Stock Pitch: Ergomed (LON:ERGO)

Ergomed was pitched to the Stockopedia Staff Investment Club (SIC) on 5 May 2020 and we bought a position two days later at 418p per share.

After being stopped-out of our initial positions in the market pull-back in March, Ergomed was the third share to be added to the folio (after BOTB and Codemasters).

None of us knew it very well but it passed our initial filters and looked interesting because it had pivoted to a new model and was starting to become profitable. Yet the market (and analysts) seemed to be slow catching on.

It has been one of our better performing holdings since then, and while there are uncertainties, you could argue that it’s still early days and deserves to be held in the folio.

As always, these notes are a way for us to chronicle and share some of the thinking in the SIC and are not investment recommendations.

Pitch Profile/Category/Style

What is the company’s name and ticker symbol and on what exchange does it trade?

Ergomed trades as ERGO on the AIM All Share Index (and is a constituent of the AIM 100 Index).

In which sector amp; industry group does the company operate?

It’s in the Healthcare sector under Biotechnology amp; Medical Research.

What is the share price, market cap, size group, liquidity and risk of the stock?

Currently ~800p, giving it a market cap of ~£384.7 million. Between 1 May and 1 October 2020, the price rose from 405p to 760p, or ~88%.

It’s classified as an Adventurous Mid-Cap.

The free float is 66.8%

Average daily volume over 3 months is 219.7k (up from 119.9k back in May) – so average volume has been increasing recently. EMS is 3,000 shares.

What is the opportunity style/type/classification?

Quantitative – Stocko Framework

High quality, high momentum, low value – making this a High Flyer. Signs that it might be a misunderstood growth stock and that analyst earnings forecasts are perhaps struggling to keep up with it as the growth accelerates.

Ergomed StockRanks October 2020

Interestingly, Ergomed has had the High Flyer profile for over a year, and actually looked slightly more expensive 12 months ago, when all recent financial results were showing losses. So quality and momentum have been the strong factors here.

Ergomed StockRanks October 2019

Importantly, it appears to be high quality – and the early signs are that it is getting more and more profitable after changes that have been made in the business in recent years.

Momentum is positive at the moment. It delivered three earnings forecasts beats last year and has already done the same in its recent H1 2020 results. Brokers have been consistently upping their EPS forecast upgrades – and Ergomed has got a nice (albeit short) record of beating them.

Qualitative – Peter Lynch framework

Ergomed generally fits with Peter Lynch’s idea of Fast Growers. Broker coverage remains relatively low (only two have forecasts), which means there’s a case for believing it’s not widely-understood, certainly in the PI space. That said, the there is already institutional interest from some managers, including small-cap growth specialist Mark Slater, who has a ~7.0% stake.

What does the company actually do, and what’s its history?

Ergomed is a service provider to the pharmaceutical industry. It does three main things (although the main business is in 1 and 2):

1. Clinical research – known as “Contract Research Outsourcing” (CRO) – which means it runs drugs trials and handles the clinical organisation and services for other companies’ drugs development. It specialises in specific areas like oncology, neurology, rare disease and immunology. These contracts can be worth a few million pounds each in revenue and typically run for two to three years.
2. Pharmacovigilance (Ergomed calls this division PrimeVigilance) – which is mandated by regulators and involves making sure that newly developed treatments (by other companies) are closely monitored and don’t have adverse effects.
3. Ergomed also has some interests (both wholly-owned and partnerships) in drug development.

Ergomed floated in 2014 with largely the same business model it has today, except that its drugs co-development business was a higher priority back then. It raised £9.7 million and used £6 million of it to buy PrimeVigilance in the US.

Importantly, Ergomed has been in transition over the past two or three years. It used to be heavily focused on co-developing new treatments, but there was a heavy Ramp;D cost to that. It meant that over the past five years it moved from being barely profitable to consistently loss-making.

More recently it has stopped funding any new initiatives in that speculative part of the business to focus on the “services” side. It also introduced some cost-cutting measures early in 2018. That change led to a swing to profitability in the 2019 financials.

These days it’s more interested in selling picks and shovels than doing any actual digging.

What is the company’s business model? How does it make money?

The company makes money from service contracts. It seems to be quite well diversified in terms of income streams from different activities. Revenues were reasonably well split between the two main divisions in 2019.

Source: Edison Investment Research (link)

Over the past three years, the fastest growth has been seen in Pharmacovigilance (PrimeVigilance):

Source: Ergomed (link)

Key facts about the main divisions:

CRO

• 60+ active clients
• 70+ active studies underway
• 300+ employees

PrimeVigilance

• 160+ customers
• 700 employees
• Leading independent consultancy in this market
• Operates in 100 countries
• Has a very sticky customer retention. Each year, new new sales cohorts tend to remain as customers, while new ones are added on:

Source: Ergomed. Pharmacovigilance division growth

What is the state of the company’s market amp; competition?

According to Grand View Research, the global healthcare CRO (contract research organisation) market size was valued at US $37.1 billion in 2019 and is expected to see a CAGR of 6.6% out to 2027. One of the biggest markets in the world is the US – which is where Ergomed is focusing its expansion efforts.

Time and cost constraints for pharma drug developers is one of the main reasons this market is growing. It seems to be easier for them to outsource this work. Not only is it cost-effective, but CRO firms like Ergomed have very strong technical expertise.

There is competition in the market, and it is increasing, but Ergomed says it is becoming more competitive as a mid-tier player, and competing well against larger-tier firms too.

These are some of the company’s core market areas and their expected growth rates:

Source: Ergomed (link)

What is the company’s strategy amp; competitive advantage?

Ergomed presents its advantage as being “expertise” and “speed” and its focus on specific medical areas. In particular it has strength in managing “orphan drugs”, which are treatments for illnesses/diseases that are rare or unusual and may not have any other treatments.

Growth – it wants to increase exposure in North America. It recently acquired Ashfield PV Inc (for US$10 million (all cash)), which was immediately renamed under the PrimeVigilance brand. The aim is to expand its pharmacovigilance business in the US, and the CFO Richard Barfield has indicated that more Mamp;A activity in the US may follow. Overall, it’s planning to be a global business and already has offices in 16+ countries.

The Ashfield PV acquisition added 40 new customers to the group and came with a $9.8m contracted order book. It generated $11.6 million of revenue in 2019. Richard Barfield says the opportunity to cross-sell to the expanded client base was a major factor for doing the deal.

What trends is the company currently benefiting from that could provide a tailwind?

General industry trends for pharmaceutical companies of all sizes to call on specialist consultancies like Ergomed to handle drug development studies and manage ongoing pharmacovigilance.

What is the company’s track record of growth amp; profitability?

Between 2018 and 2019, the company saw normalised EPS swing from -6.36p to +14.7p. This has come from its pivot away from loss making development projects to a service-oriented model.

In the Financial Statement below you can see how this contributed to a swing to profitability in 2019.

In the first half of 2020, Ergomed’s revenues continued to grow and there are signs that it is becoming increasingly profitable (with signs of improving margins).

In its H1 2020 interim results, the company reported a slight decline in y-o-y revenues on the CRO side of the business. This was caused by delays to industry-wide pharma trials as a result of Covid-19. Richard Barfield suggests this was a good result under the conditions. Meanwhile, growth in the pharmacovigilance division continues to be strong.

Source: Ergomed (link)

What’s been happening in recent trading statements etc?

In its H1 2020 numbers, Ergomed reported a 14.8% y-o-y rise in sales to £40.4 million, and 74% rise in its cash position to £14.1 million. Its order book of future contracted revenue was up 28.0% to £151.4 million.

Because pharmacovigilance is mandatory for pharma companies to carry out, this side of Ergomed’s business has apparently been resilient during the disruption caused by Covid-19 in 2020. Its overall employee headcount has grown from 850 to 1,000+ so far this year (all of them are remote at this time). Its involvement in what’s regarded as essential medical research means that many projects and studies have proceeded as planned. It has also been involved in managing Covid-19 treatment studies.

More recently, the company has announced plans to do a capital reduction. Historically, losses and impairments have left a deficit in the retained earnings reserve in both the consolidated and company-level accounts. Having matured as a business, this kind of deficit is a blocker to things like paying a dividend. So the company has proposed a transfer to make the returned earnings reserve positive. If approved, it will have no impact on cash.

Are there any catalysts that could drive a rerating in the short or medium term?

The stock has already performed well over the past 18 months, but one question is whether the market really gets the story and whether institutions will become heavier buyers of the shares. There are signs (presentations, etc) that the company is working on this.

Small, speculative healthcare stocks (especially drugs developers) can be immediately ignored by risk-averse investors. But this is not a developer, it’s a service business – and increasing recognition of this could be helpful.

Three earnings forecast beats last year and one already this year could be a catalyst for further momentum.

The capital reduction looks like a step on the path to future dividend payments from what is increasingly looking like a cash generative business. So that may catch institutional attention.

What are the biggest risks for the business?

The biggest risk to Ergomed’s growth is competition and its ability to continue to win contracts.

Generally it is dependent on pharma companies continuing to outsource these operations – and revenues could be impacted if projects are delayed or cancelled.

Ergomed has hinted at plans for further acquisitions. It does have Mamp;A experience on the executive team and the cash to do deals, but bolt-on acquisitions can fail.

In 2019, Ergomed’s top 5 clients accounted for 28% of sales – so revenues could be affected if any major clients were lost.

What is the ownership structure of the company, and do management or founders have significant stakes?

Miroslav Reljanovic, the executive chairman, founded the business in 1997 and still has a 22.5% stake.

The executive team (including Mr Cameron, COO and Mr Barfield, CFO) have interests in the shares as a result of Long Term Investment Plans.

Has it a history of diluting shareholders, or (better) buying back shares?

There has been some dilution in the past. There was a £2 million placing in 2018 and the company has previously used shares as a component in some of its acquisitions. That now seems to have stopped. There has been very little dilution more recently.

What is the company’s financial status amp; balance sheet strength?

Debt free. F-Score is currently 7 and there are signs that may improve if the current financial trend persists through to the full year numbers. Either way, there are no obvious concerns here at the moment.

Cashflow has improved markedly over the past 2-3 years and the there are signs of an increasingly strong balance sheet. Positive cashflow enabled the all-cash acquisition of Ashfield PV.

How is the company currently valued both absolutely and relative to its sector and the market as a whole?

Ergomed stock is relatively expensive, with a current Value Rank of 17. The trailing PE ratio stands at ~50x, with a forecast PE dropping to ~30x.

At this stage – so soon after a swing into profit – it’s possible that the market might under-estimating future earnings growth, which could affect the valuation forecasts. On the back of H1 2020 results, normalised EPS forecasts for this year nearly doubled from 12.0p to 23.8p, suggesting that analysts have hitherto underestimated the company’s future growth rate. But that may be sensible and it’s difficult to make assumptions there.

It’s also possible that the stock has attracted a growth premium over the past year, given the popularity of AIM-quoted small-cap growth shares in that time. That may be a risk.

After the H1 2020 results, Edison Investment Research upgraded their valuation to £409 million or 845p/share from £345 million or 713p/share previously.

It’s notable that Ergomed has been growing revenues at 26% CAGR over the past six years, and that growth is forecast to continue. With the loss-making business now effectively closed-off, if it can get more of those sales dropping to the bottom line, the valuation may be reasonable. The management seem to think that a combination of organic growth and acquisitions will help them do that.

What do the brokers currently think?

EPS forecasts for 2020 and 2021 have been on an upward trend over the past 12 months – but there is low coverage from brokers.

What would the person selling to us be thinking and who are they?

Speculative and adventurous small-cap biotech and healthcare has been a relatively hot sector in 2020, but there are other shares that have been more explosive than Ergomed. Sellers could be those looking for dramatic gains in riskier stocks elsewhere in the sector.

After a solid run over 18 months, there maybe investors looking to bank profits and find other turnaround opportunities.

What is private investor sentiment at the moment?

Institutional and Stockopedia Community sentiment are both currently net positive on the stock.

What do you think – has the market failed to grasp Ergomed’s shift to a more service-led business model? And just how big is that market opportunity? We’d like to hear your views…

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