CROs Poised to Benefit From Biopharma Outsourcing

Our thesis for the contract research organization industry remains that continued outsourcing from biotechnology and pharmaceutical companies will drive growth for the larger global CROs that help design and conduct clinical trials. After transferring coverage of the major late-stage CROs, we are maintaining our narrow moat and stable trend ratings for Syneos Health SYNH, PRA Health Sciences PRAH, and Icon ICLR. We’ve downgraded market leader IQVIA’s IQV moat rating to narrow from wide after reconsidering the company’s long-term competitive positioning in the clinical research and data spaces. Of these four, Syneos is most attractively valued, but we note that it’s the only one with a high uncertainty rating as a result of its high debt load.

With IQVIA’s moat downgrade, we’ve lowered our fair value estimate to $114 per share from $118. While we believe that intangible assets and switching costs underpin a narrow economic moat for IQVIA, we no longer have confidence that the company will earn excess returns for at least 20 years. Returns on invested capital were significantly diminished following the 2016 merger of Quintiles and IMS Health, and we do not have high confidence that the company will maintain its monopolistic hold on aggregated patient data for more than a decade. CROs and software companies are increasingly engaging with patient data as it begins to play an increasing role in clinical research and commercialization, and we believe improving technology and interoperability could eventually lower barriers to accessing this data.

We are maintaining our $53 fair value estimate for Syneos Health, the result of the 2017 merger of INC Research and inVentiv Health. After lackluster growth in the quarters following the merger due to some large cancellations, the commercial segment is finally stabilizing, and we like the company’s focus on integrated deals that drive revenue for the clinical and commercial businesses. However, the company took on significant debt for the merger, which could constrain its capital-allocation strategy in the near term. We expect Syneos to complete fiscal 2018 with total debt at about 5.6 times adjusted EBITDA, with most of the debt maturities pushed out to 2022 and beyond.

We’ve raised our fair value estimate for Icon to $111 per share from $106 to reflect our slightly higher growth expectation in the near term. We expect Icon to continue diversifying its revenue base away from client concentration risk from its top client, Pfizer, while maintaining focus on lucrative partnerships with large biopharma clients. We like management’s disciplined acquisition strategy and solid execution, as evidenced by its higher operating margins and higher adjusted returns on invested capital compared with peers.

We’ve lowered our fair value estimate for PRA Health to $81 per share from $87 after re-examining our long-term cost assumptions. We still model robust top-line growth and continued margin improvement, but the company has slightly higher exposure to lower-margin staffing solutions than its peers. In 2019, we expect management to roll out its plans for integrating Symphony data with its clinical research solutions.

Merger Diversifies Syneos' Client Base INC Research's 2017 merger with inVentiv Health launched Syneos Health, the new entity, into the upper echelon of large, global, late-stage contract research organizations, but at the price of a significant debt load. We believe Syneos is one of a handful of CROs with the global infrastructure necessary to compete for large, multinational, late-stage trials and secure strategic partnerships with large pharmaceutical companies. However, the debt load could limit capital deployment in the near term.

Most of Syneos’ CRO business comes from the most lucrative area of the CRO market: long, complex trials that require hundreds if not thousands of patients across the globe and thus have ample room for missteps. Trial sponsors need a CRO, not only with strong technical know-how in specific disease areas, but also with the expertise in local country cultures and government relations. Further, clients expect CROs to consistently trim trial times and deliver quality outcomes. Late-stage trials consume a significant portion of drug patent lives, making reduction in clinical trial time a priority for CROs and their customers. We like that Syneos does not have a lot of exposure to less-moatworthy early-stage trials, but the option is there if clients need it.

INC Research was a leader in late-stage clinical research from small- and mid-cap biopharma, while inVentiv Health had better exposure to large pharma. We believe the increased exposure to large pharma was a necessary strategic move because partnerships with these large clients form sticky relationships with high switching costs. The combined company has a diversified client base and provides a full portfolio of offerings, including staffing solutions and commercialization. While we don’t see significant competitive advantages in the staffing and selling business, both complete Syneos’ portfolio of services and offer flexibility to clients. The lower-margin commercial solutions business has been struggling in recent years but returned to growth in the last couple of quarters as management has established a cross-selling strategy, offering hybrid contracts with both clinical and commercial components.

Late-Stage Trial Business Digs Narrow Moat We believe Syneos merits a narrow moat rating as a result of its exposure to multinational, late-stage trials. Syneos possesses key intangible assets, including data from over 100 million patients and expertise in complex clinical trials, including disease areas like oncology and neurology. These assets enable Syneos to offer quick, efficient, and high-quality trials, enforcing switching costs. We believe that exposure to late-stage clinical trials is crucial for moats in the CRO space, as late-stage trials are larger in scope and complexity, are often multinational, and have higher risks of failure, which enforces switching costs. More complex trials provide room for differentiation, and global CROs leverage their expertise to shorten the clinical trials and ensure accuracy and precision. Recent bookings and backlog metrics indicate that the CRO addressable market is growing steadily as the biopharma industry continues to outsource research and development spending to CROs. The complex, multinational nature of late-stage trials limits competition to a few of the largest CROs that have the necessary global infrastructure, including Syneos. We estimate that Syneos is the third-largest of late-stage CROs with global capabilities, following IQVIA and PPD, with PRA Health and Icon close behind, and we like that it has limited exposure to early-stage trials.

Before the merger, INC Research had sizable global exposure to small and midsize biopharma customers, full-service work, and complex disease areas. InVentiv Health, on the other hand, was mostly FSP (functional services provision, or staffing solutions) and commercialization. We do not believe FSP or commercialization significantly strengthen a CRO’s competitive advantage, as CROs add the most value with full outsourcing, where they can leverage intangible assets to shorten drug-development times while producing quality work. However, the merger diversified the client base, adding exposure to large biotech and pharmaceutical clients. We believe that a diversified client base strengthens Syneos’ competitive advantage as small and midsize clients are likely to always need full outsourcing, while large pharmaceutical companies offer profitable preferred partnerships with high switching costs, choosing one or a few trusted CROs to which they funnel most of their new business. Further, large pharmaceutical companies control the majority of the industry’s research and development spending and command industry trends. Syneos reported that its top 10 customers have worked with Syneos for an average of 18 years, highlighting the topnotch retention of CROs with global, late-stage capabilities.

Syneos' Debt Means Higher Risk Than Other CROs We give Syneos a high fair value uncertainty rating compared with the medium rating we've assigned its peers we cover. Syneos is exposed to the same vulnerabilities as many of its peers, primarily levels of research and development spending from the biopharma industry. However, with its higher leverage from the 2017 merger, we believe Syneos is at higher risk of being constrained with its capital-allocation strategy in the near term.

While we don’t believe a decrease in R&D spending or outsourcing is likely in the near term, all CROs are exposed to these risks if biopharma funding is constrained, if there are changes in the drug-approval regulatory landscape, or if the biopharma industry faces other macroeconomic headwinds. CROs can be susceptible to impact from large cancellations, whether due to clinical failure or reprioritization, because it can be difficult to repurpose capacity that was previously allocated to that large trial. With about 25% of revenue coming from its five largest clients, we believe Syneos is slightly susceptible to this risk, but its exposure to smaller biotechs helps diversify the client base. We estimate that about 60% of revenue comes from large biopharma and the rest from small and midsize clients.

Syneos has nearly $3 billion in debt obligations after the merger, which heightens its uncertainty level. If performance deteriorates or the company faces major changes in biopharma R&D spending or outsourcing, Syneos may have trouble meeting interest payments and investing in its business to sustain growth. There is a risk that the company could lose market share, especially if it remains financially constrained and cannot pursue tuck-in acquisitions to evolve at the pace of competitors.

After accounting for interest rate swaps, about 45% of the company’s long-term debt is variable-rate, which could be a concern in a rising rate environment. However, the company generates steady cash, and we believe it will be able to meet its obligations.

Syneos’ major debt maturities are pushed out to 2022 and beyond, which provides the company ample opportunity to grow and unearth synergies from the merger. We expect deleveraging and share buybacks will remain the top capital deployment priority over the medium term. The company’s current capital structure significantly constrains the amount of tuck-in acquisitions it can pursue, while we expect continued smaller acquisitions from its peers. We would be concerned if Syneos’ ability to pursue strategic bolt-on deals is hindered beyond near-term integration efforts, especially as nascent trends in data and analytics begin to shape the industry.