By David Krempa
Top-tier clinical research organizations possess strong competitive advantages that should allow them to take an outsize share of the rapidly growing market for outsourced research and development. Specifically in the late-stage business, we believe CROs' global scale, depth of data and expertise warrant narrow economic moats. Despite our expectations for low-single-digit growth in global biopharmaceutical R&D spending during the next five years, increased outsourcing penetration and market share gains by top players should drive 10% compound annual top-line growth for the CROs we cover: Quintiles (Q), Covance (CVD), Parexel (PRXL), ICON (ICLR), Charles River (CRL), and WuXi (WX). Margin expansion from operating leverage and better asset utilization will create an even more pronounced impact on the bottom line, where we expect a 21% five-year compound annual growth rate for earnings per share, slightly faster than the Street's consensus estimate of a 17% CAGR.
Big Pharma Partnerships Validate CROs' Value Proposition
Big Pharma's increased outsourcing and willingness to sign long-term partnerships is a validation of CROs' value proposition. We believe CROs can add value to the drug-development process for pharmaceutical firms big and small, primarily by improving on the cost, speed or success of drug development.
Better asset utilization at CROs leads to lower development costs. With small biopharmaceutical firms, cost savings from outsourcing can be enormous. By outsourcing discovery and development, capital-constrained firms do not need to make the significant investments necessary to acquire facilities, equipment and staff. However, even at larger firms with existing infrastructure, CROs can often reduce costs through more efficient asset utilization. Clinical trial demand at pharmaceutical firms tends to be lumpy and can result in significant downtime. CROs are able to maintain full-time staff and facilities all across the globe, even in situations where it would be cost-prohibitive for a pharmaceutical firm to do so.
Pharmaceutical firms looking to conduct trials on their own either have to quickly hire employees when there is demand for a trial, or maintain permanent employees who would see low utilization and would be a cost drain during downtime. Trying to hire on demand results in weaker talent (good talent is already locked up), delays (it can take weeks or months to hire workers), and/or higher expenses (contractors can be hired quickly but charge a premium).
In early-stage trials, the savings can be even more profound due to the asset-heavy nature of the business. These facilities typically run at low capacity under Big Pharma, but CROs are able to pull business from numerous different pharmaceutical clients to fill up the facility and operate at more efficient levels.
Existing patient and investigator relationships lead to faster enrollment and drug development. Covance CVD estimates that more than 50% of clinical trials do not meet their timeline or size targets for patient enrollment. CROs are able to help give firms the best opportunities to hit their goals. The biggest opportunity for time savings in the drug-development process is through faster patient enrollment in trials, but CROs also aid sponsors in strategic planning, getting trials approved by regulators and data aggregation and analysis. CROs have accumulated patient databases as well as relationships with and performance data on regulators and investigators across the globe, all of which allow CROs to strategically advise clients which specific locations in the world and which investigators are most likely to deliver the necessary number of patients as quickly as possible. Since the patent clock begins ticking while a drug is in development, getting a product to market even a few months ahead of schedule, or avoiding a delay, can translate into huge financial gains for a sponsor.
Pharma firms benefit from CROs' experienced and specialized talent. By outsourcing to CROs, pharmaceutical firms are typically able to benefit from more specialized and experienced talent that can help with strategic decisions and trial design. Many pharmaceutical firms may not have enough demand to keep a full-time team dedicated to specific niches, such as regulatory affairs in Poland, or a rare form of cancer, but the CRO will have experts in those fields.
Top-Tier CROs Earn Moats Primarily Through Attractive Late-Stage Businesses
We believe competitive advantages are strongest in the late-stage businesses, where the need for global scale limits competition to only the largest CROs. By contrast, in the early-stage business, there are fewer barriers to entry, significantly more competition and the asset-heavy nature of the business weighs on returns on invested capital.
In the late-stage (Phase II and III) drug-development business, there are few global competitors, minimal invested capital is needed, and there are numerous ways for CROs to add value to the development process and command a premium price. The asset-light nature of the business makes CROs essentially consultants to the sponsor (pharma/biotech client). CROs advise and help clients with all aspects of the trial, including planning the size and structure of trials and comparator drugs to use, submitting the trial for regulatory approval, choosing geographic regions and investigators to use, enrolling patients, collecting and analyzing data, and completing applications for regulatory approval.
The biggest factor driving CROs' moats is their global infrastructure, which creates a cost advantage over smaller competitors. Phase III trials usually require thousands of patients and frequently take place across many geographic locations. Sponsors need a CRO with the expertise in all local country cultures, government relations and with physician/investigator relationships. We believe the competition for these global contracts is limited to just the six largest CROs.
A secondary moat source for CROs is the intangible assets of their expertise, data, and reputation. CROs are able to maintain experts on numerous different niche areas all across the globe. They have experts in disease treatments as well as constantly evolving local government regulations, which helps sponsors choose exactly where to locate trials based on the type of disease it is targeting. CROs' data and experience in thousands of trials help clients position their trials for the highest probability of success. CROs are not able to record proprietary data on their clients' specific drug interactions and results, but they are able to retain data on enrollment in specific regions and investigator sites, which CROs use to advise future clients on site selection. CROs' data can also be used to predict more accurate timelines, which can lead their sponsors to savings in other functions such as manufacturing.
Pharmaceutical and biotech firms will also award contracts based on the brand and reputation of a CRO, giving an additional advantage to established players. Regulators put clinical trials under intense scrutiny, and even the slightest error or abnormality in a clinical trial can cause regulators to reject a drug or require a new trial. Sponsors want to see existing infrastructure and a long and successful record from a CRO before putting the future of a potentially billion-dollar asset in its hands. Although the physical barriers to entry are small, a new CRO would have a challenge convincing pharmaceutical firms to trust it with their highly valuable assets.
Expected quality and speed, not price, are the primary decision drivers when sponsors award work, allowing top-tier CROs to charge a premium. Sponsors are willing to pay a premium to increase the chances that their trials will get completed on time and that data will be recorded accurately with all protocols followed. Less financially secure biotech or pharmaceutical companies may be tempted to use smaller CROs that try to undercut on price and overpromise enrollment sizes and timelines in an attempt to win business, but these CROs have a much higher likelihood of failing to enroll the number of patients they had promised, which results in significant delays and often requires another CRO to come in and rescue the trial. The risk/reward trade-off of choosing a smaller CRO to save a little money is rarely appealing.
In drug development, speed is paramount. Patent law puts drug developers in a constant race against the clock. In the United States (and most developed countries), drug patents begin when the new molecule is discovered, so a significant amount of the patent life is eaten up during clinical trials. Getting a product to market faster gives the sponsor a longer period to monetize the product. Timelines vary by size and complexity of trials, but it typically takes 3-12 months to pick investigator sites and get a trial approved by local regulators and another 3-12 months to enroll patients. We believe a top-tier CRO could easily shave a few months off the process compared with a weaker competitor or a less experienced pharmaceutical firm. Even an improvement of a few months in the total process would yield huge benefits for the sponsor. For a blockbuster product, even after discounting profits back for 15-20 years, an extra three months could mean tens or even hundreds of millions of dollars' worth of present value.
In early-stage R&D (drug discovery, preclinical testing and Phase I trials), there is heavy competition and very little differentiation among CROs, and we believe it is largely a no-moat business. We believe pharmaceutical firms largely outsource because it is cheaper, not because the CROs are able to do the work better or faster than they would in-house. CROs can utilize facilities better than pharmaceutical and biotech firms, but it is a largely commoditized service where there is little opportunity for CROs to differentiate from their peers.
Despite heavy early-stage exposure, we award Charles River a narrow moat due to the strength of its research model segment. The segment, which breeds animals to be used in preclinical testing, enjoys significant competitive advantages. The complexities surrounding breeding animals without contamination create a significant barrier to entry. Because of its advantages, Charles River controls an estimated 50% share of the market and has been able to maintain consistent operating margins of 30%, even during the preclinical slowdown.
Shift to Strategic Partnerships Creates Positive Moat Trends for Late-Stage Players
Historically, outsourcing took place on a project-by-project basis, which opened the bidding process to hundreds of CROs. Now, Big Pharma is looking to partner with just one or two CROs to handle its entire pipeline, limiting the pool of potential CROs to global players. According to Pfizer's (PFE) global head of development operations, Pfizer has reduced the number of CRO partners it uses from 17 to just two (Parexel and ICON). In addition to limiting the pool of competitors, partnerships are leading to longer contracts and are bringing CROs deeper into sponsors' drug-development processes, creating stickier customers and higher switching costs.
Big Pharma sees numerous benefits to working closely with just one or two CROs. Despite less competition for bids, pharma firms are able to negotiate slightly lower prices by committing to the strategic partnerships. Big Pharma also reports greater efficiency and savings from lower staff levels on its end because going from dozens of different CROs to just two requires fewer relationship and project managers and allows for greater consistency in data reporting.
The shift to strategic partnerships has subjected CROs to lower prices and higher customer concentration, but we believe the transition is a net positive for top-tier players and is strengthening their competitive advantages. Pfizer said it believes there are only six CROs with the global presence to handle a strategic partnership of that size. CROs are forced to accept slightly lower prices, but we believe that will be offset by increased volume and more predictable work flow, which will allow CROs to better manage facility and staff utilization.
With these strategic partnerships, CROs have partially bet their futures on the success of their partners' pipelines. The deals typically guarantee the CRO a certain percent of the pharma firm's total outsourced work, but if the pharma pipeline faces failure or success, it will flow directly through to increases or decreases in the CRO's workload. The firm most at risk is ICON, which now receives 23% of its revenue from its largest customer (Pfizer), up from just 9% in 2009. However, our optimistic view of Pfizer's pipeline helps ease our concerns.
For early-stage companies (Charles River and WuXi) we do not anticipate any material changes in the competitive landscapes, so we think their moats are stable. We have seen an increase in strategic partnerships taking place in early-stage services, but not to the same degree as the late-stage partnerships. Even if we saw a massive adoption of long-term exclusive partnerships, it would be unlikely to increase the firms' competitive advantages because it would not reduce the number of competitors as it has in the late-stage market, where global infrastructure is necessary.
Despite the long-term nature of partnerships and our belief that competitive advantages are strengthening, we do not believe the industry warrants a wide economic moat. Long-term contracts have created greater visibility into long-term earnings, in some cases even up to 10 years; however, there are roughly half a dozen competitors that provide a comparable service, so there is no guarantee that pricing will remain rational for the next 20 years.
Trifecta of Tailwinds Should Drive Top-Line Growth at Late-Stage CROs
We project rapid top-line growth for the late-stage development CROs we cover - Quintiles, Covance, ICON and Parexel - fueled by slight increases in global R&D spending, greater outsourcing penetration and market share gains among the top players.
We expect modest 1.1% growth in global R&D spending during the next five years. Our projection is based on a bottom-up analysis of the largest 18 global biopharmaceutical firms we cover. We aggregate Morningstar's 10-year explicit forecasts of R&D spending to arrive at a market estimate. These firms make up a combined $78 billion in annual R&D spending, or nearly 70% of the estimated $115 billion in global R&D spending, which we believe is a good proxy for the global R&D environment.
Also, CROs are handling a growing share of global drug-development spending. Patent cliffs helped accelerate that trend during the past few years, as they pressured pharmaceutical firms to cut costs where possible, and we think positive experiences with CROs in strategic partnerships will drive further outsourcing.
Based on publicly disclosed information from companies and third-party sources, we estimate that approximately $80 billion is spent each year on drug development and $35 billion is invested in drug discovery. Of the $80 billion for development, we believe approximately $26 billion, or 32.5%, was outsourced last year. We expect the outsourced penetration rate to increase to 43% by 2017. This increased penetration rate would create a 5.8% CAGR for the industry even absent any growth in global R&D spending. Based on our expectations for 1.1% growth in R&D spending, we forecast the total CRO market to grow at a 7.0% five-year CAGR.
Long term, we expect approximately 55%-65% of development spending to be outsourced. We believe that as Big Pharma firms get more comfortable with strategic partnerships, eventually they will outsource the majority of development spending. A number of factors will limit this from approaching 100%. For one, Big Pharma firms have shown a desire to keep some internal capabilities so that they are not completely reliant on CROs. Sponsors will also always have internal R&D employees such as doctors and scientists on staff advising on drug candidates, strategic decision-makers, project managers that manage CROs, and various other necessary functions. Processes such as drug manufacturing and logistics are also likely to remain largely in-house.
The third driver of growth will be the ongoing shift toward strategic partnerships that will allow market share gains for the large CROs. We expect all four late-stage players we cover to gain share during the next five years. Usually a sponsor won't disrupt currently ongoing trials when it awards a new partnership, so it may take years before the new partner realizes the full benefit of the partnerships. We expect market share gains to come from both the maturing of current partnerships as well as the initiation of new ones. We expect the market share from these four players to increase from 25% in 2012 to 31% by 2017, which would provide a five-year CAGR of 3.6%, even assuming no growth in R&D spending or penetration rates. Combined with the 1.1% global R&D spending growth and the increased outsourcing penetration, we expect the big four CROs in our coverage universe to see 11% growth in their late-stage business segments.
Consistent book/bill ratios above 1 confirm the strong growth outlook for the sector. Although book/bill ratios are not a perfect indicator, they can offer directional guidance on growth prospects. Since bottoming in 2009, book/bill ratios have been consistently above 1.0 for all four late-stage players, signaling strong growth prospects across the industry.
Operating leverage and partnership maturity should lead to even faster earnings growth. Margins have already started rebounding from trough levels, but we believe there is still room for significant margin expansion across the industry.
For early-stage firms, depressed margins have largely been the result of over capacity. Double-digit sales growth in the early 2000s led to constant shortages of early-stage capacity. Banking on double-digit growth continuing over the long term, CROs rapidly increased capacity, which ultimately proved to be a poor use of capital. When demand finally started slowing, caused by a combination of the financial crisis drying up funding and Big Pharma patent losses causing firms to slash early-stage investments in favor of late-stage opportunities, firms were still bringing additional capacity on line.
In the late-stage business, the key to profit margins is managing staff levels. At Parexel and Icon, margins have come under pressure as recently signed partnerships forced the firms to drastically increase staff levels before revenue started flowing in. We expect margins to increase considerably in the coming years as the partnerships reach their full pace.
While gross margins have come under pressure because of the staffing issues, revenue has continued to grow across all CROs, allowing most firms to leverage selling, general and administrative costs. Parexel and ICON have made significant strides through a combination of natural operating leverage and restructuring activities. The two firms have seen a decrease in SG&A costs of 500 basis points and 290 basis points, respectively. With these significant SG&A improvements, the firms need just a slight improvement in gross margins to return to pre-crisis operating margins. If gross margins were to return to levels anywhere near pre-crisis levels, operating margins would far exceed peak margins. Covance's SG&A spending has actually deteriorated since the firm hit peak operating margin in 2008. The discrepancy from its peers is partially due to the firm's heavy reliance on the early-stage market, where revenue has not yet rebounded, but is also due to Covance's reluctance to restructure and reduce its staff. The firm has made small job cuts where it closed facilities, but management has been strongly opposed to layoffs.
ICON and Quintiles Offer Most Attractive Opportunities in Industry
As the Pfizer partnership matures, we expect ICON to post the fastest earnings growth in the group during the next five years. However, the firm trades at a discount to its late-stage peers Covance and Parexel, based on a multiple of 2014 earnings. As one of the smallest players among the top tier, ICON will see bigger upside benefits from new deals than any of its peers. As we think deals will increasingly be awarded to just the big six CROs, ICON is likely to see the biggest benefit. We believe the market is overestimating the risks surrounding ICON's heavy reliance on Pfizer. Although Pfizer provides more than 20% of revenue, the risk from product failures (Phase II products failing and not entering Phase III, resulting in less business for ICON) is no higher than it would be with a more diverse revenue base, since pipeline success probabilities are independent. The larger risk would be Pfizer changing its strategy and outsourcing less, or switching to a new CRO. We believe partnerships will create sticky relationships, resulting in very high contract renewal rates and a high probability that Pfizer renews its contract with ICON when it expires in 2016.
Quintiles is the clear leader in the CRO industry. The firm's late-stage sales are more than twice the next-largest competitor, and we also believe it has the best talent and expertise in the industry. Quintiles' size puts it in contact with more clinical trials than any competitor, making it the go-to CRO for the most complicated and expensive trials. Quintiles worked on all of the current top 20 best-selling biologic products and approximately 75% of all oncology products approved over the past decade. As CROs get more deeply ingrained in the decision-making process with sponsors and are relied on for their expertise more than just their ability to complete a task, we think Quintiles will be sought out. The firm's large size means it is likely to grow at a slightly slower rate than its peers, but we believe investors are being more than compensated by the stock's lower valuation.
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