By Brian Marckx, CFA
READ THE FULL PBSV RESEARCH REPORT
Lab Sale Improves Profitability, Further Bolsters Cash, Provides Strategic Options. Moving Price Target to $2.25/share…
Pharma-bio Serv (PBSV) reported financial results for their fiscal third quarter ending July 31st. Revenue growth remains very robust, particularly as it relates to Puerto Rico and U.S. consulting – the #1 and #2 largest contributors to total revenue. Total revenue jumped 31% yoy and more than 18% sequentially to $5.2M, the highest level since Q4 2015 ($5.9M). Through the first nine months of fiscal 2018, total revenue was $13.8M, up nearly 16% from the comparable prior-year period.
Consulting revenue was $4.7M, up 35% yoy and 22% better than Q2. Consulting revenue increased sequentially for the third consecutive quarter, expanding by an average of 12% per quarter since fiscal Q4 ’17. Through the first nine months of 2018, consulting revenue grew almost 20%. The recent and accelerating strength in consulting revenue is particularly encouraging given PBSV’s decision to sell their (Puerto Rico-based) laboratory assets (i.e. Scienza Labs). Lab revenue grew 4% in Q3 but was down almost 7% through the first nine months of the year. The lab similarly lagged consulting on a profitability basis (per 10-Q footnotes) with the former generating an operating loss of $237k YTD, compared to $911k of operating income generated by consulting services.
Similar to results through the first six months of the year, revenue growth in Q3 did not come at the expense of elevated spend - in fact, operating expenses as a percentage of revenue were the lowest in 3 ½ years. That, combined revenue at an 11-quarter high and the beefiest margins in 2 ½ years, pushed operating profit to $368k – a level not achieved since Q1 2016.
Net income and EPS, which further benefitted from $368k in non-recurring income associated with adverse effects of last years’ hurricanes, also were at multi-year highs. Captured in ‘other income’ (i.e. below operating income) on the income statement, $148k relates to property damage-related insurance recoveries while the other $220k relates to U.S. federal grant money paid to P.R. employers that retained (i.e. did not lay off) staff during the post-storm recovery period. Q3 net income and EPS were $731k / $0.03 on a GAAP basis and approximately $400k / $0.02 adjusted for the non-recurring income – even on an adjusted basis, Q3’s numbers are the best since Q4 2015.
Announced in mid-August and closed on September 17th, sale of the Scienza Lab laboratory assets sheds a segment which accounted for 12% - 13% of PBSV’s total revenue over the last two years but which also struggled to cover its fixed costs. Romark Global Pharma, LLC, a pharmaceutical client of PBSV’s (per company investor presentation), bought the assets for $5M, which is payable as $2M cash and a $3M two-year promissory note.
Consistent with management’s historic approach towards not providing much in the way of financial or strategic guidance, sale of the lab was accompanied by only brief comments from the company….“With the completion of the sale, we move forward with our strategy to concentrate our focus and efforts on our core consulting business, and streamline our operating segments” (Victor Sanchez, PBSV CEO, 8-k filed 9/21/18). But, given disclosures in their public filings which indicated that the lab segment had consistently been less profitable (proportional to revenue contribution) than their consulting operations (in aggregate) over the last two years, anything more than just brief comments may not (necessarily) have been necessary.
While opportunistic timing may have played a role, we think the decision was based around strategic initiatives aimed at accelerating revenue and income growth. While lab revenue posted strong growth from 2014 through 2016 and quickly bounced back following interruption from the hurricanes, this segment was never consistently profitable. Conversely, while consulting revenue has been on a downward trend since reaching a peak of more than $31M in 2013, it did not dip into the red until 2016. And while 2017 was marked from interruption from the hurricanes, PBSV’s quick recovery and resurgence of growth from Puerto Rico as well as the United States has resulted in rapid improvement in profitability of consulting services.
PBSV employed expense-control initiatives during times of lower activity which were effective in mitigating losses/improving profitability. That, along with time and material contracts which provide a large degree of ‘margin protection’ helped to limit losses from consulting services. Unlike the consulting business, the capital-intensive nature of the lab does not lend itself to significant cost-cutting. In order to generate a profit, PBSV’s lab needed to meet a minimum revenue threshold to cover its fixed costs (including depreciation on capital assets). Given that it struggled to do so (and, presumably, the outlook was that that would continue to be the case) and PBSV had an opportunity to sell the lab for $5M (and to an existing customer), we think it was a sensible and shareholder-friendly decision.
View Exhibit I
The table above is aggregated from PBSV’s filings and provides a general guide as to the profitability of the lab versus that of the consulting business. Note that the respective pre-tax income figures, as presented above, of each of the two itemized business segments (i.e. lab, consulting) does not reconcile exactly with what is implied in the pro formas (8-k filed Sept 21st and included in this report, below). For example, according to the table above (i.e. per the 10-K) FY2017 lab pre-tax loss was $649k. But, the pro formas imply that it was only $369k. We think the difference (i.e. $649k - $369k = $280k) likely represents general overhead expenses that have been allocated to the lab (but which is not specific to either business segment). If that is the case, we think much or all of this expense ($280k in FY2017) is likely to remain following the lab sale, while it is the direct-lab expenses ($368k in FY2017) that will be shed.
So, while the table above provides insight into relative profitability of consulting versus that of the lab, the pro formas may be more representative of aggregate profitability ex-lab. The tables below illustrate the benefit to margins, operating expense, net income and EPS for fiscal 2017 and the nine months ending 7/31/18.
View Exhibit II
View Exhibit III
Cash balance continues to grow…
Aside from possibly repurchasing additional shares (another ~1.7M shares can be repurchased under their existing stock buyback program), we do not have any particular insight as to management’s plans for potentially reinvesting their now even-larger cash position. Pro forma for the sale, cash balance was $16.9M as of July 31st – and that does not include the $3M promissory note (which will be fully collected over two years). In addition, operating cash flow is improving with the recent revenue growth and cost-containment efforts.
Recognition of certain non-recurring items during fiscal 2018 related to the hurricanes and change in U.S. tax law makes profitability and cash flow analysis a little more difficult. For simplicity, our analysis removes the (non-recurring) $2.7M tax expense (in Q1) related to the one-time transition tax as well as the $368k in hurricane-related reimbursements (in Q3). And, as always, we exclude changes in working capital given the potential to skew. Using this methodology, cash flow from operations was $902k in Q3 and $1.15M through the first nine months of 2018. Capex was minimal ($0 and $58k, respectively).
We are encouraged by the recent accelerated growth in PR and US consulting revenue, particularly given the relatively high margins and direct benefit to cash flow, income and EPS. Given that consulting at these current levels is in the black and generating cash, a substantial portion of each incremental dollar should flow through the income statement.
Or model updates reflect incremental benefit from the sale of the lab. Specifically, significant improvement to service margin, a slight improvement to operating expenses, operating income and EPS. While the now even more sizeable cash balance provides that much more flexibility in terms of strategy, our model does not (yet) reflect any assumed new (i.e. inorganic) growth catalysts. That could change, however. In the meantime, share buybacks afford an opportunity to reinvest cash and do so at a very attractive valuation.
We look for consulting revenue to grow at a 4-year CAGR of approximately 15% through 2021. We use an industry PE/G ratio of 1.9x to value PBSV. We look for 2020 EPS of $0.08 which values the company at approximately $2.25/share. The stock currently trades at about $0.99, indicating the shares are trading cheaper than fair value.
We also note that the shares continue to trade well below book value and only slightly higher than cash value. Pro forma for sale of the lab, book value (7/31/2018) is estimated at $21.6M, or $0.94/share. Pro forma cash balance is $16.9M, or ~$0.73/share. We think book value should provide a floor on the stock.
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