- PBSV enjoys competitive advantages in a very profitable geographic niche.
- 5 year Revenue CAGR of 17% with a FCF return on invested capital of 78%.
- Very solid balance sheet that continues to get better.
- Trading at 4x EV/FCF.
- Large insider ownership.
- Ongoing share repurchase program of 40% of float
In my many years as an investor I have rarely come across a business as efficient and profitable as PBSV and even more rarely at a price this good. The stock is thinly traded and thus overlooked by many funds and individuals. The best bargains seem to always be in the obscure areas of the market and are often only available to smaller investors. PBSV is the epitome of this kind of investment.
Pharma-Bio Serv Inc (PBSV) is primarily a compliance consulting and project management company incorporated in Delaware and headquartered in Puerto Rico. They have a well-established and consistent relationship with a large majority of the dominant players in the pharmaceutical, biotechnology, medical device, and chemical manufacture industries in Puerto Rico and the U.S.
As the compliance world becomes more of a headache for the major medical-related companies they are increasingly utilizing outsourced experts, such as PBSV, to help them navigate the ever-changing environment.
92% of revenues are derived from time and materials contracts while the remaining revenues are produced by lab testing and fixed fee contracts.
PBSV enjoys high returns on invested capital and pre-tax margins of more than 17% due to their reputation and market dominance in Puerto Rico, a flexible cost structure, and an owner-oriented management that looks to only take contracts where PBSV possesses a cost advantage. Fortunately, there are many contracts where they have a significant advantage. From their 10K: "We believe we enjoy competitive advantages over other consulting service firms because of our historical market share within Puerto Rico (20 years), brand name, reputation and track record with many of the major pharmaceutical, biotechnology, medical device and chemical manufacturing companies, which have a presence in the markets we are pursuing."
However (with a few exceptions like Wal-Mart) most geographically niche-dominant companies struggle when they venture outside the periphery of their niche. PBSV must have a high degree of competence in the markets that they have recently pursued given their margin stability and strong profitability during their recent growth. Most of their recent growth has come from the U.S. but they have also made progress in Europe. They have a focus on growing their U.S. business but management seems wise enough not to pursue growth simply for growth's sake which could destroy value in the superb business they have created over decades. Indeed management is well-incentivized to act in the best interest of shareholders given they collectively own 51% of the outstanding shares.
Thankfully, at these prices we pay nothing for the growth and even get the Puerto Rico operations at a compelling discount.
The balance sheet is essentially debt free. Since 2008 they have compounded book value at 35% annually. Net current assets are at $18m, $13m of which is cash, with a market cap of $33m.
Risks
The main risk I see is customer concentration. PBSV's top 3 customers were responsible for 55% of revenues in fiscal 2013. This isn't as alarming as it sounds though. Again from their 10k: "In spite of the fact that just a few customers represent a significant source of revenue, our functions are not a continuous process. Accordingly, the client base for which our services are typically rendered, on a project-by-project basis, changes regularly." Meaning that the loss of one of these large customers in one year will not necessarily transfer to the next although it could make for a rough year. The recent weakness in revenues and profits is probably just some lumpiness along the growth journey.
Some may say that the recent economic struggles in Puerto Rico could discourage business, but the numbers sure don't show an issue yet. I think the economic issues of the Puerto Rican government will turn out to be a non-issue here. See here or Paulson for support of that hypothesis.
While I hate to list trading illiquidity as a risk (ease of divorce is not a good reason in favor of commitment) it is real here. Average volume is about 5,000 shares per day over the last few months. If you have $10m to put to work you had better look elsewhere.
Valuation
Currently PBSV trades at:
Price to Sales 1.12x
EV to FCF 4x (FCF yield of 25%)
Price to Book 1.8x
CROIC 78%
Previous 3 years of EBIT:
2011 $3.5m
2012 $5.7m
2013 $6.1m
With a Greenblatt TTM earnings yield of 22% and a return on tangible capital of 55%, PBSV would rank near the very top of the Magic Formula screen if companies under $50m market cap were included.
For good reason, I have always been a fan of using Buffett's "owner earnings (net income + non-cash charges - maintenance capex)" instead of GAAP earnings. This is essentially what we have in the $5m FCF number at the base of my valuation.
I am not a fan of relative valuations especially when evaluating a business with a cash return on invested capital (CROIC= FCF/(Equity + Liabilities - Non Interest Bearing Current Liabilites - Cash)) of more than 75% so I won't use direct comparables here. If PBSV were a large multinational company it could possibly command a FCF multiple of 20x. But it isn't. So if we whack the multiple with an ugly stick a few times to compensate for its microcap status, lack of trading liquidity, and maybe even a pullback in earnings (which would be unanticipated) we might get a multiple somewhere in the 8x to 15x range. Given that an average market multiple during a normalized environment is about 15x and that PBSV is of a much higher quality than the vast majority of the market this seems reasonable and likely conservative to me. Using a 10x multiple on $5m of earnings plus net current assets of $18m we get a fair value share price of $2.96 on today's share count and a value of $3.24 if we factor in the recently announced share repurchase program.
Alternatively, if we used a basic DCF model where we grow FCF at 10% (a large discount to recent FCF CAGR%) for 5 years and assume a 4% terminal value for 5 years with a 12% discount rate, we arrive at a fair value of $2.74 when tangible book value is included. I think this is conservative.
Of course these are back of the envelope calculations or, as Ben Graham put it, "Security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. It is quite possible to know that a woman is old enough to vote without knowing her age..."
Possible Catalyst
Just days ago, the company announced a share repurchase program targeting 2m shares. Currently there are 23m shares outstanding so a boost of ownership of 9% is always nice but the most value to me comes as a technical catalyst.
While there are 23m shares outstanding, the float is only about 5m shares due to large insider and institutional holdings. Using their beautiful balance sheet to repurchase 2m shares, if they actually do it, is sure to inspire much higher prices.
Disclosure: I am long PBSV personally and in client accounts.
