By: Steven M. Roge, CMFC
eResearchTechnology: Investment Diagnosis
Share Price: $6.12
Intrinsic Value: $7.05
Buy Below: $4.93
eResearchTechnology, Inc., (ERT) together with its subsidiaries, provides technology and service solutions that enable the pharmaceutical, biotechnology and medical device industries to collect, interpret, and distribute cardiac safety and clinical data. The company’s cardiac safety products and service solutions include EXPERT, which provides workflow enabled cardiac safety data collection, interpretation, and distribution of electrocardiographic (ECG) data and images, and enables analysis and cardiologist interpretation of ECGs performed on research subjects.
In addition, the company offers cardiac safety consulting; ePRO, an electronic patient reported outcome service that allows subjects to report data for a clinical trial; and project assurance services comprising study initiation, project management, site qualification, configuration, technology and regulatory review, research dashboards and electronic reporting, data management, uniform standards and standard operating procedures, migration services, onsite research and technology advisory services, support services, including online and help desk support, and software maintenance. It markets and sells service solutions through global direct sales, sales support, and professional services organizations with principal operations in the United States and the United Kingdom. The company was founded in 1977 and is headquartered in Philadelphia, PA. (Source: Yahoo! Finance)eResearchTechnology, Inc. will benefit from an increase in operating cash flow due to its acquisition of Research Services 234 GmbH (RS) in May, 2010. In the remainder of 2010 after their combination, RS accounted for 35.4% ($47.2 million) of all ERT’s revenues for the year. ERT’s revenue growth will accelerate in 2011, with the inclusion of a full year of RS revenues.
The RS acquisition is a sound business decision. ERT is no stranger to acquiring businesses: the Company acquired Covance Cardiac Safety Services, Inc. (CCSS) on November 28, 2007. Revenues and free cash flow have increased since the addition of CCSS. ERT’s capable management controlled costs by closing redundant operations in CCSS. Based on this experience, integration of RS should continue to go smoothly.
The addition of RS has expanded ERT’s market to Germany, and the combined firm now makes sales in three regions: Germany (39.5%), North America (44.4%), and the United Kingdom (16.1%). In addition to the benefit of smoothing sales by diversifying revenues, ERT’s multinational operations have afforded the firm tax avoidance strategies that delay repatriation of foreign funds to the US parent company. The firm’s effective tax rate has dropped from 2009 (38.9%) to 2010 (31.6%). ERT also has hedged its exposure to the Euro and the British Pound.
In addition to the RS acquisition boost to revenues, ERT will benefit from a favorable multi-year outlook for medical research and development. ERT makes sales based on the final stages of treatment testing, in clinical trials that occur over roughly six years at the end of an approximately 12-year testing period between drug discovery and submission for FDA review. ERT experiences volatility that comes from its focus on clinical trials. Recently, the economic downturn restricted funds available for clinical trials, reducing ERT’s sales through 2010. This trend will reverse as companies find funds to push their backlog of drug candidates through clinical trials and subsequent production before their patents expire. This up-trend will continue in the long-term because overall medicine R&D spending in the United States increased from $65.9 billion in 2009, to an all-time high of $67.4 billion in 2010. This spending feeds a pipeline of drug discovery that must progress through clinical trials before patents expire.
ERT’s electronic patient-reported outcome (ePRO) solutions will gain share of the electronic medical research data market. In April 2011, ERT won $10 million in bids to implement its ePRO products for new client firms. This new business represents a large fraction of the market for electronic data management in clinical trials, which has been estimated at $100 million in 2010. Prior to winning these contracts, ERT’s management suggested that the RS acquisition would place it in the top five ePRO providers. New ePRO business will come easily to ERT because it provides the widest variety of data-capture solutions, and because its products are now sold and supported by operations in three countries. Clearly, ERT will be among the top firms in the ePRO market based on its legacy ePRO service business, recently announced new clients, and additional sales based on the ERT-RS business combination.
Furthermore, the market for modern, electronic data management in clinical trials and healthcare will grow the market for ERT’s ePRO products and its cardiac safety data products. More and more hospitals and research groups will phase-out paper data collection and archival in favor of electronic data. This trend is driven by the benefits of electronic data over paper records: an organization’s best analysts can interpret data from any location, ensure greater accuracy, and gain instant retrieval. Thus, ERT will experience sales growth in its electronic cardiac safety data products even though ERT is the market leader. ERT will primarily take customers away from paper, not from other electronic data capture and management systems.
Management and Stewardship: ERT’s decision makers have interests that are generally aligned with shareholder interests. Insiders have increased their holdings of ERT by 9.4% and now account for 3.72% of outstanding shares. Chairman and Chief Science officer, Dr. Joel Morganroth, owns ERT options and shares worth $9.0 million.
However, it is unlikely management would be willing to sell the company in the foreseeable future because Dr. Morganroth would endanger the compensation he earns as an independent contractor for ERT. In 2010, he was compensated for these services on a percentage of consulting revenues basis, and earned $1.2 million. (He has been paid more for these consulting services in previous years as an independent consultant under different compensation arrangements.) Additionally, the firm appears to be an unlikely acquisition target in light of the additions of CCSS and RS. Growth through the acquisition of CCSS and RS demonstrate the management’s appetite for the control of more assets, not less.
The firm utilizes share-based compensation for its employees, and has diluted ownership by about 0.9% per year from 2008 to 2010.
Valuation: Relative value metrics show that ERT is trading at a reasonable price at or below its peers:
Financial Metric ERT CRL LH
P/E (ttm) 29.9 N/A 18.9
P/S (ttm) 1.9 10 1.9
P/B 1.9 6.3 4.1
EV/EBITDA 7 40.1 9.8
ROIC ( 5-Yr. Avg.) 11.56% -7.07% 14.3%
It is worth noting that the Price/Book ratio is not very informative for technology companies. Assets like internally-developed technologies are not recorded on a company’s balance sheet. What’s worse, the same patent or research would be recorded on the balance sheet if it was bought from another company even though its value would have been omitted from its developer’s balance sheet. These accounting conventions make the P/B ratio difficult to use for these companies.
ERT’s financial statements show choppy capital expenditures for large acquisitions (CCSS and RS), which causes free cash flow to be choppy. Subtracting a 5-year averaged CapEx from operating cash flow gives a more stable value, and the stability of these adjusted free cash flows justify a discounted free cash flow model. Growth rates for 2010, and 2011, are the average of analyst estimates. A 15-year horizon for historical FCF growth rates (8.36%) is used to match the duration of the drug development and FDA approval process. Simply put, drug development initiated with today’s record R&D budgets could take as long as 15 years to move to FDA approval and production.
FCF Growth Years
18.9% 1
20.5% 2
8.36% 3-15
0% Terminal
10.8% Discount Rate
0.90% Dilution
$7.05 Total Per Share IV
24 Multiple Y0 FCF
0.76 Price % of IV
$4.93 30% Discount Price
To achieve a 30% upside, we recommend buying shares at, or below $4.93.
Sources: ERT website, sec.gov company filings, Yahoo! Finance, phrma.org, innovation.org, Morningstar.com, Data provided by EDGAR Online’s I-Metrix Professional, XBRL-enabled applicationDisclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time.We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.
