CRO Investment Opportunities Remain Compelling

by: Morningstar

By Lauren Migliore

The contract-research-organization industry continues to feel the pain from a host of factors that derailed drug development spending and disrupted the trend toward clinical trial outsourcing over the past two years. Many 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. Quarterly revenue growth for CROs is highly contingent upon new business bookings in prior quarters, particularly for companies specializing in clinical trials with long durations (late-stage providers). While the financial performance of the CRO industry remains below historical levels, new bookings appear to be back on track and cancellations have moderated compared to the crippling amounts experienced in 2009.

Drug Spending Pullback Weighs Heavily on Early-Stage CROs
Third-quarter results from Covance (NYSE:CVD) and Charles River (NYSE:CRL) illustrated how the global pullback in drug development spending continues to hamper the near-term performance of the contract research industry. Revenue for both firms was either flat or negative year over year, on lower bookings in prior quarters, delays of scheduled study starts, and pricing pressure in toxicology caused by industry-wide overcapacity. Toxicology has suffered for some time now as macroeconomic challenges have caused drugmakers to scrutinize expenses and focus resources on late-stage candidates that offer quicker revenue potential. To address soft market conditions, both Covance and Charles River announced plans to reduce capacity and significantly lower their cost structures during the quarter. Although there remains some glut in capacity, these actions should help improve the pricing dynamics for toxicology, especially as pharmaceutical companies begin to reinvigorate their preclinical activities.

Despite these challenges, we think the current level of constrained development spending is unsustainable. Drugmakers approaching patent cliffs will need to reinvigorate their early development pipelines, and market leaders such as Covance and Charles River are well-positioned to capture an increasing portion of their R&D budgets over time. As evidence of the strength of the CRO model, Covance was selected to be the primary partner for Sanofi-Aventis (NYSE:SNY) during the third quarter. This alliance drove year-over-year backlog growth of 26%, and Covance ended the quarter with more than $6 billion in its book of business.

Late-Stage Development Shows Resilience
Late-stage development has held up relatively well compared to early-stage activities, and the third quarter saw fairly resilient performance from most firms focused in this segment. Pharmaceutical Product Development (NASDAQ:PPDI) witnessed top- and bottom-line expansion during the quarter, as a resurgence in bookings growth and various cost-control measures began to work into the firm's financial statements. Although project delays and cancellations resulted in lower-than-expected top-line growth for PAREXEL's (NASDAQ:PRXL) first quarter of fiscal 2011, cost controls allowed the company to turn in one of its most profitable periods to date. Kendle's (NASDAQ:KNDL) top- and bottom-line performance is still off year-ago levels, although the third quarter marked the first period of sequential revenue growth in more than two years. However, ICON's (NASDAQ:ICLR) third quarter came in below our expectations thanks to unanticipated losses in the firm's burgeoning central lab business.

Bookings trends suggest that the improvements seen during the quarter may be sustainable, with the major CROs' reported book/bill ratios above 1.0 across the board. Kendle recorded its highest level of net sales since the fourth quarter of 2008, and both lower cancellations and current-period sales helped net book/bill reach 1.5 (the highest level since the third quarter of 2007). Both PPD and Parexel also recorded strong gross business wins during the quarter, although client pipeline reprioritizations resulted in unusually high cancellation rates. Moreover, we are also seeing evidence among the large late-stage CROs that the pace at which new business wins will translate into revenue growth has slowed. The contract research industry is evolving into a strategic partnership model, and revenue appears to be running off more slowly than under prior individual study arrangements. A host of new long-term strategic alliances have been announced over the past year, resulting in an unusually large number of projects in start-up mode and forcing CROs to incur sizable up-front investment in infrastructure and headcount. However, we expect these headwinds to be short-lived as production levels normalize, and we believe the benefits of these strategic partnership relationships outweigh the short-term challenges.

Unsustainable Spending Levels Position CROs for Recovery
While late-stage CROs are still dealing with the growing pains associated with transitioning into a long-term strategic model, we have already begun to see improvements in revenue, profits, and future trial demand. Early-stage drug development continues to suffer, but we think the market is poised for recovery. This segment seems to have reached a trough, as evidenced by relatively stable volume and pricing over the last year. While the exact timing of recovery remains uncertain, a number of factors point to a coming normalization of demand, including the completion of several large mergers, rationalization of preclinical capacity, improved biotech funding, and the fundamental need to drive therapies through the development process. Considering the compelling value prospects offered by the CRO model, we expect drugmakers to outsource an increasing portion of their research and development budgets to a select group of preferred providers. While much uncertainty still surrounds near-term performance, we think the industry's leading players--with their global scale and therapeutic breadth--will benefit from these trends over the long run.

Shares of Charles River look especially undervalued as current trading levels seem to reflect the worst-case scenario of our discounted cash-flow analysis, which assumes almost no growth in R&D spending and continued declines in preclinical services over the next five years. We think these are unrealistically dire assumptions, and near-term uncertainty has presented investors with an attractive entry point for the stock.

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