Ergomed — What’s next after stellar 2020 performance?

Founded in 1997, Ergomed is a full-service pharmaceutical services company. Its two divisions are CRO, which provides Phase I to III clinical trial services, and PrimeVigilance, which provides post-marketing PV (Phase IV) services. The company has expertise across all common disease areas but is predominantly focused on oncology and rare diseases/orphan drugs. The company was listed on the AIM market of the London Stock Exchange in 2014. At 31 December 2020, Ergomed employed over 1,150 people and 300 contractors across 16 offices globally, had completed 600 studies with over 125,000 patients enrolled across 60 countries and was supporting products in over 100 countries. It has 240 active clients (including those of the recently acquired PrimeVigilance USA and MedSource) and low client concentration. Because of the well-balanced pharma services offering (PV and CRO), Ergomed has proved to be a resilient business and delivered excellent returns in 2020.

Ergomed’s revenue was up 27% to £86.4m in FY20. Gross profit increased to £39.7m from £29.5m, with gross margin improving to 45.9% from 43.3%. FY20 adjusted EBITDA increased to £19.4m from £12.5m in FY19. Adjusted FY20 EPS increased by 29.6% y-o-y. Throughout 2020, Ergomed grew its order book substantially, which stood at an all-time high of £193m at end-2020, up 55.5% y-o-y. We note that although this benefited from the accretive acquisitions of both Ashfield and MedSource in 2020 (c £40m), underlying organic growth in the order book was also strong (+24.6%, c £31m) in part reflecting an increase in cross-selling between its service offerings (CRO and PV) and its broadening US sales presence. This provides high revenue visibility for FY21.

Ergomed had cash of £19.0m and was debt free at the end of FY20 (vs £14.3m at the beginning of the year), which is impressive considering the company made two acquisitions in 2020 with cash outflows totalling £13m. Underlying organic cash generation was a healthy £18m in FY20, representing strong cash conversion. In addition, the company has access to £30m in unused credit facilities.

Unsurprisingly, the CRO segment was flat in 2020 with like-for-like CRO revenues ending at £31.3m (after adjusting FY19 revenues for a £1.6m one-off). This was entirely related to clinical trial delays caused by workflow disruptions in hospitals. Many trials either slowed down or were forced to slow patient recruitment. Ergomed’s key markets are the US and Europe, where vaccine deployment should be relatively efficient, so we expect the CRO segment to rebound throughout 2021. In H220 CRO segment service fee revenues were up 13.5% over H120 and up 16.7% y-o-y, which indicates the potential magnitude of the rebound. We forecast CRO segment revenues of £56.0m and £63.3m in 2021 and 2022 respectively.

The CRO segment was significantly strengthened in the US after the acquisition of MedSource in December 2020. The private US-based CRO booked $19.3m (£14.5m) and $17.0m (£12.8m) in service fees in 2019 and 2020, respectively, while adjusted EBITDA was $1.3m (£1m) in 2019. Ergomed indicated that MedSource is on track to recover from the impact of the COVID-19 pandemic in 2021 and guided to a potential uplift of 4–5% in revenues over 2019. Therefore, in addition to the expected resumption of organic CRO growth, MedSource will significantly boost 2021 CRO revenues and expand Ergomed’s presence in the US.

MedSource was acquired for $16.2m (£12.2m) in cash and $1.8m (£1.4m) in shares (at a 30-day average daily closing price before the acquisition). The initial cash outlay was $7m (£5.2m), as the company retained MedSource’s cash (no debt). There is an earn-out of up to $7m (spilt 90:10 cash and shares) depending on performance in 2021. The transaction was immediately accretive, according to Ergomed.

Ergomed’s CRO business segment is full-service, clinical and able to execute clinical development from the first patient through regulatory approval to post-marketing studies. Services offered include, but are not limited to, clinical trial and project management, medical writing, regulatory affairs, quality management and PV. A typical full-service clinical trial contract would consist of the CRO organising all aspects of a study, including the creation of an internal team to run the trial. A CRO contract is typically signed a couple of months before a clinical trial is expected to start. Revenue is recognised over the life of the contract when hours are billed and targets are met (eg patients are enrolled). Tight control over these margins is critical to ensuring profitability. How effectively a CRO uses its billable employees is key to driving both revenue and profit. A poor understanding by senior management of how its employees are being used will result in missed targets, higher costs and damaged reputations, while good control of this will enable a management team to push margin and revenue growth.

Widespread lockdowns caused disruption to the clinical drug development industry in 2020. However, demand for PV services remained high, which allowed Ergomed to record strong organic growth in 2020. Like-for-like revenues in the PrimeVigilance segment increased to £46.0m, up by an impressive 30% and on a par with growth of 29% recorded in pre-pandemic 2019 over 2018. Including the Ashfield Pharmacovigilance (now PrimeVigilance US) acquisition, total 2020 revenues were £55.1m, up 56%. Ergomed acquired US-based Ashfield Pharmacovigilance from UDG Healthcare in January 2020 in a deal that was immediately accretive to earnings, according to the company. We forecast PrimeVigilance segment revenues of £63.6m and £73.6m in 2021 and 2022, respectively.

Ergomed’s PrimeVigilance business segment focuses on PV work across the globe. Once a drug is approved and marketed, regulators require pharma companies to track the safety of their drug to ensure no unforeseen risks arise. This originally involved tracking any adverse events that patients experience, but has evolved to cover a whole suite of product lifecycle management.

Pass-through revenues are Ergomed’s expenses reimbursed by customers, but booked in the top line according to IFRS. To get the true profit per segment, these pass-through revenues need to be adjusted. Reported gross margins for the CRO and PrimeVigilance divisions were 35.1% and 52.0%, respectively, in FY20. Once pass-through revenues are stripped out, underlying gross margins were 46.3% for CRO and 52.5% for the PrimeVigilance division.

Our valuation of Ergomed is virtually unchanged at £683m or 1,400p/share from our post-results update in March 2021. This is derived from our DCF model (Exhibit 6) using a 10% discount and 2% terminal growth rates. Our valuation implies an EV/EBITDA multiple of 30.5x based on our FY21 forecasts. We note Ergomed trades at a premium EV/EBITDA (FY21e) of 26.9x compared to peer average of 20.0x (but in line with Medpace).

Ergomed has demonstrated sales growth rates (2017–20 CAGR of 22.0%) that are higher than the growth of most peer group companies (Exhibit 7). Medpace is the smallest company by market cap in the peer group and has demonstrated an even higher CAGR in revenues of 28.5% over the same period. Medpace’s current EV is almost 10x larger than Ergomed’s, which indicates much larger CROs can sustain high growth rates. Ergomed is significantly smaller than the rest of its listed peers, it is also differentiated (focused on orphan drug development) and active in M&A. For these reasons, we believe it can sustain our forecasted growth rates and margins over our projected period in the DCF model.

After a transformational 2020 for Ergomed, we decided to examine the sensitivity of our valuation to different assumptions and understand how bull and bear case scenarios could look. Sales growth and operating profit margins are the two variables that influence the company’s cash flow generation. Therefore, in our sensitivity analysis (Exhibit 8) we focused on these two underlying inputs:

Exhibit 8 provides a two-dimensional sensitivity analysis of these two variables. We also note that cash flow-based valuation methods discount cash at WACC and do not assume that the company could grow further via M&A and generate additional returns. Because Ergomed has an active M&A strategy, there is a significant possibility that accumulating cash will be used to acquire businesses, which, if successful, could deliver additional returns. For this reason, there is potential for additional upside on top of the values in Exhibit 8.

Ergomed is reimbursed on a time and materials basis as a services company and not based on study outcome; as such it is not associated with the usual biotech and drug development risks, including clinical development delays or failures, regulatory risks, competitor successes or partnering setbacks. However, it is subject to business risks that include the loss of key clients, changing costs and increased competition. Ergomed relies on its reputation; any failure to deliver on contractual obligations with clients could affect its ability to win new contracts. It is sensitive to pressure around clinical trials, notably around patient enrolment, where actual timelines and costs could drastically differ from a proposal if the correct planning is not undertaken.

Innovation in healthcare is driving sales and growth in the number of clinical trials being initiated, as pharmaceutical and biotechnology companies continue to invest substantially to remain ahead of competition. The number of trials being initiated globally is increasing, as is their complexity. As a result, the operation of clinical trials in their entirety and on a day-to-day basis is beyond the expertise of many pharmaceutical and biotechnology organisations, especially newly spun-out biotechnology companies. CROs can provide expertise when the industry needs it.

At the same time, the development costs are rising, while success rates remain relatively flat (one in 10 drugs that enter human clinical trials will succeed). As a result, the R&D return on investment is increasingly underwhelming. To counter this, pharmaceutical and biotech companies are choosing to outsource services to specialist CROs, a sector now worth $43bn (2020) and expected to grow to $62bn by 2024 (CAGR or 9.5%, source: Statista).

Industry-wide consolidation has created several large (>£5bn market cap) CROs (eg IQVIA, LabCorp, Syneos, Parexel) with global capabilities, the recent example being the merger of ICON and PRA Health Sciences announced on 24 February 2021. While these CROs can provide a full range of services, expertise in one specific technology, disease or geography will vary on a company-by-company basis. The opportunity exists for smaller CROs that can offer specific expertise. Ergomed aims to grow its market share by its focus on oncology, rare diseases, PV and its core geographies of the EU and US.

The CRO industry is broadly split into companies that offer pre-clinical services and those that offer clinical services. Pre-clinical work involves pre-discovery work (finding new targets and causes of disease), drug discovery (finding a promising lead compound) and pre-clinical research (testing lead compounds in cellular and animal models). In the clinical CRO sector, companies are broadly focused on delivering human clinical trials through Phase I, II and III, in addition to post-approval studies (Phase IV) and support.