Revenue, Profitability at 6-Year Highs. Big Cash, Stellar Balance Sheet Enhances Growth Prospects……
Not only has Pharma-Bio Serv’s (OTC:PBSV) revenue rebounded from the disruptions caused by two hurricanes (causing massive destruction across Puerto Rico in late-2017) and the subsequent (unrelated) sale of the company’s Scienza Lab assets (in November 2018), but profitability has as well. In fact, since the devastation from hurricanes Maria and Irma in fiscal Q4’17, PBSV’s revenue climbed 34% in 2018 and is up another 21% through the first nine months of fiscal 2019, ending July 31, 2019 (comparisons exclude any contributions from lab assets in each period – i.e. as-if lab had been sold at end of fiscal 2017).
Profitability has also shown significant improvement. Operating income increased 110%, or $665k, from $605k during the first nine months of fiscal 2018 to $1.27M over the same period in 2019 – the first three consecutive quarters since the divestiture. And, as the lab had been a drag on earnings, the improvement in profitability is even more dramatic when as-reported (i.e. lab not considered discontinued op) 2018 results are used as the prior-period comparator1.
For additional context of the significance of the improvement, PBSV generated $1.3M of operating income on $14.7M of revenue through the first nine months of fiscal 2019 – representing an 8.7% operating margin. This is the highest operating income and operating margin over any fiscal first nine-month period since 2013 (i.e. six years ago) – which was a record year across almost all categories of the income statement including revenue, gross margin, operating income, net income and EPS.
And while the resurgence in revenue and income growth is highly encouraging – and, in our opinion, validation (particularly as it relates to improved profitability) of the decision to divest the lab, it’s important to remember that this organic growth was not only accomplished without compromise to the balance sheet, but occurred commensurate with a meaningful bolstering of the company’s financial position.
As growth in both profitability and health of the balance sheet has shown to be a potent combination for building shareholder value, PBSV’s recent financial performance may be a prelude to similarly improved performance of the share price. And the beefy cash balance, which stood at almost $15M at July 31st and benefits further from $1.25M in promissory note repayments (i.e. receipts from the acquirer of the lab assets) in September (Q3’19), means PBSV has substantial growth-oriented firepower to further enhance shareholder returns.
Management has indicated that they remain vigilant in evaluating potential growth opportunities – which presumably could include both organic and M&A related options. In the recent past PBSV has also returned a portion of the cash balance to shareholders in the form of share repurchases and, in October 2018, paid a $0.075/share dividend. More than 1.6M shares remain authorized under the share repurchase agreement and, while we have no particular insight, it’s conceivable that (lacking any ‘better’ growth-oriented reinvestment options) the company may consider declaring additional dividends in the future.
Fiscal Q3 2019 Results: Potent Turnaround in Consulting, Lower Expense Fueling EPS Growth
Revenue (unless otherwise noted, all comparisons are ex-lab) increased 7% and 21% in the three- and nine-months ending July 31st, 2019 as compared to the respective prior-year periods. Noteworthy is that, even when including the lab revenue in the prior year – which amounted to $1.6M through Q3 – YTD’19 total revenue (which includes no lab-related contribution) is still up by more than 6% growth. This highlights the potency of the turnaround in the company’s consulting businesses which, coupled with elimination of the relatively high fixed costs of the lab operations, has resulted in a similarly rapid and significant return to profitability.
Puerto Rico consulting revenue is on a tear – increasing 15% in Q3 and, on a YTD basis, is up 28% from the comparable period in 2018 and 50% higher than in 2017. In fact, the $12.6M generated YTD appears to be the second highest in PBSV’s history, bested only by the $13.1M recognized during the first nine months of 2015. Also noteworthy is that PR consulting revenue has increased sequentially in each quarter in 2019.
As PR consulting now accounts for ~85% of the topline, growth in this business was the main catalyst to PBSV’s 21% revenue growth through the first nine months of 2019. More importantly, as PR consulting has been deep in the black in each of the first three quarters of the year, it has also been the majority contributor to operating income as well as representing the most significant catalyst to growth in operating income.
PR consulting contributed $1.3M in operating income, or 76% of the total YTD. While we estimate ~$200k of this relates to hurricane related insurance-claim settlements which were paid in fiscal Q2’19, even stripping this out, PR consulting contributed $1.1M, or 73%, of the tota. This compares to PR consulting operating income in the comparable prior-year period of just $521k, or ~$180k excluding hurricane insurance and related payments that PBSV recognized in Q3’18 (and which we think was accounted for as PR operating income).
So, while PR consulting revenue grew by only 28%, or $2.8M, YTD in fiscal 2019, we estimate that its contribution to operating income (excluding hurricane-related insurance and salary subsidies received in both fiscal 2018 and 2019) grew by approximately 420%, or ~$760k. We think this outsized growth in PR consulting profitability is largely reflective of greater economies of scale at higher service volumes (as while the lab sale eliminated significant fixed costs, there will always be some overhead-type expenses associated with non-revenue generating activities and assets that run through the income statement, affording additional scaling / op leverage opportunity). We also note that PR consulting operating margins have averaged 8.9% (excluding ~$200k of hurricane related insurance receipts) through the first nine months of fiscal 2019 – while up considerably from the comparable periods in 2018 (of approximately 1.9%) and 2017 (negative op income), this is well below the 23% – 24% margins that this business was returning in its heyday. More specifically, PR consulting generated 24% op margins in fiscal 2012 and 23% in 2013 on revenues of $15.2 and $15.8M, respectively.
The take-away here is that there is clearly significant operating leverage opportunity in this business (despite time and materials contracts) which is further illustrated by the fact that every 1% of incremental revenue through the first three quarters of 2019 returned 15% growth of operating income. So, if PR consulting continues its upward sales growth trajectory, this should result in even greater benefit to the bottom line. With PR consulting posting sequential growth and currently running at an annualized rate of $16.8M, or less than 5% shy of its 2015 peak (which corresponded to PR consulting op margins of ~13%), we could see an even more significant widening in margins and benefit to income.
For context of the potential upside, at its current annualized revenue run-rate and historical peak margins, we estimate that PR consulting would add $0.08 – $0.10/share to net income – or roughly equal to our estimated FY’19 EPS for the entire company. As such, even minimal growth of PR consulting revenue could have a relatively major effect on EPS growth and PBSV’s share price.
Meanwhile, U.S. consulting revenue fell 27% in the most recent quarter but is up a very healthy 29% through the first nine months of fiscal 2019. While U.S. consulting has performed well and is at a three-year high, revenue from this business remains far below historical levels with current-year annualized run-rate ($2.3M) of just 20% of its peak ($11.3M in 2013).
And despite its recent growth, U.S. consulting is in the red – albeit, at a YTD operating loss through Q3’19 of $36k, just barely. We estimate break-even of this business is roughly $600k per quarter – which compares to current-year average of $564k. As such and despite U.S. consulting accounting for only ~12% of total sales, even modest (i.e. single digit %) growth of this business from current levels could have a relatively outsized benefit to PBSV’s total profitability. So, as continued strength in the U.S. economy (and, particularly in healthcare) could have a relatively dramatic positive influence on PBSV’s earnings, this will be another area that we will be closely watching.
Expenses also continue to show improvement post lab-sale. On a post lab-sale basis, while service margin (SM) fell from 34.4% in Q3’18 to 31.5% in Q3’19, on a YTD basis its up a modest 10 basis points (from 31.5% through the first nine months of fiscal 2018 to 31.6% in the current period). Comparing pre versus post lab-sale, which again illustrates the cost-saving benefits of the divestiture, shows SM improving 70 basis points (from 30.8% Q3’18 to 31.5% Q3’19) and 490 basis points (from 26.7% YTD Q3’18 to 31.6% YTD Q3’19) in the three and nine month periods ending 7/31/19. While the improvement is encouraging, service margin is also well below its historical high, which peaked at 35.8% in fiscal 2013 (on record annual sales of $33.1M). We would expect to see SM to continue to widen with further revenue growth.
Total expenses (i.e. cost of services and opex) have similarly improved. On a post lab-sale basis, total expenses fell from 95.0% of revenue through the first nine months of 2018 to 91.3% (i.e. 370 bps) in the comparable current-year period. The improvement is even more dramatic comparing pre and post lab-sale, which shows total expenses falling 700 bps.
Total expenses as a percentage of revenue is a key metric and one that, given the consulting businesses’ inherent built-in margin (reflecting a largely variable cost expense structure), one that we think will continue to improve with growth in revenue. As while shedding of the lab means that PBSV’s expense base is now less significantly fixed, as we noted above there undoubtedly remains meaningful overhead and therefore, opportunity to further improve upon operating leverage.
Most importantly, the lab divestiture has resulted in significant improvement in profitability. Pre-tax loss was $1.4M in 2017 but pro forma for the lab sale, this improved to a loss of just $774k. Pre-tax income then improved substantially, growing by $2.3M to finish 2018 at positive $1.5M (note that this does not include gain on sale of the lab assets, which was recognized below the line). And, with the filing of Q3’19 results, we can see (from the prior-year figures, which are adjusted for the lab sale) that shedding expenses associated with the lab were responsible for a significant portion of the improved (pro forma) profitability in fiscal 2018.
Specifically, the adjusted figures show that the lab divestiture improved pre-tax income in the nine months ending 7/31/18 (Q3’18 was the final full quarter prior to the lab sale) from $675k (prior to the sale) to $995k (pro forma for the sale) and, excluding the $2.7M tax expense associated with the recent reformed tax code (“Tax Cut and Jobs Act of 2017, enacted December 2017), resulted in net margin and EPS improving from approximately 5% / $0.03 to 8% / $0.04 over the same period.
Through the first nine months of the current year, pre-tax and net income were $1.7M and $1.6M. Net margin and EPS were 11% and $0.07. This means that profitability of the first nine months of 2019 is higher than any other comparable period since fiscal 2013. While PBSV returned a similar amount (specifically, ~1% lower) of net income during the first nine months of fiscal 2014, it was at a net margin of 8% (compared to 11% in the current-year period) – which, again, highlights the recent improvement in the company’s income-generating efficiency.
We note that, despite the consistently improved financial performance, particularly as it relates to profitability, PBSV’s current share price is about 23% lower than what it was when they reported Q3’14 financial results. This speaks to our proposition that we believe the shares are significantly undervalued, particularly in the context of the recent growth in both revenue and income as well as the potential growth-stimulating firepower represented by the company’s sizeable and growing cash balance (which may be put to use to further bolster revenue and profitability).
Cash balance was $14.8M at the close of Q3’19 (July 31, 2019). Excluding changes in working capital, PBSV generated $465k and $1.66M in cash from operations in the three and nine months ending 7/31/19. This compares to the prior periods of an inflow of $760k in Q3’18 and cash usage of $1.64M in the first nine months of 2018.
The lab sale brought $2.0M in cash and $3.0M in promissory notes ($500k of the notes’ principal was received in April 2019, another $1.25M is due 9/17/19 and the remaining $1.25M is due 9/17/20). As a reminder, PBSV used ~$1.7M to pay a $0.075/share dividend to shareholders of record as of the close of business on October 15, 2018. While not specifically characterized as such, we assume, at least for now, that this is a one-time ‘special dividend’ – although also point out that the PR left open the possibility of future dividends as they evaluate their strategic options.
Given the health of the balance sheet including sizeable cash position and coupled with our expectation that PBSV’s consulting business generates positive cash flow, we think management will be actively engaged in looking at additional ways to put their resources to work. We think that, barring finding any attractive opportunities in the near term that another dividend or further share repurchases may potentially be under consideration.
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 PR consulting remains deep in the black and generating cash and U.S. consulting is closing in of break-even, a substantial portion of each incremental dollar should flow through the income statement.
Or model updates reflect benefit from the sale of the lab as it relates to the cost bases – specifically, significant improvement to service margin, and a moderate 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 now look for consulting revenue to grow at a 4-year CAGR of almost 10% through 2022 and for EPS to grow from $0.09 in the current year to $0.16 in 2022, an implied CAGR of 21%. Given the projected steep growth rate of earnings of the company, we use a 27x multiple applied to our 2021 EPS estimate of $0.134 (i.e. $3.61/share) and discount this back to the present at 15% per year. This values PBSV shares at approximately $2.60/share. The stock currently trades at about $0.88, indicating the shares are trading much cheaper than fair value.
We also note that the shares trade only about 8% higher than book value (book value as of July 31, 2019). As of today, PBSV trades at a market cap of $20.2M while book value as of the close of fiscal Q3’19 was $21.8M. We continue to think book value should provide a floor on the stock. And, with expectations that PBSV generates positive cash flow and continues to generate positive ROI on reinvested capital, we think there is good reason to believe that book value will grow.
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1. PBSV’s operating income increased 110%, or $665k, when treating the lab assets as discontinued operations (fiscal Q3’18 YTD) and by an even greater 433%, or $1.03M, if lab assets are included (i.e. not considered discontinued ops) in 2018 results