Buying or Selling a CRO? Better Check the Backlog

Over the past 10 years, I have been the executive finance lead on 3 mid-size Clinical Research Organization (CRO) divestitures and have also performed diligence on several potential small and mid-size CRO acquisitions. While all of the CROs were unique and different in their own ways, one constant is that understanding backlog is always a key aspect of any well thought out CRO due diligence process. Sellers would be wise to organize and thoroughly understand their backlog data (here is a link to an example of a backlog dashboard). Buyers should be prepared to dig in and perform an exhaustive analysis of the potential acquisition's backlog to minimize their go forward risk.

What Is Backlog?

Per INC Research’s 2015 Annual Report, backlog is defined as “anticipated future net service revenue from contracts, letters of intent and other written forms of commitments that either have not started but are anticipated to begin in the near future, or are in process and have not been completed.” Loosely translated as contracted (or close to contracted) work to be completed in the future. A growing backlog is considered a sign of momentum while a declining backlog signifies a business experiencing challenges.

New awards and change orders increase backlog while revenue recognized and cancellations decrease backlog. Slippage (contracted services not completed before the trial is finished) and backlog value changes due to exchange rate movement can also have an impact. Here is an example of a traditional backlog rollforward schedule:

A few other considerations:

Pass through items (i.e. grant payments, travel expenses, etc…) are excluded from reported backlog. These items do not contribute to CRO revenue or profitability and including them would overstate backlog value.

Backlog (i.e. projects) can typically be cancelled by customers within a short time window.

Backlog is not a governed by Generally Accepted Accounting Principles (GAAP) so companies have leeway with what they can include in backlog. Most of the public CROs have similar backlog definitions (private companies may have less consistency).

Why Is Backlog Important?

Backlog contains a great deal of information about a CRO – explaining why it is one of the primary diligence areas during a transaction. Backlog doesn’t guarantee future success, here is what INC Research states about their backlog, “backlog might not be indicative of our future revenues, and we might not realize all the anticipated future revenue reflected in our backlog.” However a strong backlog is a positive indicator towards future success and buyers of a CRO will be interested in what (is in the backlog) and how (it was won). Key characteristics for each trial (in the backlog) taken in the aggregate can provide critical information for buyers (and also be strong selling points for the sellers).

Here are some questions that backlog can help answer:

What are the CRO’s key therapeutic areas?
Who is the CRO’s primary customer base?
Is there increased risk due to a high level of customer concentration?
Is the cancellation rate greater than the norm?
Are there any risky trials that are delayed or contingent upon the success of another trial?
Are there any customers with insufficient funding in the backlog?
How much forecasted revenue over the next 12 months is currently in the backlog?
How quickly is backlog converting into revenue?

Therapeutic Expertise and Customer Base

Large CROs usually have experience in all therapeutic areas due to their large employee base. Most other CROs tend to have a more narrow focus and become experts in a few therapeutic areas. Medelis and Cap Oncology Trial Solutions are great examples, they both state on their respective home pages that they have a deep oncology focus. All studies (with a few exceptions) will have a therapeutic description – analyzing backlog data will convey a CRO’s therapeutic focus. Here is simple example in chart form:

Defining your customer base is key when managing a successful CRO. I recently discussed this point in my blog about Why CRO Win Rates Matter? Get your customer base incorrect and a CRO will suffer insufficient award totals, a declining backlog and a lot of wasted money chasing low probability opportunities. Premier Research is a great example of a CRO with a defined customer base. Premier states on their home page that biotechs make up 90% of their business.

A CRO’s stated key therapeutic expertise and customer bases must corroborated by the backlog. It won’t do an oncology CRO focused on the biotech sector any good to have a majority of its backlog be respiratory with large pharma. The strategy won’t hold and buyers will be turned off. Diligence data really needs supports the story in all areas (not just backlog).

Backlog Risk

Acquirer's will spend a great deal of time trying to assessing backlog risk. Existing backlog will be expected to contribute future revenue (as we will discuss) - the amount is impacted by backlog quality. Remember INC's definition of backlog - it leaves the opportunity for different interpretations. The phrase, "Anticipated future net revenue" really depends on your definition of "Anticipated". There is no consensus on what should be included in backlog. However, the following items are sometimes included and can increase the backlog risk profile:

Studies contingent upon the success of another trial
Trials that have officially been on hold for greater than twelve months
Trials related to customers that have insufficient funds
Trials that are taking longer than normal to execute a signed contract

CROs should have a monthly or quarterly process to scrub the backlog of any projects not expected to convert to revenue. Including projects that aren't expected to convert is extremely unethical for CROs in a sales process.

Customer Concentration Risk

Customer concentration is a measure of how total revenue is distributed among your customer base. Having too much of your business dependent on a single customer or trial can be devastating if the customer were to cancel or the drug were to fail. A while back Forbes magazine listed customer concentration as one of a business's biggest risks. Deloitte also recognized that too much reliance on one customer can be a major risk when evaluating whether or not to acquire a CRO. While there is no definitive amount of how much backlog should be with one customer, rule of thumb is approximately 10%. Obviously, the counter argument is that its better to have business with one customer rather than no business at all (I can't argue with that). However, this article isn't about business as usual. Keep in mind that acquirers of CROs tend to look at many businesses and they will always look to minimize risk. A CRO with less customer concentration risk may look more attractive and command a greater price valuation. Having more than 10% of your backlog with one customer isn't a deal breaker - just be prepared for heavy diligence so buyers can get comfortable they won't experience a large cancellation post deal closing.

Cancellation Risk

I have always found cancellations to be the biggest challenge when operating a CRO. We used to call them "Meteor Strikes" while I was at Theorem Clinical Research. They seemed to always come at inopportune times (the largest cancellation I ever had to deal with happened on my first day in the CRO industry at MDS Pharma - I was quickly baptized into clinical research) and immediately force you to change gears. The industry norm for cancelled backlog is roughly 3-5% of each quarter's beginning backlog. Having a cancellation rate consistently greater than the industry norm will be a red flag during diligence. Not much a CRO can do about cancellations if a drug fails, but there are some steps a CRO can take to limit reported cancellations:

Execute and provide good customer service - buyers will be turned off if cancellations occur from poor execution.
Don't put overly risky trials in the backlog just to pump up the backlog - the clinical research gods will giveth and taketh.
Scrub the backlog on a quarterly basis - minimize the optics of a large cancellation adjustment by (correctly) spreading the pain throughout the year.

Cancellations will happen and are expected - they are a normal part of drug discovery. Minimizing preventable cancellations and being able to communicate why cancellations occur will go a long way towards educating potential buyers.

Backlog Burn Rate

The backlog burn rate is the rate at which backlog is converted into revenue. Backlog burn is typically tracked on a quarterly basis and is determined by dividing revenue recognized by beginning backlog. Here is the calculation:

The norm backlog burn rate for CROs is typically in the 10-13% range (Medpace shows an industry calc on page 18 of their 2016 Baird Healthcare conference presentation), smaller CROs can have higher rates due to smaller backlogs. A lower backlog burn rate isn't necessarily a bad. The backlog burn rate is driven greatly by project duration, which is the length of time it takes to complete a project. Project durations can range from a few months to greater than 10 years - it really just depends on the type of trials a CRO executes. Buyers will be looking for material changes in the burn rate. Consistent burn rates will garner less questions, however if burn rates increase or decrease expect a lot of questions from buyers. Here are a few questions they may ask:

Are there delayed projects lowering the burn rate?
Has the company changed their strategy to start chasing trials with different durations (than in the past)?
Why are burn rates differing from the industry norm?
Are there anomalies (i.e. large slow burning trials) impacting the burn rate?

Identified Revenue

Buyers will spend a good deal of time getting comfort on how much future revenue (particularly the next 12 months) is sitting in the backlog (often called identified revenue). You can see how customer concentration, backlog and cancellation risk and burn rates all directly contribute to the a buyer's confidence in relation to future revenue. CROs normally try to have 70-80% of the next 12 months revenue in their current backlog. Identified revenue is a necessary component of the financial forecast buyers will create to justify their purchase. They will be looking for a certain level of profitability to:

Obtain financing needed to make the acquisition
Make sure the acquisition doesn't put a financial strain on current operations
Gain Board of Director or Investment Committee approval

I can't stress enough, sellers would be wise to have a thorough understanding of their backlog while both operating and selling their businesses.

Wrap Up

A seller of a CRO is like an author marketing a new book. Seller’s have an interesting story to tell and buyers are excited to hear that story. Many times the difference between a successful and unsuccessful sales process is whether that story is fact or fiction. Backlog is a key component in determining that outcome – both buyer and seller would be wise to do their homework.

Jason Monteleone is President at Pivotal Financial Consulting, LLC. A Strategic Financial Consulting Firm serving the Clinical Research Industry. Jason can be reached at jmpivotalfinancial@gmail.com.