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by Lauren Migliore

We think the contract research industry is on the brink of recovery. After economic uncertainty and frozen credit markets conspired to create a sharp pullback in drug development spending, bookings appear to be back on track and the crippling cancellations witnessed in 2009 have normalized. We have long maintained that the slowdown in research-and-development spending was temporary due to the fundamental need to drive new therapies through clinical trials. We expect capacity rationalization and strong bookings trends to spur top-line gains for the major contract research organizations (CROs) in 2011. With pharmaceutical firms in need of replenishing their pipelines while also cutting costs, we think the top players will continue to expand market share in this high-growth industry.

Sales Growth Reflects Stabilizing Market Conditions in Early-Stage Drug Development

The earnings reports from Covance (NYSE:CVD) and Charles River continue to reflect a sustained period of slow bookings and negative pricing trends, but the firms' projections for 2011 signal that the worst may be over for early-stage drug developers. Capacity underutilization continues to be the culprit behind persistent underperformance in toxicology, as drugmakers scrutinize expenses and focus resources on late-stage candidates that offer quicker revenue potential. However, the major toxicology players have all recently announced plans to reduce capacity, which should improve pricing dynamics as drugmakers begin to reinvigorate their preclinical activities. Facility rationalization should buoy the financial performance of early-stage CROs in 2011. We expect the financial performance of the two largest players in this segment, Charles River and Covance, will fall near the top range of management's guidance for the year as cost control and aggressive share repurchases magnify the impact of top-line gains on the bottom line.

After two years of top-line declines, Charles River experienced sequential revenue growth of 2.0% in the fourth quarter. Covance, which has fared better than Charles River during the downturn because of its success in signing large-scale deals, turned in positive top-line growth on both a year-over-year and sequential basis. In our opinion, sequential sales growth in the fourth quarter reflects stabilizing market conditions in early-stage drug development. We think demand normalization and capacity reduction could help Charles River see low-single-digit growth in 2011. We expect Covance to earn high-single-digit growth in 2011 thanks to new business wins from the firm's strategic alliance with Sanofi-Aventis (NYSE:SNY). The firm has been highly successful at locking in long-term partnerships with some of the world's largest drugmakers, and we think new strategic alliances could provide additional upside potential this year for Covance. For instance, we expect Pfizer (NYSE:PFE) to substantially up its rate of outsourcing following the firm's decision to streamline its research-and-development activities earlier this year.

Late-Stage CROs Turn in Mixed Results in the Fourth Quarter, but Earnings Pressure Looks Temporary

Late-stage development has held up relatively well compared to early-stage activities, which has helped most CROs that focus on Phase II-IV trials continue to generate growth amid the downturn. Although top-line gains continued for most firms during the fourth quarter, several company-specific issues weighed on profitability during the period. Despite pressure on profits, booking trends remained favorable in late 2010 with the major CROs' reporting book/bill ratios of at least 1.0 during the quarter. Although new business wins are encouraging, we are wary of the slower pace at which bookings may translate into revenue. For instance, Parexel (NASDAQ:PRXL) lowered its outlook for the remainder of fiscal 2011 as it became apparent that management's initial projections for backlog conversion were too aggressive. It appears the industry's shift from a transactional approach toward strategic alliances has caused traditional revenue burn-off models to become less reliable. CROs are being brought to the table earlier in the clinical trial design process, and trials are increasing in size, complexity, and global breadth. While these dynamics bode well for the major players' long-term growth and profitability, an unusual amount of projects in startup mode may weigh on results in the near term. We think the margin pressure seen by late-stage CROs is a temporary growing pain associated with transitioning into a long-term strategic model. We expect these headwinds to be short-lived as production levels normalize. Total industry backlog grew 20% from 2009, primarily driven by several major deals announced during the year.

Improvement in Future Trial Demand Positions CROs for a Rebound

A dramatic slowdown in drug development spending has wreaked havoc on the leading contract research organizations and their income statements during the last two years. Drugmakers looking to rein in costs decided to delay development spending and cancel trials outright from late 2008 through 2009. These spending delays were then compounded by large pharmaceutical consolidation, reduction in biotech funding, and uncertainty surrounding health-care reform. Although bookings have rebounded and cancellations have moderated compared to the crippling amounts experienced in 2009, quarterly performance for CROs is highly contingent upon new business wins in prior quarters. However, while the financial performance of the CRO industry still remains below historical levels, the vast majority of firms witnessed both sequential and year-over-year revenue growth during the fourth quarter. All the CROs in our coverage universe turned in book/bill ratios of at least 1.0 during the fourth quarter, signaling that growth will return to the CRO industry in 2011. Strong new bookings are a testament to our thesis that drugmakers are beginning to unfreeze their pipelines and limit cancellations. We think the CRO industry has turned a corner, as evidenced by a resurgence in new business activity and relatively stable volume and pricing during the last year. Considering the compelling value proposition offered by the CRO model, we expect drugmakers to outsource an increasing portion of their R&D budgets to a select group of preferred providers. We think the industry's leading players--with their global scale and therapeutic breadth--will benefit from these trends over the long run.

Compelling Investment Opportunities Remain in the CRO Industry

While improving performance has helped lift the shares of CROs in recent months, four firms still carry our 4-star rating. ICON (NASDAQ:ICLR) took a fourth-quarter hit when management announced its projections for a longer-than-expected delay in demand recovery. While near-term profitability pressure has a small impact on our valuation of the firm, we believe that ICON's troubles are simply a timing issue and that the firm's long-run prospects remain intact. Shares of Charles River (NYSE:CRL) also remain undervalued as continued declines in preclinical services and management concerns following the company's bungled acquisition of WuXi PharmaTech (NYSE:WX) weigh on the stock. We think the market is undervaluing the cash flow power of Charles River's RMS business, and the firm's PCS franchise should provide substantial upside for investors as demand comes back on line. Furthermore, management has been on its best behavior following shareholder backlash surrounding the highly unpopular deal. We approve of management's commitment to returning value to shareholders through substantial share repurchases.

Sales Growth Reflects Stabilizing Market Conditions in Early-Stage Drug Development

The earnings reports from Covance (CVD) and Charles River continue to reflect a sustained period of slow bookings and negative pricing trends, but the firms' projections for 2011 signal that the worst may be over for early-stage drug developers. Capacity underutilization continues to be the culprit behind persistent underperformance in toxicology, as drugmakers scrutinize expenses and focus resources on late-stage candidates that offer quicker revenue potential. However, the major toxicology players have all recently announced plans to reduce capacity, which should improve pricing dynamics as drugmakers begin to reinvigorate their preclinical activities. Facility rationalization should buoy the financial performance of early-stage CROs in 2011. We expect the financial performance of the two largest players in this segment, Charles River and Covance, will fall near the top range of management's guidance for the year as cost control and aggressive share repurchases magnify the impact of top-line gains on the bottom line.

After two years of top-line declines, Charles River experienced sequential revenue growth of 2.0% in the fourth quarter. Covance, which has fared better than Charles River during the downturn because of its success in signing large-scale deals, turned in positive top-line growth on both a year-over-year and sequential basis. In our opinion, sequential sales growth in the fourth quarter reflects stabilizing market conditions in early-stage drug development. We think demand normalization and capacity reduction could help Charles River see low-single-digit growth in 2011. We expect Covance to earn high-single-digit growth in 2011 thanks to new business wins from the firm's strategic alliance with Sanofi-Aventis (SNY). The firm has been highly successful at locking in long-term partnerships with some of the world's largest drugmakers, and we think new strategic alliances could provide additional upside potential this year for Covance. For instance, we expect Pfizer (PFE) to substantially up its rate of outsourcing following the firm's decision to streamline its research-and-development activities earlier this year.

Late-Stage CROs Turn in Mixed Results in the Fourth Quarter, but Earnings Pressure Looks Temporary

Late-stage development has held up relatively well compared to early-stage activities, which has helped most CROs that focus on Phase II-IV trials continue to generate growth amid the downturn. Although top-line gains continued for most firms during the fourth quarter, several company-specific issues weighed on profitability during the period. Despite pressure on profits, booking trends remained favorable in late 2010 with the major CROs' reporting book/bill ratios of at least 1.0 during the quarter. Although new business wins are encouraging, we are wary of the slower pace at which bookings may translate into revenue. For instance, Parexel (PRXL) lowered its outlook for the remainder of fiscal 2011 as it became apparent that management's initial projections for backlog conversion were too aggressive. It appears the industry's shift from a transactional approach toward strategic alliances has caused traditional revenue burn-off models to become less reliable. CROs are being brought to the table earlier in the clinical trial design process, and trials are increasing in size, complexity, and global breadth. While these dynamics bode well for the major players' long-term growth and profitability, an unusual amount of projects in startup mode may weigh on results in the near term. We think the margin pressure seen by late-stage CROs is a temporary growing pain associated with transitioning into a long-term strategic model. We expect these headwinds to be short-lived as production levels normalize. Total industry backlog grew 20% from 2009, primarily driven by several major deals announced during the year.

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Source: Contract Research (CROs): On the Brink of Recovery