By Lauren Migliore
We think the contract research organization (CRO) industry is on the rebound, as evidenced by a resurgence in new business activity and revenue growth during the last year. Widespread top-line growth that began in the second quarter continued into the third; on average, the CROs we cover increased revenue 11.1% and 1.8% on a year-over-year and sequential basis, respectively. We expect growth in the CRO industry to continue accelerating into 2012, and the rise of the strategic partnership model should concentrate these benefits in the hands of a select group of narrow-moat providers.
Future Hinges on Partnerships
The emergence of the strategic partnership model, which has seen the world's largest drugmakers pair up with leading CROs as long-term partners in research and development, has helped fuel the industry's return to growth. The second and third quarters marked the first periods since the beginning of the drug development slowdown that the industry saw widespread top-line growth. Covance (CVD) and Pharmaceutical Product Development were once again the biggest top-line gainers during the quarter. These firms were a couple of the earliest CROs to sign long-term deals with Big Pharma partners, and we think their continued success attests to the growing importance of incremental revenue derived from new strategic alliances.
Chinese CRO WuXi PharmaTech (WX) reported another period of double-digit revenue growth during third quarter led by the firm's burgeoning manufacturing services division. WuXi is responsible for manufacturing hepatitis C therapy Incivek for Vertex (VRTX) and Johnson & Johnson (JNJ), and the drug's first full quarter of sales since launch was a driver behind this huge jump in manufacturing services revenue compared to the prior year. We think the firm is well-positioned to capitalize on drugmakers' increasing use of both offshoring and outsourcing for their drug development needs. However, we remain concerned that rising labor costs in China eventually will eat away at WuXi's profits over time.
Charles River Laboratories (CRL) remained the laggard of the pack as the firm's earnings continued to stagnate because of persistent underperformance in the preclinical services segment. Although Charles River turned in positive top-line growth in the third quarter, most of the year-over-year benefit was due to foreign currency gains. Growth was driven by strong demand in the firm's research models and services segment. However, preclinical services continued to weigh on the firm's overall performance; management noted that a sales bias remains toward short-term, less complex studies as clients try to eliminate molecules earlier in the drug-development process to save costs. On the positive side, the firm announced it has significantly expanded a preferred-provider agreement with a leading global pharmaceutical firm and is in the early stages of similar discussions with other large clients. We think this reinforces our thesis that drugmakers will increasingly turn to outsourcing as a way to reduce fixed costs and improve the drug-development process.
Preparation Will Pay Off Down the Road
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. As the industry evolves into a strategic partnership model, CROs' investments in staff and infrastructure to prepare for increased volumes have strained near-term profit levels. Resource buildups to support recently signed partnerships, which require substantial new costs without an immediate increase in compensating revenue, have weighed on earnings for ICON (ICLR) and Parexel (PRXL)--which were named the two strategic partners of Pfizer (PFE) in May.
Although price concessions accompany the substantial volume of work that is being transferred, margins should expand as trials are optimized and increased visibility improves efficiency. Accordingly, we expect profitability at these firms to recover in 2012 as partnerships mature and productivity improves. Furthermore, aggressive cost cuts and share buybacks during the last year should continue to fuel double-digit earnings per share growth for CROs with more established strategic alliances, like Covance.
CROs Still on Sale
Overall market uncertainty is keeping shares of CROs at depressed levels. Our CRO coverage universe trades at an average discount of 35% to our fair value estimates, and we think the entire industry is attractively valued at current trading levels. ICON and Charles River trade at the steepest discount to our valuation estimates, and these two names continue to represent our top picks in the space. Shares of Covance--one of the highest-quality players in the industry--are also trading at attractive levels and have entered 5-star territory.
ICON has seen its earnings slide in recent quarters, primarily due to the addition of 500 new staff members as it ramps up hiring in anticipation of its new Pfizer partnership. We think ICON is set for a dramatic rebound in 2012 and maintain our rosy long-term outlook. Similarly, Parexel's earnings also remain off year-ago levels as the firm accelerates its hiring to meet expected future requirements of its clients. However, we think Parexel finally has turned the corner in the first quarter of its fiscal year 2012, as investments in infrastructure for the expected uptick in demand are beginning to pay off. We expect this momentum to carry into the remaining quarters in fiscal 2012 as strategic partnerships mature.
Shares of Charles River also remain undervalued as continued declines in preclinical services weigh on the stock. It appears the investment community is concerned with management’s projections for a longer-than-expected delay in the recovery of preclinical services demand, which the market seems to be looking to as the primary catalyst for the stock at this point. We think investors have been presented with an attractive entry point for this high-quality CRO. Demand normalization and capacity reduction should help the firm return to top-line growth in 2012. Overall, we expect stable, single-digit growth in research models and services and low-double-digit growth in preclinical services--primarily driven by increased outsourcing penetration--to yield roughly 7% annual revenue growth once drugmakers thaw their pipelines.
Finally, mergers and acquisitions could provide additional upside for CRO investors in 2012. The industry witnessed a flurry of acquisition activity during the last year. Private equity firms historically have demonstrated a strong interest in the sector, which has been out of favor in the market for some time and ripe for restructuring efforts. The acquisition of leading CRO Pharmaceutical Product Development (by private equity groups Carlyle Group and Hellman & Friedman) was finalized in early December and we think the firm's 30% takeover premium reinforces our favorable view on the prospects of this high-growth sector.