FOOL ON THE HILL
An Investment Opinion
Researching Quintiles Warren Gump (TMF Gump)
October 26, 1999
One strategy I use to find interesting value-oriented stocks is reviewing "fallen angels," one-time stock market leaders that have fallen out of bed with investors, a month or two after their stocks were knocked for a major loss. Basically, I'm digging through the market's garbage dumpster to see if anything has been unjustifiably thrown away by investors.
Not surprisingly, a good deal of the stocks that fall into this category -- say Rite Aid (NYSE: RAD) -- fully deserve the treatment given to them because of faltering business fundamentals or management ineptitude. Every once in a while, however, you come across the stock that is going through some rough times, but has a pretty good chance for recovery. One stock that I would classify in that category is Quintiles Transnational Corp. (NYSE: QTRN).
For those of you not familiar with the company (I am just beginning to learn about it myself), Quintiles is the market leading healthcare Contract Research Organization (CRO) and Contract Sales Organization (CSO). This means that the company helps pharmaceutical companies complete the extensive clinical trial process required to bring drugs to market (you can learn more about this process from last night's Rule Maker column), along with assisting drug company sales forces market drugs to doctors. Through its early 1999 purchase of Envoy, the company has also staked a claim in the healthcare Electronic Data Interchange (EDI) market where physicians, pharmacies, hospitals, and bill payers transmit information about treatments, costs, and reimbursement policies.
Over the past several years, Quintiles -- and major competitors like Covance (NYSE: CVD) -- enjoyed rapid growth as major pharmaceutical companies increasingly relied on contract organizations to complete more of their work. Quintiles became a market darling, rising from about $5 at the time of its initial public offering in 1994 to over $55 last December. A one-two punch in September knocked this stock off the precipitous market-darlings-of-the-past cliff.
In early September, Covance put investors on edge by announcing that it would not meet third quarter earnings estimates. Included in the reasons for this shortfall were a reduction in new contract wins, the cancellation of a major project, and cutbacks on another big project. Although this warning raised investor concern about the industry, Quintiles stock was hit too hard since most analysts considered these problems specific to Covance rather than a bad omen for the overall industry.
Quintiles changed that perspective on September 15th, when it warned investors that analyst expectations through the year 2000 were too high. Instead of earning the $0.36 per share analysts expected for the third quarter, it would earn only $0.27. The company's $0.32 projection for the fourth quarter was $0.07 lower than analyst estimates. Compounding the problem further, the company cautioned that year 2000 earnings would likely grow only 25%, when analysts had been projecting a 33% increase. (That's a double-whammy since the growth rate and the base off of which that growth is calculated are both lower.)
The primary reason for this shortfall was the cancellation of numerous large projects related to a specific class of cardiovascular drugs that was found to be ineffective. Quintiles was doing several large (read: expensive and profitable) clinical studies for drugs that treated a cardiovascular problem the same way. When the pharmaceutical companies that were trying to bring the drugs to market learned that the drugs didn't work as expected, they intelligently decided to cancel the trials instead of continuing with the futile studies. Unfortunately for Quintiles, this meant the elimination of a significant chunk of expected business, reducing anticipated profits and leaving the company temporarily overstaffed in certain areas.
Beyond the hit to expected earnings, the basically simultaneous warnings from Quintiles and Covance increased concern among investors that major pharmaceutical companies are reducing their reliance on CROs. According to this theory, industry consolidation will result in a reduced need for outsourcing since their will be fewer drug companies and bigger companies might have less of an incentive to outsource this function.
While this point of view could be true, my sense is that companies are tending to increasingly rely on outsourcing to focus company energy on core competencies. Even more important, pharmaceutical research efforts will likely explode over the next few years as the human genome is mapped and new treatments are tested. These factors should bode well for Quintiles over the longer term.
One reason to stay away from companies in trouble is that they appear not to have the financial wherewithal to withstand temporary problems. There are plenty of situations where a company has so much debt and limited cash flow that it can't afford to restructure or pursue growth opportunities. Happily, Quintiles is not in this camp.
Although the company has completed numerous acquisitions over the past several years, its balance sheet is in good shape since most of these deals were all-stock transactions. At the end of June, the company had cash and investments of $269 million and debt of $263 million, resulting in a net cash position of $6 million. On top of this nice balance sheet, cash flow from operations has been higher than net income for each of the last three years, with over $100 million in cash being produced last year. These characteristics provide an enormous amount of flexibility for the company to pursue attractive opportunities. The only constraint on the company is that making an all-stock acquisition probably doesn't make too much sense because of its low valuation.
I've only touched on Quintiles in this article, giving a brief overview of its CRO business, while ignoring its CSO and information units -- both of which should be important contributors to future results and need to be investigated before considering the stock. Nonetheless, I am amazed that the market is attributing Quintiles a price/earnings ratio of only 15x current year estimates when the company has such a solid history of value creation and earnings growth. That valuation basically suggests that the market doesn't believe Quintiles has any growth left in it. That may be correct, but I find it hard to believe based on the pending developments in the pharmaceutical and biotech industries and the tremendous growth of the past few years.
Quintiles Q2 Conference Call Coverage, Boring Port, 8/25/99 - 9/8/99