017, the year before the acquisition, against a strong demand backdrop. 

But Symphony’s growth has slowed in recent quarters, the result of several headwinds that should dissipate at some point in 2020. First, PRAH waited until the conclusion of Symphony’s earn-out period to integrate the CRO and Data Solutions sales teams. (The final $83m earn-out payment was made April 2019). Second, PRAH effected leadership changes during Q1 and added staff to create a more fulsome commercial presence. This revigorated team should support improved performance: in their first two quarters, revenue growth has improved to +5% and +7% (adjusted for a $3m deliverable pushout identified by Goldman). 

Hiccups in the Data Solutions segment (<10% of revenue) have been echoed in another sub-segment: Strategic Solutions. Housed within the CRO segment, Strategic Solutions allows clients to insource staff for select functions within a clinical project (i.e. data management, study monitoring, or other time-intensive tasks). Global biopharma clients who wish to retain project control but require added staff and capabilities to manage a fluctuating clinical pipeline may prefer this piecemeal approach. 

The unit faced disruptions in late 2018 through H1 2019 after a strong US dollar encouraged clients to shift global staffing priorities. U.S. headcounts declined and were replaced with overseas mandates – since international bill-rates are lower, this mix-shift negatively impacted billings. This past quarter, Strategic Solutions saw more hiring than it had in prior quarters, lending credence to the inflection seen in reported Q3 CRO revenue growth.   

I've mentioned in the last few quarters that strategic solutions has definitely been flatter than we would like it. It's showing very low growth in the last few quarters. And a lot of that was swinging away from hires being done in lower cost markets. So and we're finding that, that then, for the last number of quarters, have been replacing U.S.-based employees overseas, particularly Latin America, Asia and Eastern Europe. That trend seems to have shifted a little bit in this quarter and was started by – I mentioned last time that we saw the hiring plan. We are now in the process of hiring (Q3 2019).

Delays in large pharma project starts and shifts within the embedded solutions unit have caused backlog growth and conversion rates to decline below historical averages. While we don’t expect conversion to reach 2017’s level of 14.5% (2017 backlog included a fast-burning, 1-year flu study), the return of large pharma spend should result in faster sequential conversion rates for 2020. 

Slower project starts for large pharma clients have been offset by strength in biotechnology clients. PRAH amplified its efforts to attract smaller clients this year, creating an offset until the large pharma business returns: 

The biotechs are -- we find them, once we've agreed and we move forward, it's actually quite robust. And we spent the last couple of quarters actually having a much more heavier focus on our biotech, again. That's an area we've always been strong in, and we want to get back to our roots. So that's been a deliberate focus…It means that when the big pharma start to come through again, it will give us a much stronger book-to-bill, which we're anticipating at some point (Q3 2019 Call).

As of Q3, PRAH’s bookings were split 50/50 between biotech and pharma. We think mixing into higher-growth biotech clients, the lapping of weakness in Strategic Solutions (called out in Q4 2018), and the eventual recovery of large pharma projects can drive continued improvements to PRAH’s CRO growth. Organic revenue growth accelerated from 4% in FQ4 2018 to 5%, 6%, and 8% through FQ3 2019, whereas bookings growth still lags. Strong seasonality is typical of FQ4 as clients flush out budget and prepare pipelines plans for the new year, creating a favorable setup against the easy comparisons of last year. 

After a year of choppy performance, PRAH shares have (deservedly) traded to below its historical multiple and near the bottom of its peer group. This comes against a market backdrop at its valuation highs. As such, we see potential to PRAH’s P/E to reach the upper end of its historical range.

A cleaning out of KKR’s ownership stake, which had topped the shareholder register since 2014, also supports a higher multiple. KKR sold their final 6.7m shares in September. Concurrent with the secondary, PRAH announced a $500m buyback, offsetting much of the new float. PRAH bought a block of $300m in October with the remaining authorization through 2021. In all, the buyback reduces share count by over 7% (or offsets ~10 years of SBC dilution) headed into 2020. 

Using a 22x P/E against 2021 EPS of $6.50, we see shares moving towards $145 over the next year. We think long-time CEO Colin Shannon has proven himself capable of delivering new business growth while properly managing expenses and Wall Street expectations – PRAH has beaten earnings estimates every quarter since going public in 2014. But we acknowledge the risks from biotech cyclicality, industry price competition, and continued large pharma project deferrals. We still think PRAH is a good relative long in this market.