(By Lauren Migliore, CFA) The contract research organization industry is shifting away from contractual trial-by-trial arrangements toward long-term strategic alliances between the Big Pharma firms and drug-development service providers. We think this new strategic partnership model--which is resulting in both increased outsourcing penetration and market share gains for the industry's leading players--will fuel strong demand for the top-tier CROs. Strategic partnerships also increase the stickiness of client relationships, which we believe creates a positive moat trend for these narrow-moat firms. Though these secular tailwinds have resulted in improved earnings and rising valuations for CROs and investors, we still think some opportunity remains for firms like Icon (ICLR) and Charles River Laboratories (CRL), which have yet to fully participate in the CRO recovery.
Strong Book/Bill and Double-Digit Backlog Gains Bode Well for Continued Growth
We think the CRO industry rebound is in full swing, as evidenced by a resurgence in new business activity and revenue growth during the past 18 months. Increased outsourcing penetration and market share gains among the largest CROs are behind these strong new business wins. After steep declines in 2009, the widespread top-line growth that began last year has persisted throughout 2012. On average, we expect the CROs we cover to increase revenue 12% this year. Encouragingly for future growth, firms continue to turn in book/bill ratios greater than 1.0, and new strategic alliances have begun to contribute meaningfully to revenue. 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 this return to growth. Top-tier CROs, which historically have employed a transactional model to contract with clients on a trial-by-trial basis, are now being pursued by Big Pharma firms as strategic partners in drug development. CROs are being brought to the table earlier in the clinical trial design process, and trials are increasing in size, complexity, and global breadth.
Revenue Growth Translates Into Earnings Gains as Resource Buildups Ebb
Though CROs' top lines began to accelerate in 2011, many firms experienced a significant lag before revenue gains began to benefit earnings growth. Resource buildups to support recently signed partnerships, which require substantial new costs without an immediate increase in compensating revenue, had weighed most prominently on earnings for ICON and Parexel (PRXL) after being named as the two strategic partners of Pfizer last May. After going on a hiring spree in order to support the higher expected future business tied to new large-scale strategic partnerships, it seems Parexel is finally beginning to reap the benefits of positive operating leverage as double-digit revenue gains outpace expense growth. Similarly, ICON is witnessing robust earnings growth following its third-quarter 2011 low of only $0.02 per share. ICON brought on more than 700 new staff members to build up its infrastructure in anticipation of new clinical trial work from Pfizer, and we expect margins to continue improving as partnership revenue offsets these increased expenses. We expect 2012 results to come in at twice last year's levels, and we think earnings are set to rise another 50% next year. As a whole, CRO profitability has improved substantially this year, and we expect earnings to only accelerate as partnerships mature and productivity improves further. Furthermore, aggressive cost cuts and share buybacks during the past few years should also help earnings outpace revenue growth for the foreseeable future. Conversely, though we think Chinese CRO WuXi (WX) is well positioned to benefit from the dual tailwinds of increased outsourcing and offshoring of drug-development activities, revenue gains will continue to outpace earnings growth amid rising costs in China.
Strategic Partnership Model Strengthens Moats for Late-Stage CROs
The contract research organization industry appears finally to have emerged from a prolonged slowdown in drug-development spending. CROs dramatically cut costs and development time for drugmakers while also allowing companies to shift to a variable-cost structure, focus on their core competencies of drug discovery and marketing, and better adapt to regulatory changes. As cutbacks continue at major pharmaceutical firms to cope with impending patent losses, we expect the cost advantages of outsourcing to persuade Big Pharma firms to hand over an increasing portion of their drug-development work to CROs. Furthermore, only a few top-tier contract research providers have the necessary expertise and infrastructure to conduct large clinical trials around the world. With drug-development outsourcing rates expected to increase, we think these firms will continue to gain share at the expense of smaller competitors. Therefore, even if R&D spending growth remains flat, we expect increased outsourcing penetration, market share gains by global CROs, and expansion into emerging and adjacent markets (such as biosimilars) to drive strong growth for the sector's major players.
The CRO industry is shifting away from contractual trial-by-trial arrangements toward long-term strategic alliances between the Big Pharma firms and drug-development service providers. We see strategic partnerships as a symbiotic new model. By winnowing their lists of providers, pharma firms are better positioned to take advantage of volume rebates based on clinical trial work. For the CROs, strategic partnerships primarily offer growth benefits through their potential to increase the market share of the top providers. Strategic partnerships also increase the stickiness of client relationships, create more stable cash flows through long-term contracts, and result in further scale advantages for top-tier players over their smaller counterparts. Covance (CVD), first and foremost, as well as Parexel and ICON, has been at the forefront of signing large-scale deals with some of the world's largest drugmakers, and we believe the new strategic partnership paradigm is strengthening the competitive advantages of these CROs. Conversely, though we believe Charles River will continue to benefit from the secular trend of increased outsourcing, we don't think it has improved its competitive advantages, based on its concentration in early-stage development (which is less conducive to large-scale deals) and history of poor execution.
We Think There Is Still Some Upside Potential for ICON and Charles River
The CRO recovery has translated into share price gains, and our CRO coverage universe now trades at less than an 11% discount to our fair value estimates (versus around 35% at this time last year). We think rising valuations validate our long-held belief that the slowdown in drug-development spending was temporary and that the value proposition offered by these top-tier CROs eventually would woo a greater share of R&D dollars from drugmakers. Our outlook for the industry remains bright, and new strategic partnership announcements could provide additional upside to our fair value estimates.
Though ICON trades at just a 14% discount to our fair value estimate, we think there is still some upside potential as earnings continue to improve going into 2013. The Pfizer partnership is expected to begin contributing meaningfully to revenue in the current quarter, and the firm's formerly unprofitable central lab division is on the mend. We think the firm will return to double-digit operating margins by the second half of next year as it leverages its new staff and infrastructure across an expanded revenue base.
Charles River has yet to come near our fair value estimate of $50 per share. Though we have concerns regarding the past capital-allocation issues and the uncertain timing of preclinical drug-development demand recovery, the firm's valuation remains compelling. Charles River's operations are divided into two segments: research models and services, which is a highly profitable and stable business, and preclinical services, a much more volatile segment with potential for considerable growth, in our opinion. Preclinical services have fared poorly in recent years as clients try to eliminate molecules earlier in the drug-development cycle and focus R&D spending on late-stage candidates closer to approval.
Unlike the strong demand witnessed by clinical-stage providers, early-stage drug demand has yet to recover, and we think Charles River's preclinical services franchise could provide substantial upside for investors as demand comes back on line. In the meantime, the company has been able to lean on its research models and services business to stabilize earnings and provide a floor for its depressed valuation.
Given the extremely volatile nature of early-stage demand in recent years, we are hesitant to call the exact time of the preclinical rebound. However, a large amount of capacity has not been removed from the system. We expect conditions to gradually improve next year and regain full steam in 2014 and beyond because of the fundamental need to drive new therapies through development.