A stock with annual earnings growth of 30% for the last five years, trading at a price-to-earnings (P/E) ratio of 10? If you're an experienced investor, you know this is the stuff of dreams. Even with back-of-the-napkin calculations, it's a no-brainer. If such a stock continued 30% growth and returned a price-to-earnings-to-growth (PEG) ratio of one, then in only three years, you'd have returns in excess of 500%.
Of course, stocks like this rarely come along. And when they do, the price is so low because they aren't beautiful, well-toned athletes, but rather wretched invalids in need of a penicillin shot. Today's guest, SFBC International (NASDAQ:SFCC), is no exception.
The business
SFBC performs clinical development services for pharmaceutical, biotechnology, and medical device manufacturers. Suppose Elan (NYSE:ELN) comes up with a new drug. Before Elan can peddle it to doctors, the Food and Drug Administration (FDA) has to approve it. The FDA tends to be a stickler for rules; it actually likes drugs to be shown to be beneficial and safe for people before it will approve them for sale. As someone who doesn't want his head to turn purple, balloon up, and explode, I consider this a good thing.
Elan can test the drug itself, or it can hire SFBC to perform the clinical trials. SFBC will, among other things, identify subjects willing to participate in the trial, interview them, administer the medication, do all the paperwork, often house and feed the subjects, and manage the data.
The competitive position
SFBC has some significant barriers against competition. First, it's not particularly easy to set up shop and become a clinical tester. You have to have a strong working knowledge of FDA regulations and the systems in place to meet those requirements. You need the laboratories, statistical tools, and IT infrastructure to run the trials. It's not a weekend endeavor.
Not to say that SFBC is the only player in the game -- Pharmaceutical Product Development (NASDAQ:PPDI), Covance (NYSE:CVD), and Parexel International (NASDAQ:PRXL) are all significant competitors. But SFBC has competitive advantages. It has the largest phase-one facility in North America, providing an advantage when competing for large trials. It also maintains a large database of individuals willing to participate in trials. This database provides a competitive advantage for locating test subjects, particularly when you consider that trials often require subjects with specific conditions, such as cardiovascular disease or diabetes. This can be a huge advantage. A significant number of trials are delayed due to an insufficient number of participants.
Risks
SFBC sounds great, so why's it so cheap? Well, SFBC has waded into the perfect storm. It started with a report from Bloomberg entitled "Big Pharma's Shameful Secret." The report detailed numerous allegations against the pharmaceutical testing industry and cited SFBC in many of its examples. The allegations include:
- The industry exploits poor people desperate for money.
- Consent forms are difficult to understand, and many participants don't read them.
- People can be killed in these tests.
- Regulation of the industry is terrible.
- Trials are frequently run by employees who lack the proper training.
- Subjects may lie during screening interviews so that they can participate in multiple, simultaneous trials.
- Payments increase as the drug trial progresses, which is coercive.
- Conflicts of interest result in ethics and safety review boards that focus on rapid turnaround rather than patient safety.
In a follow-up article, Bloomberg reported that SFBC officials threatened three illegal immigrants with deportation if they didn't sign documents refuting the allegations in the original article. And to make matters worse, in a Canadian trial, 19 participants were exposed to a subject who had active tuberculosis. Now a senator is looking into all the allegations, the Securities and Exchange Commission (SEC) has made an informal request for information, and SFBC's top two executives have resigned. As if to kick the company when it's down, SFBC's main testing facility -- you know, the largest phase-one clinic in North America -- had to temporarily reduce the number of beds in order to meet fire standards.
Of course, these allegations couldn't come at a worse time -- the pharmaceutical industry is already paranoid about safety, given the headlines about Merck's (NYSE:MRK) handling of the Vioxx recall. And, while I believe Bloomberg portrayed the industry as negatively as possible, some of the allegations have substance. SFBC hired lawyers to conduct its own inquiry and has admitted to the deportation threats and the tuberculosis issue, though it's denied most of the other issues.
At the same time, many of these issues are either industrywide or simply sensational. It seems completely obvious that poor people will participate in these trials. Many of these trials are probably uncomfortable, and they have a high chance of making an otherwise healthy person sick. What motivation would someone have to participate other than cash? Yet if you want new medications, there doesn't seem to be a way around testing them on people who are desperate enough to volunteer.
So I see the main problems as industry issues rather than concerns specific to SFBC. If society believes these issues with clinical trials are a problem -- and I think they are -- then it's the FDA's responsibility to implement regulation that protects the interests of trial participants and eliminates conflicts of interest among independent review boards.
That said, SFBC has become the poster child for the clinical trial industry, so shareholders should recognize that the company will be under a microscope and facing significant political and media pressure. And even if no additional bad news surfaces, there's a risk that SFBC's customers, the large pharmaceutical companies, may withdraw their business due to bad publicity. So far SFBC has lost two contracts, but it claims that overall, they are still signing the expected number of contracts from new and existing clients.
What's it worth?
So what's a company like this worth? Well, the numbers vary wildly depending on your assumptions. If you were to go with analysts' estimates of 22% growth for the next five years, then 12% for the next five, then a terminal 3%, by my calculations, the shares are worth somewhere between $35 and $40. But I think this is an optimistic scenario, and as a value investor, I'd rather plan for the worst.
Suppose you instead assume SFBC loses some business next year, earnings fall to about $1.25 per share, and only then does it start growing at a similar rate. In that case, it will take two years for the company's earnings to recover to 2005 levels, and shares are worth about $25. Of course, that isn't even the worst scenario. There is a chance that, in the media glare, other significant issues will come to light. Under that scenario, all bets are off.
The upshot
At prices below $20, I think the odds favor investors. But make no mistake: This is an extremely risky company right now. With a little bit of digging, you can find companies trading at similar discounts to fair value, but with less risk. If you want to save some time, you can let us do the work -- our Motley Fool Inside Value newsletter recommends two such companies every month. You can see our top picks with a free trial by clicking here.
Fool contributor Richard Gibbons, despite all the allegations, has never participated in a drug trial. He does not have a position in any of the companies discussed in this article. Merck is a Motley Fool Income Investor recommendation. The Fool has adisclosure policy.
