Research Report on CVGR: (Target market cap: $100M)
Pennsylvania
Merchant
Group Ltd
An Investment Banking and Venture Capital Firm
Michael A. Martorelli,
CFA
Christopher J. Perry
Summary and Investment Conclusion
We recommend the purchase of Covalent Group, Inc. to investors seeking long-term capital gains.
The company operates a full service CRO called Covalent Research Alliance (CRA). CRA
differentiates itself from its competitors by specializing in clinical studies that include various types of
outcomes measurements and by developing medical outcomes and health management programs
that focus on patient compliance/education and behavior modification. The company concentrates
on the managed care industry: it markets extensively to drug sponsors interested in conducting
clinical and outcomes studies in that patient population, and is introducing its disease management
and patient compliance modules to some large managed care organizations. The founder and other
top executives have extensive backgrounds in the pharmaceutical research industry, suggesting that
CVGR has a better-than-average chance of achieving its strategic objectives.
As noted in this report, CVGR is not only a rapidly-growing CRO, but also a pioneer in developing
outcomes measurement, health assessment, and patient compliance tools for the managed care
industry. We expect the company to report strong revenue and earnings comparisons during the
next several quarters, thereby demonstrating its ability to prosper in those inter-related businesses.
While CVGR is not inexpensive today based on standard valuation parameters, we still look for
considerable upside movement in the stock (i.e., 100% or more) during the next 12-15 months.
Emerging Opportunities in the CRO Industry
Stocks representing a handful of relatively large CROs were strong performers in 1996. Individual
gains ranged from 35% for IBAH, Inc., to 104% for Parexel International. Last year was actually
the third consecutive year that CRO stocks exhibited above-average performance, paralleling once
again the industry's extraordinary performance in the revenue and earnings categories. In this rapidly
growing industry, we expect that the largest participants will continue to increase their market share.
With global capabilities, a broad range of services that cut across many phases of drug
development, experienced management teams, advanced information management systems, and
strong financial positions, companies such as Pharmaceutical Product Development Inc.
(PPDI-$24.75) and IBAH, Inc. (IBAH-$7.75) seem well-positioned for continued growth.
In our opinion, this positive outlook for the larger firms does not preclude growth for the smaller
companies in the CRO industry had a future. Indeed, we believe each of the publicly-held
companies listed below has an intriguing story to tell and sound prospects for near-intermediate term
revenue and earnings growth.
In addition to representing potential investment candidates based on their own merits, we believe
each of these companies could be an attractive merger or acquisition candidate in this steadily
consolidating industry.
In investing in the smaller companies in the CRO industry, we consider it important to select firms
with a business base and management philosophy that clearly differentiates them from other small
competitors. We also prefer companies with experienced management teams and strong financial
reporting and control systems. The former ingredient is essential if the company is to cope with the
inevitable changes in circumstances that typically plague such firms. The latter is a necessary tool for
the CEO and CFO to implement their tactical and strategic plans. We believe CVGR has an
attractive combination of ingredients for success, and devote the rest of this report to that company.
Company Background and Profile
Covalent Research Alliance (CRA) was founded in 1993 by Bruce LaMont, who had been
involved for 13 years in the design, coordination, and management of human clinical trials for the
Merck Research Laboratories division of Merck & Co. He sold CRA to the publicly-held company
then called Future Medical Technologies Inc. (FMTI) in February 1995 in exchange for 7.2 million
shares (representing a controlling interest of about 63%) in that diagnostic products company. In
mid-1996, the Board of FMTI acknowledged what had been obvious for some time - that the
organization's future lay with its CRA subsidiary (1995 revenues of about $1.5 million), not with its
FMTI diagnostic products business (1995 revenues of about $200,000). It authorized the sale of
the FMTI business and a change in the company's name to Covalent Group.
CRO Activities
As noted above, CRA performs most basic CRO functions. In a highly-competitive industry, the
company has tried to offer its prospective clients creative solutions to their development problems,
rather than merely working with its own SOPs to conduct specific clinical studies. It has built its
business by focusing on cost-effectiveness and quality of care studies. While CRA has conducted
these trials in the traditional clinic and hospital settings, it has been one of the most aggressive CROs
in performing such studies in the managed care setting in which the pharmaceutical industry is
marketing their products and targeting their research efforts. To date, it has performed retrospective
and prospective outcomes studies for more than 40 managed care organizations. CRA offers
special expertise in conducting both cost effectiveness and drug utilization studies in that arena,
including those post-marketing studies that help that customer base improve patient compliance
while reducing the demand for expensive resources.
CRA is currently managing a prospective clinical trial involving one of the nation's largest managed
care organizations, a, leading pharmaceutical firm, and a leading diagnostics products firm. This type
of study is designed to secure support by the managed care organization for use of the products,
based not only on safety and efficacy but also on the demonstrated ability of the products to lower
the cost of care while improving patient outcomes. Recently, CRA announced a contract with
another managed care provider for a study combining traditional clinical research, outcomes
research, and a voice recognition component (see the following section). This contract too responds
to one particular managed care provider's need to supplement traditional safety and efficacy studies
with cost effectiveness and quality of life data.
While we are describing this range of activities separately from the Virtual HouseCall program
outlined in the next section, it is important to note the synergies among these activities. Using data
gathered in conducting clinical trials for certain new drugs, CRA can help managed care
organizations develop drug utilization and patient compliance modules to help that type of customer
make the most effective decisions about the use of existing products in the category as well as the
best way to encourage the appropriate use of the newest medications for particular disease states.
While the company does not yet have an example of a "complete loop" product (i.e., one for which
it has conducted both clinical and cost utilization studies, then developed a Virtual HouseCall patient
compliance/education, disease management module) that clearly is one of its goals for the 1997-98
time period.
Patient Specific Disease Management/Compliance Activities
Throughout this report, we have referred to the first of CVGR's planned activities in this area - its
Virtual HouseCall product. This product is a fully automated, computerized patient data collection
system using advanced voice recognition technology. It uses an ordinary telephone as the link
between a patient (in particular, one with a chronic, high-cost disease) and his/her primary care
provider. Sophisticated software allows the computer to interview the patient on each call, analyze
the patient responses through an expert system, and provide individualized feedback regarding
behavior modification, treatment updates, and future monitoring or office visits. The ultimate
objective of any disease management effort is twofold - to improve the health of the individual and
to give the healthcare provider a tool to achieve that primary objective at minimal cost.
CVGR has developed separate modules of this product for patients with asthma, diabetes,
hypertension, congestive heart failure, and depression. Collectively, we understand these five
diseases account for about 50% of the drug budgets of the nation's managed care organizations.
The company has signed contracts for three such programs. When "turned on" by their drug
company sponsor, each will generate revenues to CVGR on a fee-per-phone-call basis. These
modules are now in the validation/testing phase. While CVGR starts each program with a standard,
off-the-shelf content layer, it works with each customer to specifically tailor that information to the
desired patient population. It also validates the details of the delivery program with each client as
well. When these modules are eventually "turned on", they must be capable of precisely and
efficiently responding to multiple calls per day/week/month and delivering accurate information and
medical guidance across a fairly wide spectrum of patients. While CVGR should start to see
meaningful revenues from these programs later this year, we believe it will be 1998 before this
product line makes more than a nominal contribution to the company's overall earnings.
Beyond Virtual HouseCall, CVGR is developing companion disease management and wellness
measurement products that focus on maintaining health rather than disease prevention. These
products and services are focused on employers who will have an increased stake in employee
wellness and who can serve as conduits to a large population. In one particular instance, the
presence of CVGR personnel at a Wellness Fair for a large pharmaceutical company led to the
development of a clinical study to be conducted in that company's own employee base.
Management
The key members of CVGR's executive management team have in excess of 125 years of
cumulative experience in pharmaceutical research. They have come to CVGR from such companies
as Merck, SmithKline Beecham, and American Home Products, and from academic institutions
such as Rush Presbyterian and Harvard University. In our experience, it is quite unusual for a small
company such as CVGR to have attracted such an experienced team of professionals at such an
early stage of its development.
As noted earlier, the founder of CRA (and the President and Chief Executive Officer of CVGR) is
Bruce LaMont, a 15-year veteran in the drug development industry. He spent most of that time
with the Merck Research Laboratories division of Merck & Co., where he designed, coordinated,
and managed clinical trials leading to NDA submissions.
William K. Robinson has been CVGR s Chief Financial Officer since June 1996. Prior to that, he
spent 25 years in various financial capacities with SmithKline Beecham, where he held the top
financial position in three of that company's different business units. He is mindful of CVGR's need
to engage a "Big Six" auditor in order to gain additional credibility with professional investors, and
has taken steps to set that transition in motion with the completion of the 1996 audit.
David Weitz became the company's Chief Information Officer in January 1995. For the previous
ten years he had been responsible for planning, implementing, and operating a computer technical
support program for Merck Research Laboratories. At CVGR, he has been the prime developer of
the Virtual HouseCall program.
Just one month ago, CVGR recruited Kenneth M. Borow, M.D., a senior executive from Merck
& Co., to serve as the company's Chief Medical Officer, and to assume responsibility for all
contract research activities. A Harvard-trained physician who conducted and managed clinical
research while a Professor of Medicine at the University of Chicago, Dr. Borow spent the past four
years conducting and overseeing clinical research programs at Merck.
In addition to these senior executives, the company has recruited the key personnel filling its
"Director" level management positions from Wyeth Laboratories, Merck, Bio-Pharm Clinical
Services, and the Wellness Council of the Delaware Valley. We expect CVGR to continue to
recruit both senior and mid-level managers from participants in the pharmaceutical research industry.
Financial
CRA posted revenues of $6.6 million for the nine months ended September 30, 1996. Management
has indicated that the fourth quarter was stronger than the third (when revenues topped $2.6
million), suggesting full year revenues in excess of $ 10.0 million. This would represent a dramatic
improvement over the comparable 1995 revenue level of about $1.8 million. Clearly, CVGR (that
is, its CRA subsidiary) made dramatic progress in gaining the confidence of pharmaceutical,
biotechnology, and managed care customers last year. It conducted work for several new clients in
1996. In accordance with the strategy outlined above, CRA performed health outcomes, drug
utilization, or pharmacoeconomic studies for many of them. At the end of the year, we understand
that the company's backlog was close to the $11.0 million level reported at the end of the third
quarter. At year-end 1995 CVGR had no backlog.
CVGR's cost of revenues approximated 57% in l9S6. The company has an infrastructure of core
management employees and a strong professional staff, supplemented by a "virtual" network of
experienced monitors, coordinators, and statisticians that it calls on for specific projects. Thus,
although CVGR might post a "cost of services" line higher than the industry average in any particular
quarter, it should be better able than many small competitors to adjust its variable cost of doing
business over the long term. Sellling, general and administrative expenses accounted for
approximately 25% of revenues in 1996. As is the case in many small companies, management
budgets the absolute levels of expenditures in various categories that make up this line item, rather
than aiming for a specific expense to sales ratio. It uses the same process to develop budgets for the
other significant (and unusual) expense item - Research and Development. In 1996, CVGR spent
almost $1.0 million developing Virtual HouseCall.
Based on the company's current revenue run-rate and its project backlog, we believe CVGR could
double its revenues to the $20.0 million level in 1997. While the model suggests a certain precision
about the quarter-to-quarter path towards this revenue level, we remind the reader that CVGR, like
most other small CROs, is highly dependent on its clients' project timing decisions for its near-term
revenue flow. Part of the increasing revenue run-rate we are projecting for the second half of the
year relates to the initial revenues expected to be generated pursuant to the company's Virtual
HouseCall projects involving three separate disease assessment programs for three different clients.
Again, revenues for the last two quarters of the year will be highly sensitive to the precise dates
those projects are "switched on" by the customers.
We are as comfortable with our annual expense projections for CVGR in 1997 as we are with our
full year revenue estimate. While it is possible that the cost of services line or the S,G,&A expense
line could vary somewhat during the year depending on the pace of new business activity and the
timing of certain revenue flows, we believe it is quite reasonable to expect an operating margin of
about 12.012.5% of revenues this year, versus an estimated level of almost 8.0% in 1996.
Assuming some nominal interest income and a normal tax rate, we believe CVGR can earn about
$0.13 per share in 1997. This does not assume any additional shares that may result from a
follow-on stock offering, although we do consider that to be a viable option.
Valuation
As can be seen in the table , the stocks of the 14 publicly-held CRO companies are selling at rather
hefty premiums to the overall market. On both a market capitalization/revenue basis, and a
price/earnings basis, and using 1997 estimated results, CVGR appears to be trading near the middle
of the range of its comparables. Few, if any, of the smaller companies on that list have CVGR's
breadth of experience in dealing with the managed care industry, or its patient compliance/disease
management revenue-generating capabilities. With each passing quarter, we believe CVGR's
management will continue to demonstrate their grasp of the business opportunities available in the
company's chosen fields, as well as their ability to deliver the results we have outlined in our earnings
model. Over time, we expect the investment community to increase both its familiarity with the
company and its involvement with the stock. Given the company's visible growth prospects, and
assuming an industry and stock market backdrop that we expect to remain quite favorable, we
believe CVGR is capable of supporting a market capitalization closer to $100 million than its
present level of $51 million during the next 12-15 months.
This communication is neither an offer to sell nor a solicitation of an offer to buy any securities mentioned
herein. The information contained herein has been obtained from sources which we believe to be reliable, but
we do not guarantee its accuracy or completeness. Any opinions expressed herein are statements of our
judgment on this date and are subject to change without notice. Pennsylvania Merchant Group Ltd ("PMG
Ltd") or persons associated with it may have a position in the securities mentioned herein. PMG Ltd makes a
market in CVGR.
Dated February 21, 1997
Return to Previous Page |
