Outsourcing Your Laboratory

The increasing cost of drug development coupled with long delays in regulatory approvals has made R&D a daunting task for small drug developers. This has opened up a new business opportunity in the form of contract research organizations, or CROs -- where companies can outsource their R&D department at a fraction of what it would cost to develop a drug in-house.

CROs now offer end-to-end research and development support starting right from drug discovery and going all the way to marketing support. New Jersey-based Covance (NYSE: CVD  ) is a leading CRO offering contract research services to leading pharma and medical device companies. Covance's stock price has jumped 76% in trading in the last 12 months, reflecting the boom in this interesting business segment.

Services offerings
Covance essentially operates through two segments: early-stage and late-stage drug development. Early-stage development includes support services for discovery, preclinical, and clinical services. Late-stage development includes central laboratory, clinical development (phase 2-4), and market access services.

Late-stage development services represent a major earnings driver for the company. At this stage, most developing biotechs with true potential -- the ones that reach the later clinical phases -- are flush with cash from external funding and other sources.

The company has strong alliances with leading companies in various research areas. It has a 10-year agreement with Sanofi amounting to $1.2 billion-$2.2 billion for early- and late-stage drug development, a $1.6 billion late-stage development program with Eli Lilly for 10 years, and a $42 million agreement with Kellogg for nutritional chemistry services. It also had alliances with Merck for genome analysis.

Opportunity for Covance in the CRO market
The industry is highly fragmented with many participants including small and medium players, despite being dominated by several high-profile companies. It ranges from large companies like Covance to small specialty firms. With increasing demand for novel therapies, especially in the orphan drug market where R&D costs are necessarily higher, companies have a growing need for lower-cost research. Overall, total spending on R&D is $150 billion -- including $75 billion for drug development, $40 billion for drug research, and $40 billion in other segments. The outsourcing research market is experiencing growth in the specialty segment as drug and medical devices manufacturers are pouring their funds into it.

Covance also generates 20% of its revenue from non-traditional activities like drug discovery, drugs R&D, post-R&D, and other adjacent markets. High penetration and strong focus on non-traditional businesses will provide more support for revenue growth in the future. Covance can capture a larger market share by focusing on the specialty segment and growing into the animal health and medical devices market.

Stable financial performance
Covance's early stage and late-stage business segments represent 40% and 60% of total revenue, respectively. Early stage services showed low growth compared to late-stage development services.

In the recent quarter that ended on June 30, late-stage services posted a 17% year-over-year growth to $378 million. The growth was driven by increased volume in central laboratories and revenue from clinical development. Early-stage revenue remained flat, and overall services revenues for the company were $592.3 million, an increase of 9.1% over the prior year. As of June 30, the company's adjusted net book-to-bill was 1.31 times adjusted net orders of $776 million, and backlog was $6.73 billion.

The company's bottom line also demonstrated significant growth in the recent quarter. At the end of the quarter, Covance is financially strong with cash balance of $446 million.

Based on the current trend across its business segments, the company should experience modest growth in early-stage development services and expects to generate around $860 million-$870 million in annual revenue between 2013 and 2015. Late-stage product development services continue to drive the company's top line performance. It is expected that the company will generate revenue of $1.5 billion-$1.7 billion annually between 2013 and 2015.

Competitive position in the CRO market
Apart from Covance, the CRO market has two leading providers: Quintiles (NYSE: Q  ) and Parexel (NASDAQ: PRXL  ) .

Quintiles provides drug development and associated laboratory services. The company operates through two segments, product development, and integrated health care services.

During the second quarter of 2013, backlog was $9 billion, and year-to-date book-to-bill ratio was 1.21 times. New business were up by 13%, around $1 billion, due to growth in product development. The company's services revenue remained flat at $944.2 million, largely due to an unfavorable currency impact. The company expects to generate revenue growth from its services by 3.8% to 5.2% and increase its adjusted earnings per share of 10.2% to 15.8% in the coming period.

Parexel offers a wide range of clinical research, medical communications, consulting, and advanced technology products and services on a worldwide basis. It operates in three segments: Clinical Research Services, PAREXEL Consulting and Medical Communications Services, and Perceptive Informatics.

During the fourth quarter that ended June 30, the company's net book-to-bill ratio was 1.21 times with new business of $559.2 million and backlogs of around $4.6 billion, up by 4.9% over the prior year. Services revenue also increased by 18% to $463.1 million as compared to prior year.

The company continues to have upside potential in clinical research services with differentiated product offerings. Parexel will generate revenue of $1.89 billion-$1.92 billion and an earnings per share of $1.95-$2.11 for the 2014 fiscal year.

Investment highlights
Covance has a well diversified portfolio of services across the early and late-stage development process. The company has a leading position in clinical laboratory services that will further enhance its offerings. Strong alliances with leading pharma companies such as Sanofi, Eli Liliy, Merck, and Kellogg provide long-term contract research services. In addition, a strong financial position provides comfortable positioning. Overall, the company has strong potential in the CRO services industry.

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