This article is part of our Rising Star Portfolios series.
I first purchased shares of the pharmaceutical industry's fourth largest contract researcher, Icon (Nasdaq: ICLR ) , for my Rising Star portfolio just last month. At the time, I cited misunderstood earnings power (on cyclically depressed earnings); the potential for lucrative cash flows from a recently signed, exclusive contract with Pfizer (NYSE: PFE ) ; the expectation that contract-researchers will capture an increasing share of pharmaceuticals' R&D investments; and Big Pharma's need to reinvest and rebuild its pipeline of drugs.
Coupled to some rock-solid competitive advantages, it seemed a pretty sure thing. And yet, amid concerns of Eurozone fall-out, a sputtering economy, and weak earnings, Icon shares have since languished, declining 15% in the time since my initial purchase. My take is this: Icon's been unfairly tagged as a "European" company, where in reality, its long-term earnings power is tied to entirely different market dynamics.
Will European fallout and a weak U.S. economy affect the company in the short run? Sure. But at today's prices, acknowledging the longer-term potential of the business, I don't think any of it matters. That's why I'm buying more, in an amount equal to 2.1% of my Rising Star Portfolio's first-year capital. As it stands, it seems that concern over the economy's state, Icon's euro affiliation, and what I believe are temporarily depressed earnings mask a great value.
An Irish company that's not really Irish (or European)
Part of what's illed Icon shares is that it's an Irish company, and 47% of its 2010 revenue derived from Ireland and Europe. But calling Icon Irish -- or even European -- is like calling drugs an entirely American invention. Icon's revenues derive from global pharmaceutical and biotechnology companies' R&D expenditures, which in the long run should bring more growth in patient expenditures.
A sputtering U.S. economy and Eurozone meltdown would affect Icon's near-term fortunes, but a little context is appropriate. Consider: Even after the credit crisis roiled markets and global R&D expenditures contracted, Icon's revenue grew 4% from 2008 to 2010.
Taking a longer view, I think the possibility of weakened economies and recently lower returns on R&D investment at Big Pharma actually strengthens Icon's hand. Pharmaceutical companies will seek the most capable strategic partners and cost savings in response, and contract research organizations with global patient networks, deep experience conducting trials, and relationships are best able to deliver some combination of cost savings and accurate, timely trial outcomes. Icon, as the fourth largest CRO, delivers on these counts.
My take is this: Even if global R&D investments contract, it's likely to grow -- as outsourcing penetration grows (as a percentage of total R&D expense) and premier CROs' market share of total outsourcing dollars grows. So-called "global CROs" comprise 35% to 40% of R&D expenditures, and outsourced R&D has another 35% to 40% share of the addressable market. By that measure, even if R&D outlays decrease 15%, and global CROs' market share increased to 60% of outsourced R&D (as outsourced R&D grows to 60% penetration), Icon's revenues could more than double in ten years.
Underpriced earnings power
As I mentioned in my original write-up, Icon's margins have recently suffered, and mightily, as the company's upped its staffing levels, to meet demand from a recently signed strategic, exclusive agreement (shared with CRO heavyweight Parexel (Nasdaq: PRXL ) ) with Pfizer (NYSE: PFE ) and higher R&D investments across the industry. Thus far, it's not come.
The Street hasn't treated the shares too kindly in response. I see one of two outcomes: If demand doesn't recover, it can cut staff, and margins will pick up. But if demand does recover, then so too will margins. I don't think there's a long-term risk to Icon's earnings power, but the market's pricing it that way. That weighs to our advantage: Icon shares trade hands at 12 times my estimate of normalized free cash flow.
Rumors are that Carlyle Group's been nosing around Pharmaceutical Product Development (Nasdaq: PPDI ) , weighing a buyout after the company put itself on the block. And what's attractive in Pharmaceutical Product Development doubles for Icon: deep patient networks, global expertise, and deep relationships. Moreover, with some 19% of its market cap in cash, a debt-free balance sheet, and depressed earnings, Icon certainly looks the part of a private equity investment. And while hardly a certainty, the potential is a nice kicker.
Add it up
Icon shares might not appreciate tomorrow, and they might decline more before they go up. But here, I see a rare value: a secular growth story at a stellar valuation. That's why I'm back for seconds.
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