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Equity Research: Does ICON present a compelling investment opportunity?

Part 3
Equity Research: Does ICON present a compelling investment opportunity? (Part 3 of 4)

Why analyst expectation of a margin compression is unreasonable

Thesis Details

Top Line Solid, But Margins the Real Story
With the favorable industry dynamics as a backdrop, the Street appears to be underestimating the potential margin expansion that ICON can achieve.  A key area where the CROs compete, beyond the company’s respective expertise, is in pricing.  Due to the competitive nature of the business and the commoditization of the CRO space, pricing is an important factor when entering deals, particularly when entering into strategic partnerships that provide a ‘guaranteed’ revenue stream for an extended duration. Given the competitive environment, it is difficult to drive margin upside with pricing power.

ICON5Enlarge Graph

As such, ICON has been laser-focused on improving margins by leveraging operating expenses.  Following the implementation of a transformational deal with Pfizer in 2011, ICON’s gross margins fell under significant pressure, falling nearly 500bps to 35.3%.  ICON has successfully right-sized its cost structure since then, lowering SG&A as a percentage of revenue by 200bps in both 2012 and 2013.  With Pfizer fully ramped and overall industry demand healthy, utilization trends should continue to benefit margins, and pricing appears healthy.

Despite several quarters of sequential margin expansion, the Street is expecting compression in 1Q14.  While there could be some seasonality driving this (weather impact, perhaps), this appears conservative.

Further illustrating this point is the full-year margin expectation for ICON in 2014 relative to its 4Q13 starting point.  In 2013, full-year margins finished around 150bps above the 4Q12 levels.  While it’s unreasonable to continually expect that type of expansion, it also seems that lower overall margins in 2014 vs. 4Q13 levels is unreasonable.

Why analyst expectation of a margin compression is unreasonableEnlarge Graph

Further aiding ICON’s earnings per share is its advantageous tax position.  Given it is headquartered in Ireland, ICON benefits from a corporate tax rate of just 12.5%, and is targeting just a 16% tax rate in 2014, which compares to public CRO peers ranging anywhere from the mid-20s to low 30s.

Market Realist Take

ICON’s results for the fourth quarter of 2013 beat analyst estimates. For the full year 2013, revenue grew 20% to $1.34 billion. EPS on GAAP basis for 2013 was $1.65 per share compared with $0.92 in 2012. During the quarter ICON booked $446 million of net new business, a book to bill of 1.29x. As a result, it enters 2014 with a backlog in excess of $3 billion and therefore provided full year 2014 revenue guidance in the range of $1,415 to $1,465 million, representing growth of 6% to 10%, and earnings per share guidance in the range of $2.05 to $2.20, an increase of 16% to 24%. Peer Quintiles (Q) said it made progress on its growth strategy, concluding 2013 with another strong quarter in net new business generating a book-to-bill ratio of 1.29 for the full year. In addition, it expanded its income from operations margins and grew its full year diluted adjusted earnings per share by 18.6%, compared to the prior year. Quintiles believes it is well positioned entering 2014 with the largest backlog in the industry at $9.9 billion dollars which will fuel 2014 constant currency service revenue and earnings growth.

According to a report from market research firm Transparency Market Research, in 2013 the total amount of work outsourced to CROs globally reached $31.1 billion, almost $10 billion more than in 2009. The report added that the outsourced research market is expected to reach $65.03 billion by 2018. The Chemical Pharmaceutical Generic Association (CPA) last year forecasted that the global CRO market is set to experience average growth of 11.4% a year to 2017, reaching a value of $43 billion by then from $25 billion in 2012. The U.S. dominates the global  pharmaceutical contract research and manufacturing services (PCRAMS) market and will still lead in 2017, when it will account for 24.9% of the total, but there will be a marked decline on the 33.7% share of the market held by U.S. players in 2012. ICON and its peers Covance (CVD), Parexel (PRXL), Quintiles (Q), and Charles River Labs (CRL) are poised to benefit from this growth in the industry.

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