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PBSV: Results Remain Very Strong, P.R. Consulting Revenue Particularly Robust

06/21/2018
By Brian Marckx, CFA

OTC:PBSV

READ THE FULL PBSV RESEARCH REPORT

Fiscal Q2 2018 Results: Results Remain Very Strong, P.R. Consulting Revenue Particularly Robust…

Pharma-Bio Serv, Inc. (OTC:PBSV) reported financial results for their fiscal second quarter ending April 30th. Results remain relatively very strong with Q2 revenue up 12% from the comparable period in 2017 and 5% higher than Q1 of this year. Revenue in both of the first two quarters of 2018 were higher than any quarter in the prior year. Revenue from Puerto Rico consulting, at $3.2M, was particularly robust and the highest level since fiscal Q4 2016. Lab-related revenue (which also P.R.-based) has also rebounded, posting strong double-digit sequential growth in each of the last two quarters.

And it is not just the top line that has impressed. The combination of revenue growth and expense-control has trimmed operating loss to some of the lowest levels in the past two years. The relative strength in financial results is particularly noteworthy given the island-wide devastation caused by the two hurricanes that made landfall in September of last year (i.e. ~mid-fiscal Q4 ’17).

As we noted in our Q1 update in April, fortunate to have suffered relatively minor damage from the storms (which were estimated to have caused over $10B in losses across the island of Puerto Rico), PBSV was able to resume operations within just a few days after the hurricanes came ashore. That ability to quickly get back on their feet and resume operations helped stem revenue attrition from Puerto Rico. And a significant jump in revenue from Europe, as a result of PBSV shifting some work to that part of the world, helped offset the relative weakness in storm-battered Puerto Rico. Meanwhile, PBSV's (largely) variable-cost cost structure, inherent of time and materials contracts, resulted in a decline in operating expenses.

So while PBSV's financial results have not been unscathed, there is little doubt that the outcome could have been much worse. And, importantly, with total revenue averaging 10% sequential growth (including 15% related to P.R. operations) since fiscal Q4 '17 and operating loss better than any period during 2017, the worst of the hurricanes looks to be behind them.

And while PBSV has clearly begun to recover, revenue still remains well below historical levels. We reiterate our thesis on why we think there is further significant upside ahead. Certainly, the critical nature of Puerto Rico’s pharmaceutical industry on the mainland U.S. and PBSV’s reputation as one of the industry’s top service providers bodes well for a rapid recovery in the company’s operations and revenue – particularly as it relates to their lab and PR consulting business. And with the expectation that results will continue to benefit as the island further recovers, we think PR consulting and lab revenues will exhibit additional growth in the quarters to come.

PR consulting revenue was $2.6M in Q4 '17 - the lowest level since fiscal Q3 2011. It then rebounded to $2.7M in Q1 '18 and to $3.2M (+5% qoq, +17% yoy) in Q2. While still well below the quarterly averages of $4.4M in 2015 and $3.6M in 2016, the recent trend is clearly positive. It has also been significantly better than what we had anticipated. The expectation is that P.R. consulting activity should continue to increase.

As a reminder, management recently indicated that they expected P.R. consulting (and lab operations) to return to historical levels – with the implication also that that could happen fairly rapidly. Clearly the numbers through the first six months of the current year support that theme. P.R.consulting revenue in the first half of 2018 was $5.9M, up 7% from 1H '17 (i.e. pre-hurricanes) and +10% from 2H '17 (i.e. hurricane-effected). We have only slightly upwardly adjusted our second-half P.R. consulting estimates - but given the fact that PBSV's rapid rebound has proven our recent estimates too conservative, our forecasts may still be too low - as always, our model is subject to change.

U.S. consulting revenue was $341k in Q2, up 13% yoy and 16% better than Q1. It is also slightly better than the $304k quarterly average during 2017. U.S. consulting revenue also took a beating in Q4 '17, falling to $202k, which was the weakest U.S. consulting sales number since at least Q1 2011. The sequential growth is somewhat encouraging as while we do not have specific insight into the recent significant weakness, we do not think the hurricanes (which also hit parts of the U.S. mainland) are to blame and think it may be mostly project-timing related.

As a reminder, the company recently shuttered two U.S.-based offices (in PA and CA) as part of its recently implemented "streamlined business development approach". Importantly, these were leased (sales-oriented) offices and PBSV's business model and time-and-material contracts means opportunistically re-ramping can be achieved on a relatively short time frame. But, it may be too early to predict a sustained recovery in U.S. sales, particularly given our lack of any detailed project-related insight. However, PBSV has been opportunistic in the past and we expect they will continue to be so. Additionally, PBSV has been considering the use of remote facilities in the U.S., which could provide the benefits of lower cost and even greater flexibility. The company recently mentioned that, having recovered from the hurricanes, that they can now focus more attention on the U.S. consulting strategy. Importantly, expense-containment efforts, including closure of satellite offices, have helped to push down operating expenses to near historically-low levels and resulted in significant improvement in overall profitability.

Relative to Europe, revenue from that territory had been a surprising bright spot and helped to partially offset the hurricanes' impact to P.R. revenue in Q4 '17. In fact, the $512k in revenue from Europe in Q4 was the highest from that area of the world since Q3 2014. Even more impressive was that it then grew 41% sequentially to $721k in Q1 '18. The recent strength appears to be the result of PBSV shifting some work from PR to Europe with management recently noting that their European operations recently began providing assistance to the workforce in Puerto Rico. While unfortunately European revenue fell to a much more normal historical level of $210k in Q2 '18, we may still see some more outsized growth from this territory as a result of new consulting opportunities.

Laboratory services, which is also located in P.R., has also rapidly recovered and continues to be a particular bright spot for PBSV. Revenue from this segment cratered by 41% from Q3 to Q4 '17 to just $311k, the lowest level since Q4 2012. About one-half of that qoq decline was attributed to the storms. PBSV had previously indicated that while some property damage repairs were required, that their lab (and other facilities in Puerto Rico) did not suffer any structural damage – and also implied that (similar to P.R. consulting) lab activity and revenue should return to more normal levels. It has quickly done just exactly that with revenue rebounding 54% (sequentially) to $479k in Q1 '18 and growing another 22% to $584k in Q2. The annualized run-rate through the first six months of 2018 puts Lab revenue on-track to be the second highest in company history.

Similar to the P.R. consulting segment, recovery of Lab revenue has been much more robust and rapid than we had anticipated as evidenced by the fairly sizeable beats to our Q1 ($243k E vs $479k A) and Q2 ($482k E vs $584k A) revenue estimates. We, again, attribute that to a combination of PBSV's good fortunes in not sustaining more damage, their recovery efforts and the fact that they are one of the industry’s top service providers. And while 1H '18 Lab revenue was not enough to fully cover fixed-lab related expenses (lab operating loss was $220k), this segment affords much more scalability (than does most pure consulting projects) at incrementally higher levels and as such, offers the possibility of relatively outsized contribution to operating income. So, if Lab activity continues to pick up, that could benefit overall operating income.

Relative to expenses and operating income…as consulting-related activity waned, PBSV recently began implementation of some right-sizing measures aimed at leveling operational capacity to that of market demand and activity. These cost-cutting measures, which included headcount reduction in certain support and sales areas, as well as closure of non-core offices, have significantly reduced operating expenses. OpEx dropped from $2.8M in 1H '17 to just $2.2M in 1H '18 – a decrease of 20%. Importantly, these initiatives have not come at the expense of revenue growth. Over the same period revenue increased by 8% - the net result was operating expenses as a percentage of revenue falling from 35% to 26%. This is the lowest level (as a percent of revenue) for any consecutive six-month period since Q3-Q4 2015 and a major impetus to significant narrowing of operating loss. Operating loss was $130k through the first half of 2018, the best two-consecutive quarter period since Q2-Q3 2016 (op loss of $26k). Given their obvious importance to profitability, OpEx levels will be something to continue to keep an eye on – even very incremental revenue scaling at these OpEx levels can result in a fairly dramatic benefit to operating income.

Meanwhile, gross margin, also showed some recovery from the 16.8% level in Q4 2017 – as a reminder, the hurricanes were responsible for shaving about 570 bp off GM in that quarter. GM was 25.7% in Q1 and 22.9% in Q2 '18 - while not what we would necessarily characterize as robust and still well below historical levels, the 24.3% average through the first six months of 2018 compares favorably to the second half of 2017 (20.1%) and hopefully indicates an upward trend. This will also be a metric to watch. While GM may show some short-term variability, we think it expands with revenue growth and currently model full-year 2018 GM of 24.7%, compared to 23.2% in 2017.

In terms of liquidity, PBSV continues to maintain a solid balance sheet and cash position. Cash balance was $13.0M at fiscal Q2 quarter-end – which is a slight decrease from $13.2M at the close of Q1. Collection of A/R, current balance of which is $6.6M, could further bolster cash position. Importantly, PBSV continues to have no concerns about collectability.

Operating cash flow was a $151k outlflow and $1.3M inflow in the three and six months ending April 30, 2018. When excluding changes in working capital, these were $42k inflow and $2.5M outflow - the relatively large outflow mostly relates to the $2.7M income tax liability which PBSV first recorded during fiscal Q1 '18 (i.e. ending January 31, 2018). As a reminder, this liability was initially disclosed in the 2017 10-K (and which we explained in a prior update) and relates to recent changes to U.S. income tax treatment of subsidiaries’ earnings and profits. Specifically, it relates to accumulated (i.e. prior to fiscal 2018) undistributed earnings and profits of PBSV's Puerto Rican subsidiaries. It is payable over eight years (8% yrs 1 – 5, 15% yr 6, 20% yr 7 and 25% yr 8) beginning in February 2019. The company expects to fund it with working capital.

Given the sizeable cash balance and our forecast of improving cash flow, we have no concerns about the company’s liquidity position. In addition to A/R collections, cash balance could benefit further from potential insurance recoveries. As a reminder, PBSV previously noted that as of the end of fiscal Q4 (i.e. October 31, 2017) approximately $50k in property damage-mitigation repairs had been made and Q4 gross profit was negatively impacted (from lost sales) by ~$275k. The company further noted, as it relates to potential insurance recoveries, that the “Company carries insurance to mitigate these losses, as well as for property damages.” And, per both the Q1 and Q2 10-Qs, “The Company’s insurance provider is currently assessing the extent of the damages to the facilities, as well as the business interruption losses and additional expenses incurred by the Company until electrical power and other basic utilities were restored [November 22, 2017]. Based on current accounting guidance, the insurance proceeds will be recognized upon collection, as a gain contingency.”

Outlook / Valuation:

PBSV Rapidly Recovers From Hurricanes…
Hurricane Maria slammed Puerto Rico on September 20, 2017, causing massive and widespread destruction throughout the island which has been estimated at more than $100B. Despite the devastation, PBSV was able to resume operations in Puerto Rico within about one week after Hurricane Maria made landfall. Fortunately, the company did not suffer significant damage to their facilities or to personnel. Given the size and strength of the hurricanes, the direct hit on the island and overall massive destruction that they caused, we were surprised by the relatively minor impact to Q4 financial results and their quick recovery as evidenced by the significant growth in revenue. The reason, in large part, is likely related to not only PBSV’s ability to quickly resume operations (via generator power) but also of their P.R.-located clients’ ability to do the same. We also think the robustness and speed of the initial recovery bodes well for further rebound in P.R. consulting and lab activity and related revenue throughout the remainder of 2018.

While European revenue fell to more historical levels in Q2, we think there could be more outsized growth from this territory as a result of new consulting opportunities. Meanwhile, U.S. consulting has shown some recent signs of picking up, which may be a direct result of a renewed and greater focus on finding new opportunities there. Shuttering their two U.S.-based offices has helped with cost-control and the use of remote facilities should allow greater flexibility.

Other potential growth-related opportunities include their new Calibrations division (“Metrologix”) in Puerto Rico (development of which was completed in Oct 2017), Pharma-Brazil and, possibly, entry into Cuba. Pharma-Brazil is a wholly-owned subsidiary which PBSV registered in 2015 in order to provide consulting services to the Brazilian market. Given the historical strength (until recently) in Latin America-related project demand and revenue, this area of the world, including Brazil, could offer meaningful growth opportunity for PBSV.

Relative to Cuba, in December 2016 PBSV obtained a license from the U.S. Dept of Treasury Office of Foreign Assets Control (OFAC) authorizing the company to perform certain services and transactions with a Cuban state-run organization. While too early for us to hypothesize the significance of this (PBSV’s has yet to generate meaningful revenue from Cuba), the OFAC license may provide PBSV with (at least) foot-in-the-door opportunity to a country that has been largely off-limits to most American companies (with some exceptions). And the recently restored (at least formally restored) diplomatic relations between the U.S. and Cuba and potential that sanctions are reduced in the future may mean that this foot-in-the-door could eventually result in even greater opportunity for PBSV (this is wait-and-see status, however, given indications by President Trump that he may reinstate limited access to Cuba).

Model Update…
We have made only incremental tweaks to our model following Q2 2018 results. We think there may be some hangover from the hurricanes, although the relatively muted disruption to Q4 ’17 and quick recovery over the following two quarters suggests these should not be long-term issues. Despite upward revisions to our modeled revenue as a result of PBSV’s more rapid and robust recovery, we still underestimated top-line growth in both of the first two quarters of fiscal 2018. And while we have, again, made upward revisions, our 2H '18 forecasts could still prove too conservative.

As it relates to gross margin - we now look for GM of 24.7% (revised down from 25.5% as a result of softer than expected GM in Q2) for the full year 2018, which compares to 23.2% in 2017 and 29.6% in 2016. PBSV's cost-containment efforts have had a significant and positive impact to profitability but not at the expense of revenue growth. Even very incremental revenue scaling at these OpEx levels can result in a fairly dramatic benefit to operating income as well as to cash flow.

We look for revenue to grow at a 4-year CAGR of approximately 13% through 2021. We use an industry PE/G ratio of 1.9x to value PBSV. We look for 2020 EPS of $0.06 which values the company at approximately $1.50/share. The stock currently trades at about $0.63, 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. Book value was $18.0M, or $0.78/share as of April 30, 2018. Cash balance currently sits at $13.0M, or ~$0.56/share. We think book value should provide a floor on the stock.

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