3.5x) and 20x FCF. A recent hiring spree, in anticipation of a growth uptick and move towards later-stage trials, combined with a soon-to-be-remedied full tax rate (35% now; moving to 20-30% over time) result in PRXL’s below-industry margins. Management seeks to remedy this with organic growth and a cost-reduction plan to achieve $50-60m in annualized savings within the next few years. Management further believes margins can swell 150-200bps next year with 15-20% long-term EPS growth and sustained 20%+ ROICs. Looking at Parexel’s pristine long-term operating history, we’re apt to agree.

Parexel’s success springs from three primary growth drivers: i) global pharmaceutical R&D growth (c. 2-4%/year); ii) increased outsourced penetration (currently c. 50%); and iii) industry consolidation. Taken together, Parexel’s organic revenue growth can average 7-9% and total growth reaches 10-12% with reinvestment of FCF into bolt-on M&A. Both our primary research and a variety of public studies support these notions. Industry forecaster ISR predicts a 7.9% industry growth CAGR from 2014 to 2018; recent sellside surveys of pharma staff predict R&D growth of 4-7% in 2016 – a sentiment maintained through September; and both anecdotal and quantitative data from our own primary diligence speaks to the entrenchment of CROs in the global clinical research process. As one clinical director explained, CROs dampen the volatility of internal budgets by converting fixed R&D capital costs (overhead, clinical staff, reporting infrastructure) into a variable cash expense. This allows research organizations to focus on what they do best: drug discovery and/or selling and marketing. The top five CROs have about 50% share, trending towards 60% by 2017, with Parexel near 10% share. Industry leaders like PRXL can gain ~100bps of share per year from smaller firms as sub-scale organizations no longer possess the scale to satiate global research projects in a world of growing regulatory complexity.

Within this consolidating industry, Parexel stands out for the breadth and depth of its services. Parexel has worked with all of the top 50 companies in the biopharma space, with some form of involvement on 95% of the top 200 biopharmaceutical products on the market. Further, a recent analysis of clinicaltrials.gov cited Parexel’s involvement in more clinical trials than all but one of its peers, the larger but slower-growth Quintiles. Our diligence discussions buttress these assertions. Paraphrased from the head of clinical research at a major pharmaceutical company about his relationship with Parexel, ‘If someone sneezes in Korea, I’ll know…if a group of patients shows side-effects, I’ll know immediately instead of two weeks. That way I’m prepared when the FDA calls.’ Another remarked, ‘Between Parexel and [a second retained clinical outsourcing partner], I expected Parexel to outperform, and they have.’ That’s not to say that Parexel is without faults. All of the top five CROs can adequately service a multi-national client, and over time the CRO group must become more cost efficient. But Parexel appears to have positioned itself ahead of these trends: it has nearly quadrupled the size of its low-cost India staff, from 200 in 2010 to roughly 900 today. We think this broad-based labor expansion, especially those in low-cost jurisdictions, may predate both near-term growth and margin improvements.

Kerrisdale Partners

While we’re excited about Parexel’s near-term growth prospects, we’re also encouraged by the stickiness of the current revenue book. Parexel’s backlog measures at $5.2bn versus $2bn of annual revenue. The trailing twelve months book-to-bill ratio resides at 1.2x and the historical range measures 0.9x to 1.5x. Augmenting the core CRO business, Parexel also runs a 45-50% gross margin software business – pieces of which, like the data-monitoring tool Perceptive MyTrials, are used by the top 15 pharmaceutical companies – and a consulting group that captures regulatory and commercialization business. The consulting outsourcing market is projected to grow from $2bn in 2014 to $4.5bn in 2020, a 15% CAGR – twice as fast as CRO services.

If its prior success holds, Parexel can continue to reduce industry-wide costs while helping companies innovate. With the business priced at under 2x revenue alongside recurring cash flows and an unlevered balance sheet, we expect superior shareholder returns over time.

Conclusion

We continue to be confident about the composition of the current portfolio. Regardless of how the overall market performs, we expect our portfolio to fare well over the long term.

Thank you and please don’t hesitate to contact me with any questions.

Sincerely,
Sahm Adrangi
Kerrisdale Partners

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