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PBSV: Lab Sale Proving To Be Wise Move As Profitability Continues To Improve

By Brian Marckx, CFA



Fiscal Q1 2019 Results: Lab Sale Proving To Be Wise Move As Profitability Continues To Improve

As we await the reporting of Pharma-Bio Serve, Inc.’s (OTC:PBSV) fiscal Q2 2019 results (ending April 30th), which will likely happen either late next week or early the following week, we review their recent financial highlights. As a reminder, the company divested their laboratory assets in September 2018 and as we had predicted, it has resulted in substantial improvement in their financial performance.

Revenue (which is now reported ex-lab), jumped 34% in fiscal 2018, to $17.8M. Puerto Rico consulting revenue increased 32% yoy while U.S. consulting revenue was up 76%, which included 102% growth in Q4’18. The benefit to revenue growth is even more apparent now that we can compare year-over-year financial results on pre and post-lab sale bases. So while pre-lab sale, total revenue grew 8% from Q1’18 to Q1’19, growth on a post-sale basis was 23%.

But the even more significant highlight that has come from shedding of the lab assets relates to the decrease in the expense base. Gross margin in fiscal 2017 with the lab included was 23%, but (pro forma for) ex-lab, it was 29%. On a continuing operations basis (i.e. excluding lab), gross margin was 32% in fiscal 2018, up 310 basis points from 2017. Meanwhile, gross margin in Q1’18 with the lab included was 26%, but ex-lab, it was 32%. Gross margin in Q1’18 was also 32%.

Total expenses were (i.e. cost of services and opex) were $17.0M, or 109% of revenue, in 2017 with the lab, but only $14.1M, or 106% of revenue without the lab. That improved further in 2018, with total expenses aggregating to $16.7M, or 94% of revenue, in that year. And this continues to improve – in the most quarter (i.e. Q1’19), total expenses were $4.1M, or 90% of total revenue. This compares to $4.2M (100% of revenue) with the lab and $3.5M (94% of revenue) ex-lab in Q1’18.

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, 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 $1.5M (in the black). And the most current publicly available financials indicate that shedding expenses associated with the lab were responsible for a significant portion of the improved profitability in fiscal 2018. Specifically, the fiscal Q1’19 10-Q shows that the lab divestiture improved Q1’18 pre-tax income from just $37k (i.e. prior to the sale) to $229k (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 improving from approximately 1% to 6% in that same period.

Q1’19 pre-tax and net income were $514k and $471k, respectively. Net margin and EPS were 10.3% and $0.02. This is the most profitable start to any fiscal year since Q1’14 (and on a net margin basis, the best start since Q1’13), when the company posted net income and EPS of $662k and $0.03. Perhaps interestingly, the stock trades today at less than 50% of what it did when the company reported Q1’14 financial results. This speaks to our proposition that we believe the shares are significantly undervalued, particularly in the context of the company’s sizeable cash balance which may be put to use to further bolster growth and profitability.

Cash balance was $15.8M at the close of Q1’19 (January 31, 2019). The lab sale brought $2.0M in cash and $3.0M in promissory notes. 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 cash repurchases may potentially be under consideration.

Lab divestiture
As a reminder, announced in mid-August and closed on September 17, 2018 sale of the Scienza Lab laboratory assets sheds a segment which accounted for 12% - 13% of PBSV’s total revenue over the last two years but which also struggled to cover its fixed costs. Romark Global Pharma, LLC, a pharmaceutical client of PBSV’s (per company investor presentation), bought the assets for $5M, which is payable as $2M cash ($1.75M plus the application of a previously paid deposit of $0.25M), which has been received, and a $3M promissory note (tranches of $750k, $1.25M, $500k and $500k due in September 2019, September 2020, March 2019 and September 2019, respectively).

While opportunistic timing may have played a role, we think the decision to sell the lab was based around strategic initiatives aimed at accelerating revenue and income growth. While lab revenue posted strong growth from 2014 through 2016 and quickly bounced back following interruption from the hurricanes, this segment was never consistently profitable. Conversely, while consulting revenue had been on a downward trend since reaching a peak of more than $31M in 2013, it did not dip into the red until 2016. And while 2017 was marked from interruption from the hurricanes, PBSV’s quick recovery and resurgence of growth from Puerto Rico as well as the United States has resulted in rapid improvement in profitability of consulting services.

PBSV employed expense-control initiatives during times of lower activity which were effective in mitigating losses/improving profitability. That, along with time and material contracts which provide a large degree of ‘margin protection’ helped to limit losses from consulting services. Unlike the consulting business, the capital-intensive nature of the lab did not lend itself to significant cost-cutting. In order to generate a profit, PBSV’s lab needed to meet a minimum revenue threshold to cover its fixed costs.

These fixed costs included depreciation on capital assets and amortization – which, based on the most recent 10-K, appears to have been significant lab-related expenses. We know this by comparing the ‘depreciation and amortization’ lines from the cash flow statements of the 2017 10-K versus that included in the most recent (i.e. 2018) 10-K, which treats everything lab-related as a discontinued operation – and therefore aggregates its effect (revenue, expenses, taxes, etc) into a ‘loss from discontinued operations’ line item. Per the 2017 10-K (i.e. when the lab was not considered a discontinued operation), depreciation and amortization (i.e. of the entire company) was $444k in 2017, which compares to $108k when the lab is accounted for as a discontinued operation. This means that the lab assets incurred ($444k - $108k = ) $336k of depreciation and amortization in 2017, or 76% of the total in that year.

The allocation in 2018 appears to be even more significant. Through the first nine months of 2018 (i.e. prior to the lab sale) depreciation and amortization expense was at an annual run-rate of approximately $608k (for the entire company). The cash flow statement in the 2018 10-K, which treats the lab as a discontinued operation, shows depreciation and amortization of just $75k. This implies annualized lab-related depreciation and amortization of ~$533, or almost 88% of the (rough calculated) total.

So, given that the lab struggled to cover its fixed expenses (and, presumably, the outlook was that that would continue to be the case) and PBSV had an opportunity to sell the lab for $5M (and to an existing customer), we think it was a sensible and shareholder-friendly decision.

We cover PBSV with a $2.50/share price target. See link for free access to our updated report on the company.

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