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The world market for pharmaceutical contract research services is set to grow by an average of over 13% per year over the next five years, according to recent analysis by Jefferies. This trend bodes well for contract research organizations (CROs), which should be expected to see accelerating revenue growth and as a consequence margin expansion.

In recent years, drug makers have been pressured by the 'patent cliff,' a period of greater than average patent expirations for blockbuster drugs, such as Lipitor. As such, drug makers have turned in recent years to contract-research organizations in order to outsource the clinical trials required for the approval of new medicines. Total spending by pharmaceutical companies on CROs is expected to rise from 44% presently to 55% by the end of the decade. The average spending for the 100 largest pharmaceutical companies over the past decade is $82.2B per year, thus an 11% increase corresponds to $9.0B per year by 2020, a substantial amount for an industry that presently represents $26B in annual revenue.

There are a number of prospective CRO investments to choose from and a summary is provided below (Table 1). Covance (NYSE:CVD), Parexel (NASDAQ:PRXL) and Quintiles (NYSE:Q) are based in the United States, while Icon Plc (NASDAQ:ICLR) is based in Ireland and WuXi PharmaTech (NYSE:WX) is based in China. From a quantitative standpoint, Parexel appears to be the strongest choice as it has lowest price/earnings and price/sales ratios with the highest gross margin, expected earnings growth and return on equity.

Table 1: Key Statistics for Several Contract Research Based Companies

Company NameSymbolP/EMarket CapitalizationPrice/SalesForward EPS Growth (3-5 Yrs)Gross MarginRevenue Growth (5 Yrs)ROE
CovanceCVD29.74.94B1.9414.9%28.1%7.7%12.1%
Icon PlcICLR27.72.47B1.9017.7%37.1%12.1%11.3%
Parexel InternationalPRXL24.72.55B1.2123.0%27.6%11.4%18.9%
Quintiles TransnationalQ32.25.97B1.5112.7%10.3%2.4%-18.0%
WuXi PharmaTechWX26.292.73B4.9714.9%35.9%29.9%16.7%

An additional reason to consider buying Parexel now is that the stock has pulled back following a disappointing quarterly report and remains 18% below its annual high price. Parexel issued guidance below previous estimates seeing revenue in the range of $1.89B to $1.92B for the 2014 fiscal year. Forward earnings are estimated at $2.44/share. Figure 1 shows the moderation of growth in sales and earnings over the next 12-months. Lower expectations give some margin of safety over the short term, while over the longer term Parexel should be the beneficiary of the mentioned secular trends.

Figure 1: Parexel Forward Estimates (click to enlarge)

Source: Y-Charts.

The stock has begun to recover and the recent sell-off has returned Parexel to its 5-year average valuation on the basis of price/earnings and PEG ratio (Figure 2). Since bottoming in early 2009 at $7.77/share, Parexel has returned 481% substantially outpacing the market. The stock has also outpaced the market over the longer term.

Figure 2: Historical Valuation of Parexel (click to enlarge)

Source: Thomson Reuters.

Given the historic outperformance of Parexel, its valuation and above average prospects for growth it seems very likely that Parexel International will continue to outpace the market over the longer term. As such, an investment in Parexel seems like a very desirable one at the present time.

Source: Buy Parexel International On Increasing Pharmaceutical Contract-Research Spending