FOOL ON THE HILL
An Investment Opinion

Quintiles Transnational: Priced Right?

By Dale Wettlaufer (TMF Ralegh)
September 9, 1999

Would you pay $4 billion for a company encompassing 1) The world's leading pharmaceuticals and biotech contract research company; 2) the world's leading contract sales organization for such industries; and 3) one of the top two healthcare electronic data interchange (EDI) and informatics companies?

That's the question facing investors looking at Quintiles Transnational <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: QTRN)") else Response.Write("(Nasdaq: QTRN)") end if %> right now. Since coming public in 1994, the company's shares have appreciated seven-fold, with a yearly compound annual return of about 46% since April 1994. Was the market wrong? Are early Quintiles investors paying for the early scorching performance with dead money, net, over the last three years? It all depends on your perspective. If you bought the company five years ago, you're probably happy with the overall result, but if you bought it within the last three years, you're probably getting a little antsy.

The market could have been right, but a little over-optimistic to begin with. Whichever it is, supernormal returns in the past do not necessarily mean the company is overvalued today, and it does not mean on its face that the company cannot be mispriced today.

The outsourced pharmaceutical and biotech product development industry (or contract research) should come in around $6.0 billion in total revenues for this year, or about 15-20% outsourcing penetration of all drug development spending worldwide, according to Needham (Feb. 5, 1999). The big attraction here is the secular growth of drug research spending overall, plus the increased penetration of the outsourcers like Quintiles and Covance Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CVD)") else Response.Write("(NYSE: CVD)") end if %>. Taken together, those two trends should result in secular growth for the Contract Research Orgnaization (CRO) industry of 20% per year for at least five years. At present, Quintiles has a $2.02 billion backlog and a revenue run-rate over $1.8 billion.

Quintiles is by far the largest drug commercialization outsourcer, or contract sales organization (CSO), with 40% of the total $1 billion in outsourced spending for 1998. The secular growth rate here is 30% per year, according to Needham. Along with contract research, contract commercialization is intended to give pharmaceuticals companies a time-to-market advantage, flexibility in cash flow and capital resource planning, and an overall strategic advantage in segregating lower value-add activities from higher value-add activities. Not that these activities are low value-add, but anything in comparison to the financial value-add of a successful portfolio of pharmaceutical or biotechnology products is necessarily going to be smaller in comparison.

Finally, Quintiles is a healthcare information company engaged in numerous segments, the largest of which is Envoy, its healthcare electronic transaction processing unit. This unit extends beyond transaction processing for healthcare providers and payors. It includes market share reporting, strategic data mining, enterprise resource planning services, claims management, and marketing information support. This is the highest value-add segment of the company:

Segment, operating margin (%)
Product development: 12.5%
Commercialization: 9.3%
Quinternet Group (including Envoy): 22.3%

Like all transaction processors, Envoy and Quinternet Group is a low incremental cost business that generates excellent margins past the breakeven point.

The key point to consider here is the transition of the CRO/CSO companies from being a sort of logistics safety net for the pharmaceutical companies to being an integrated part of the pharmaceutical companies' long-term strategic plans. Much like the electronics contract manufacturing services industry, which went from a nice-to-have tactical support mechanism for electronics original equipment manufacturers to a need-to-have strategic partner, the same thing is happening in the CRO/CSO business.

Quintiles CEO Dennis Gillings summarized it this way in the second quarter conference call:

"We have two emerging but extraordinarily strong factors that are delivering ever-growing competitive advantages for us. The first is outsourcing in the pharma industry, [which] is fast becoming a strategic decision about partnering rather than a tactical one about one-off projects. Second, our Quinternet technology platform has made enormous progress and is driving our customers to the strategic decision of partnering with Quintiles. This is because our Quinternet technology provides a very broad base of service and information throughout healthcare and pharma. It is worldwide, it has the widest connectivity to physicians, payors, and pharma, and it is built on the combination of strong relationships enhanced by technology, and that connectivity relationships technology is vital to the healthcare sector."

Financially, the contract research business should be anywhere from a high teens to mid-20% range return on capital business, as it doesn't appear to be a highly asset-intensive business with pretty decent margins. Contract sales should show similar characteristics. The big drag on the financials right now is the massive amount of equity issued in the Envoy acquisition. If you mark up the goodwill that didn't get recorded in the pooling-of-interests transaction, you're talking about additional equity of over a $1 billion added to Quintiles' balance sheet. Adding around another billion dollars in other unrecorded goodwill from an extensive list of transactions the company has engaged in to get to its industry-leading scope and scale, invested capital here is around $3 billion (when you net out liquid securities and excess cash from debt, of which there is little).

Off estimated revenues of $2.46 billion for next year and a mid-13% operating margin, prospective return on capital for fiscal 2000 would be around 7.2% (assuming a 35% tax rate). In other words, all the equity, no matter whether you pool it or treat it as a purchase, weighs down the financial profile. Buy-versus-build will be a question that would be more closely examined by boards of directors when they have no choice but to account for mergers and acquisitions exclusively under purchase accounting rules. That's not to say that a company is unattractive at present even if it's underperforming its cost of capital. Not in the least. With all three industry segments growing at 20-30%, the internal rate of return on existing invested capital can advance quite rapidly, assuming no deteriorating in pricing in the industry.

Assuming $2.46 billion in revenues in fiscal 2000 and a 2001 revenue growth rate of 20%, capital turns would advance from 0.82 times to 0.92 times if 2000 earnings are totally retained and no share buybacks take place. Return on capital would surpass 8%, an increase of more than 80 basis points. Assuming the same growth rate for fiscal 2002, return on capital could advance another 80+ basis points. In other words, there's a huge implied equity base at work here that does not show up on the balance sheet but of which shareholders of acquired entities demand a return. In the near term, the return on the implied equity is not great, but given the excellent promise of this industry, cash-on-cash returns here can move up rapidly.

With a mean EPS estimate of $1.87 for 2000, the company is trading at 18.8 times expected earnings. Another way to look at it is enterprise value to invested capital, which is around 1.3 times. On its face, that's quite inexpensive in today's market for a company exhibiting these types of growth dynamics. Just as the top tier of electronics contract manufacturers have been re-valued in the last 18 months or so based on their abilities to provide the scale and scope necessary to entrench themselves in the global electronics supply chain, I think there is the distinct possibility that the same could happen here. Financially, returns from here will depend to some extent on the choices the company makes in regard to build-versus-buy in expanding the business. For what's in place now, however, I think it's pretty apparent that the company is not priced correctly, and I put the discounted cash flow value north of $55.

Key points:

1. Quintiles is the top player in contract drug development and commercialization services.

2. The company is also dominant in healthcare EDI, owing to its Envoy acquisition.

3. Return on capital, taking into account unrecorded goodwill from an extensive list of acquisitions, will be in the mid-6% range for fiscal 2000. Given secular growth rates of 20% and more in core businesses, internal rates of return on capital can advance rapidly and overcome cost of capital in a short time. This isn't some cheesy new-age healthcare roll-up. Attaining global scale and scope is necessary to building a competitive moat in this business. Near-term capital deployments have been a must to attaining Quintiles' competitive position.

4. Outsourcing is rapidly progressing from a tactical nice-to-have choice for the pharmaceutical and biotech industry to a strategic, need-to-make choice. Quintiles has the scope and scale to fulfill that need on a global basis.

5. The market's realization of the unique competitive position of Quintiles and continued execution of its financial strategy could result in a quick re-valuation of the shares to the mid-$50 range. On top of that, intrinsic growth of the company as it's now constructed is better than 15% for the appreciable future.

Risks

6. The prolonged slide (and crash) of Covance, a CRO competitor, could hold down Quintiles in the near term. With a narrower set of competencies and customers, Covance isn't the same sort of company as Quintiles.

7. Percentage-of-completion revenue recognition is at work here, which can be seen in the unfavorable working capital dynamics at Quintiles in the second quarter. Over the short term, the accrual of revenues and workdown of unearned income can result in somewhat bumpy cash flows -- over the longer term, the picture should be smoother. Some may key in on these factors in the short term. I personally think it's imprudent to focus on one quarter's cash flow. Both Quintiles and Covance, actually, product operating cash flow well in excess of earnings.

8. Additional mergers and acquisitions bringing on large additions to the equity base could discourage the market. Investors are in a show-me phase with the Envoy transaction.

Quintiles Q2 Conference Call Review:
-- Quintiles Q2 Call, Part 1
-- Quintiles Q2 Call, Part 2
-- Quintiles Q2 Call, Part 3
-- Quintiles Q2 Call, Part 4
-- Quintiles Q2 Call, Part 5
-- Quintiles Q2 Call, Part 6