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Research Outsourcing 2.0: Stabilization of the industry and early stages of recovery in demand
The Contract Research Organization (CRO) industry continues to show signs of improvement, following the low point in the second and third quarters of 2009. CROs had been on an impressive growth track prior to the downturn in 2009, when bookings and revenue dropped sharply as a result of project delays and cancellations stemming from the large pharmaceutical mergers and a weak biotech funding environment .The closing of the Pfizer (PFE)/Wyeth and Merck (MRK)/Schering-Plough mergers has helped removed a significant overhang from the pharma outsourcing side of the business, and there has been some relative improvement in biotech funding.
Although there have been positive signs throughout the industry, the improvement remains varied across different segments. The recovery in the Clinical business, where most of the large CROs like Pharmaceutical Product Development (PPDI), PAREXEL (PRXL), ICON (ICLR), and Kendle (KNDL) have a significant presence, has clearly been stronger than in Preclinical and Discovery. This can be attributed to the relative improvement in Pharma outsourcing (which has a greater impact on Clinical) compared to biotech, and a larger percentage of biotech outsourcing going towards less-risky, clinical projects.
Late stage CROs have posted two consecutive quarters of solid (above 1.0) book-to-bill ratios (gross bookings minus cancellations divided by revenue). Indeed, the average book-to-bill ratio for the first quarter was more than 1.2, with PAREXEL posting an impressive 1.6 ratio. Meanwhile, the outlook for demand has continued to improve, while cancellations, which have been a major issue for CROs, should moderate. Cancellation levels spiked in 2009 (as a percentage of backlog, bookings, and on an absolute basis), but have begun to return to normal levels, with the closure of the pharmaceutical mergers and declining project rationalization. However, project delays are still occurring at high levels, adding some volatility and uncertainty to quarterly booking trends, and it may still take some time for Pfizer and Merck to fully integrate acquisitions and move ahead with typical outsourcing plans.
At the same time, preclinical demand has exhibited few signs of an early recovery. Charles River Laboratories (CRL), and to a lesser degree Covance (CVD), generate a large portion of their overall revenue from early-stage services. The ongoing pipeline rationalization at pharma and biotech firms, with an emphasis on more-advanced projects, presents a challenge for the early-stage businesses. Meanwhile, overcapacity is also a headwind, with the related pricing pressure likely to weigh on profitability. Yet, there have been some positives in the early-stage space, with Covance reporting a solid 1.2 book-to-bill ratio in the recent quarter. However, we believe that it may take longer for smaller early-stage companies to see a substantial pickup in bookings.
Investors have responded favorably to the early recovery in industry demand. Shares of many CROs began to rise near the end of 2009 and into 2010, as money poured in early in anticipation of improving demand. The sector outperformed the broader market in early 2010, though the performance varied among the publicly traded CROs. PAREXEL was the most notable performer, with shares soaring nearly 70% during the first three months of this year, partially reflecting its strong industry position, with the broadest international presence, and diversified service offerings. More important, the company has the most significant leverage to an improving bookings forecast, due to its unique margin expansion opportunity. Indeed, even considering recent margin gains, PAREXEL’s margins are still only half of some of its competitors, and with recent cost-cutting, the company is positioned for sharply higher profitability, as the top line improves.
However, investors may have gotten ahead of themselves with respect to this sector, considering that the improvement has been relatively modest thus far, and certain segments remain under pressure. We believe that the industry recovery will progress at a reasonable pace, and are encouraged by recent results. Yet, we expect some bumps along the way, and look for greater divergence in the results and share price performance of individual companies.