Contract Research Organizations: Nothing but Woes

Includes: CRL, CVD, KNDL, PPDI
by: Alan Brochstein, CFA

I have followed the Contract Research Organizations (CROs) for quite some time. These providers of outsourced clinical trials have enjoyed years of strong growth as they have increased not only their penetration of but also their importance to their biotech and pharmaceutical customers. Yesterday's news, though, suggests that this economy has taken yet another victim, though not entirely by surprise.

In the morning, Kendle International (NASDAQ:KNDL) pre-announced a huge miss. Their 8-K used words that should put fear into all investors in the industry: "pricing pressure". Pricing is impacting its business across all segments and geographies. It also cited project delays and cancellations as well as a rapid drop in the pipeline for new business. Later in the day, Pharmaceutical Product Development (NASDAQ:PPDI), a company I know quite well and a member of my watchlist, lowered its guidance for the rest of the year. Its CEO, Dr. Eshelman, stated:

In this challenging economic environment, we have experienced unprecedented cancellation levels, significant rescheduling of existing backlog, and lower-than-expected authorizations for the first quarter.

KNDL was mauled, falling more than 50%. PPDI's release came just as the after-hours trading session closed, though it fell in sympathy with the rest of the industry following KNDL's announcement. It is likely to test levels not seen since 2004.

The table below () lists the major players in the industry. I follow Covance (NYSE:CVD) closely as well. CVD and and especially Charles River (NYSE:CRL) tend to be more focused on pre-clinical and Phase 1 trials, while the rest of the industry has more exposure to later-stage trials. The real problem now is that we have an environment with falling prices. There is apparently excess capacity now, but this isn't an industry that enjoys much price elasticity, so any cuts will go right to the bottom line. The bulk of the cost structures for these firms is in labor, so it will be hard to to implement cost controls beyond right-sizing for the shrinking demand.


I don't expect this bad news, though not entirely unexpected, to be met by a relief rally. While valuations are relatively low and prices have been hammered over the past 16 months, it will take some time for investors to become comfortable that the bottom of margins is in sight. Encouragingly, the balance sheets are relatively strong for the group, with several in a strong net cash position. If one is inclined to invest, I would recommend CVD or PPDI, two of the leaders. In a market focused on growth, perhaps the smaller players merit more attention, but now is the time for strong management that can navigate the tough times. CVD has a lot of exposure on the front-end, but it is worth noting that they have significant long-term contracts.

Disclosure: No position in any of these stocks

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