Downturn Has Transformed Drug Company Business Model

by: Ryan Savitz

The healthcare industry is undergoing a large transformation and the whole landscape has drastically changed in the last few quarters. The distressed markets have created immense opportunities for large cap pharmaceutical and biotechnology companies looking to expand their business by expanding their product lines.

Even though credit is hard to come by, these “cash cow” companies have been able to raise the necessary funds in order to successfully follow through with their acquisition strategy. In the last few months we saw Pfizer (NYSE:PFE) purchase Wyeth, Merck (NYSE:MRK) sweep up Schering Plough, Roche (OTCQX:RHHBY) acquire the rest of Genentech, and Gilead Sciences (NASDAQ:GILD) acquire CV Therapeutics.

This ramp up in healthcare M&A activity has not been seen in recent years, especially at the levels and sizes we are currently encountering. Is the model of the healthcare industry changing?

What is in the pipeline? How many drugs have entered Phase III testing? These questions were originally the buzz around healthcare investors and analysts, but now it seems as if the tides have turned and now the real question lies in: Who has the most cash, or can borrow the most? Recent earnings reports from the large and small contract research organizations, or CROs, further provide validity to my point. CROs receive work that has been outsourced by healthcare companies and provide services that include, but are not limited to, product development, formulation and manufacturing through clinical trials, toxicology and data management.

CROs really saw increased usage from the early to late 1990’s up until pretty much just recently. Covance (NYSE:CVD), one of the largest players in this unique subsector, reported an 18 percent drop in quarterly profit and cut its guidance severely. Covance lowered its 2009 profit outlook to $2.50 to $2.70 per share from a previous forecast of $3.00 to $3.20 per share. Mean analysts from Reuters had estimates of $2.89 a share.

A smaller CRO, Kendle International (NASDAQ:KNDL) reported earnings a few weeks ago citing “unprecedented biopharmaceutical industry conditions,” and said it would not meet analyst expectations for the quarter because of increasing project cancellations, delays and a reduction in new business signings. They reported a cancellation rate of 45 percent in the first quarter.

A few days after Kendle’s release, Pharmaceutical Product Development Inc. (NASDAQ:PPDI) came out with earnings that caused significant downward pressures on the rest of the industry. For 2009, PPDI forecasted earnings of $1.54 to $1.60 a share, on revenue of $1.40 billion to $1.47 billion, down from its original forecast of $1.97 to $2.05 a share, on revenue of $1.60 billion to $1.67 billion. So what does all this mean?

Well, these once very profitable companies are obviously struggling immensely, and their short-term to medium term outlook is very negative. Wouldn’t you think the large biotech and pharma companies would outsource their clinical trials for drug development and monitoring in order to reduce costs, and maintain their solid margins? I thought they would, but obviously the tides have turned and that is not the case. They are not aggressively growing their pipelines anymore or developing ”blockbuster” drugs at the same pace they had in previous years. Now, the model has changed. Large firms are actively acquiring firms in similar areas of medical need. The markets reacted well when Gilead Sciences picked up CV Therapeutics in order to expand its small, but rapidly growing cardiovascular franchise. Can this exist forever?

I feel this evolving business model will exist for about another year to year and a half and then large firms will turn back to a model that has worked for decades, until their pipelines can be sustainable. It seems that for the current time period, it is more cost effective to keep testing in-house while pipelines get reconstructed to their previous strength. CROs will be revived and will be great stocks to keep an eye on during a full economic recovery. When gauging this trade, focus on healthcare as a percentage of GDP and more specifically, pharmaceutical costs and spending to determine if the time is right to open a position in the CROs. Since successful investors stay ahead of the trend, the question going forward is, who is next to make the big move?

Disclosure: The fund the author manages is long GILD.