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Morningstar | Syneos Health Beats on Revenue but Margin Hurt by Mix Shift; Lowering FVE to $51 Per Share

Syneos Health started off the year with a mixed first quarter, beating consensus expectations on the top line but reporting lower-than-expected operating margin. After adjusting our expectations for margin improvement throughout our explicit forecast, we are lowering our fair value estimate to $51 per share. Although shares are trading below our new fair value estimate, we recommend a larger margin of safety for Syneos due to its high uncertainty level, which is based on its high leverage following the 2017 merger. We are maintaining our narrow economic moat rating for Syneos, as we continue to believe that the contract research organization's intangible assets and switching costs will drive excess returns.

Total revenue of about $1.1 billion represents a 5.8% increase from last year, largely in line with our expectations. Clinical solutions revenue was softer than we had anticipated with $805 million up 2% from last year, but it was more than offset by strength in commercial solutions, which posted $314 million, up 16% year over year. Clinical new business awards looked solid by our estimates, but we concede it is difficult to compare with historical levels as the company did not provide adjusted historical figures for the new accounting standards.

Operating margin of 2.4% was up 140 basis points from last year but below our expectations. Clinical solutions adjusted EBITDA margin was flat, while adjusted EBITDA margin in commercial improved by 30 basis points. We've revised our margin expectations for both businesses, anticipating more FSP work in clinical and higher operating expenses in commercial. We're now projecting the full-year adjusted EBITDA margin for the whole company to be 13.6%, flat year over year. However, margin improvement is key to our long-term forecast, so we'll be watching this carefully as management continues to uncover synergies and leverage the company's top line.

Following the merger, Syneos has long way to go to catch up to peers on operating margin. It's difficult to pinpoint the drivers behind this quarter's slow operating margin improvement due to opaque comments from management on the call, but management indicated that both mix shift and seasonal expenses were factors. We posit that revenue shifted toward lower-margin FSP (functional service provision) rather than full-service solutions. Full-service solutions form the basis of our narrow moat thesis for large contract research organizations (CROs) because we don't see as much room in FSP for CROs to add value by cutting trial times and expediting drug development as we see in full-service solutions.