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Wednesday, November 11, 1998

An Investment Opinion
by Louis Corrigan

Parexel's Trials

Parexel International (Nasdaq: PRXL) is the number three provider of contract research for the pharmaceutical and biotech industry based on annual sales. With the market for contract research organizations (CRO) growing at 20% to 25% a year and many of the largest players gaining market share as pharmaceutical companies parcel out increasing amounts of clinical trials management and even marketing and sales functions, Parexel would seem to be well-positioned. Yet the trials its investors have lived through are enough to leave them feeling like guinea pigs.

On October 29, Parexel reported that fiscal Q1 revenue rose 32% to $82.8 million, or 62% before the restatement of year-ago period results due to acquisitions. Earnings per share increased 22% to $0.22. Unfortunately, that was two cents shy of estimates. Worse yet, management indicated that revenue and EPS growth will decline to 20% to 25% in the current quarter before turning up in ensuing quarters to register in the 25% to 30% range for all of FY99. After the 41% EPS growth Parexel delivered in FY98 and the 30% plus gains analysts had been expecting, this was an unpleasant wake-up call.

Parexel shares plunged on the open, trading as low as $20 1/4 before ending the day down $15 3/16 (42%) at $21 1/16 on extraordinary volume of over 16 million shares. Other leading contract research firms got whacked, too. Market leader Quintiles Transnational (Nasdaq: QTRN) closed down $5 3/4 to $42 1/4 despite reporting estimate-beating results just the week before. Number four player Pharmaceutical Product Development (Nasdaq: PPDI) sank $4 3/4 intraday to $23 5/8 before ending the day down just a quarter at $28 3/8. Fast-growing Kendle International (Nasdaq: KNDL) gave up $2 3/4 to close at $25. Only number two player Covance (NYSE: CVE) remained largely placid.

Investors should always follow a company's key competitors as well as its suppliers and customers since broad shifts in a sector eventually affect all participants to some degree. In some cases, though, the market draws industry-wide lessons from what's largely a company-specific problem. That's one reason why industry turmoil can give investors a chance to profit, as my Foolish compatriot Warren Gump discussed in this space last Friday and again on Monday.

That's especially true when the story that triggers the massacre looks far less disturbing on closer inspection. While it's often stupid to catch a falling knife, there are also plenty of cases where investors simply rush for the exits without paying enough attention to management's version of the story. In this case, not only have the innocent CRO victims largely recovered, but Parexel's shares have themselves also rallied for a 20% gain as more thoughtful investors stepped in.

Parexel's first quarter revenue fell about 3% short of expectations due to two factors: a period of flat orders in prior periods plus "extended start-up times for recently awarded large clinical programs," according to Chair/CEO Josef von Rickenbach.

For the five fiscal quarters ending with the March 1998 period, orders were relatively flat, in the $70 million to $75 million range. Yet orders have leapt of late, with $113 million in new business wins in the latest period and $110 million in the June quarter. With 25% to 35% of the revenue from these new wins consisting of very large multi-year contracts topping $20 million, the projects associated with these contracts are simply more complex and thus take longer to launch into the dynamic revenue phase.

As von Rickenbach and CFO Bill Sobo, Jr., repeatedly explained on the post-earnings conference call, the process of finishing the protocol design, defining the database, training personnel, and completing regulatory paperwork involves interaction between Parexel, the pharmaceutical client, and outside parties. The delayed start-ups had nothing to do with management talent, patient enrollment, or other factors more squarely in Parexel's control. There were no unusual customer cancellations or intentional delays by customers on contracted projects. Since Parexel recognizes revenue based on hitting certain contractual milestones, cash streams have simply been pushed out slightly.

Indeed, the company expects growth to pick up in the fiscal third quarter and to continue to improve thereafter. Part of the long-term story is that Parexel has made important investments in medical marketing services (MMS), such as the March acquisition of PPS Europe Limited, which nearly doubled its MMS operations. This gambit is only beginning to pay off. While the contract research unit (two-thirds of revenue) and consulting unit (one-sixth of revenue) grew at a 30% plus clip in the first quarter, the marketing biz is still showing just 20% plus growth. But management expects gains in marketing revenue could eventually outpace the company's overall growth rate.

While operating margins came in at 9.3% for Q1, flat with the June and year-ago periods, they're expected to rise to 9.5% for the whole of FY99 on the way to 10% plus thereafter. What's more, despite necessary investments to prepare for the increasing workload, gross margins actually came in on target at 35.1%. As one analyst on the conference call opined, the company would have actually beaten estimates had revenue come in as planned. In other words, the revenue shortfall was really the main problem and the company actually delivered record new orders for the period. Indeed, backlog is up 34% year-over-year.

On the downside, receivables rose to 65 days sales from 54 in the June period. Yet management sees days sales outstanding improving in the December quarter. It was partially the result of a rise in unbilled receivables connected to the large clinical trials projects. Chair von Rickenbach said these clients are amenable to what Parexel considers fair payment schedules, indicating that the firm doesn't see any evidence that pharmaceutical firms are attempting to use Parexel basically to finance part of their working capital needs.

Also worth noting is that Parexel's top five customers accounted for 44% of business in the period, up from 36% in June, as its largest client made up 15% of total revenue. Customer concentration is a hazard of the contract research industry, and it could get worse as large pharmaceutical firms establish preferred relationships with particular CROs. Yet Parexel did work for most of the top 20 pharmaceutical and top 10 biotech companies last year, and it's signed up new customers the last two quarters.

Since short-term hiccups often turn into longer-term problems, the market tends to discount management's soothing explanations. Often rightly so. Yet looking at Parexel's three-year chart, it's clear that declines of 30% to 40% are pretty common for this typically high P/E stock. In fact, before the latest gyrations, the stock fell 38% from its July high only to rise 83% off its August low. With analysts projecting 32% long-term growth for the company, it looks like a modest bargain at 27 times the revised consensus earnings estimate of $1.00 per share. Of course, the Q1 numbers left analysts skeptical of that long-term growth.

Still, Parexel has $69 million in cash and no debt, so it's in good shape for more acquisitions, which seem inevitable. The Q1 numbers really weren't bad. Management's explanations for the shortfall made sense. New business is rolling in at a record pace. Indeed, Parexel is one of the few companies capable of managing such large, complex clinical trials. If you think that pharmaceutical and biotech firms will continue to spend on R&D and that CROs will get more of this $40 billion annual pie than the roughly 10% they now claim, then Parexel's Q1 results may have actually provided plenty to feel good about.