Icon Plc (NASDAQ:ICLR) is an Ireland based contract research organization that manages clinical trials for global drugmakers. The contract research industry is quickly consolidating as it shifts from a market dominated by small niche players to large companies offering global scale.
Icon's already a big player in the clinical trial industry, but it's far from the biggest. That suggests that larger CROs including Quintiles (NYSE:Q) and Covance (NYSE:CVD) may find that an Icon acquisition makes sense, particularly given its tax friendly status.
The benefit of inversions
Rising political scrutiny is increasing the urgency for companies interested in inversions. The tax reducing strategy has caught the attention of regulators worried over losing billions in tax revenue from companies shifting headquarters abroad.
That worry may translate into a tightening of regulations governing tax inversions that could ultimately derail future deals.
Currently, companies are accomplishing two shareholder friendly things by doing inversions: they're reducing taxes and putting cash held abroad to work.
Here's how it works: A company like Medtronic (NYSE:MDT) inks a deal to buy the Ireland based Covidien, allowing it to put to use billions in cash held abroad that if brought back into the U.S. would be heavily taxed. Medtronic provision for income taxes totaled $640 million last fiscal year on $17 billion in sales, and Medtronic and Covidien's effective tax rates are roughly 18% and 15% per year, respectively. That suggests that shifting Medtronic overseas for tax purposes could save shareholders around $95 million a year.
While that's good news for investors, it's not good news for the Treasury's war chest. In response, Washington is considering changing regulations that currently say that the acquiring company's ownership of the new entity can't be more than 80%. Under the proposed changes, that ownership would be limited to just 50%, meaning that acquiring companies would effectively have to buy companies bigger than they are to still qualify for inversion. Faced with that hurdle, a flood of inversions could be coming by year end before new regulations take effect.
Potential benefit for CROs?
One of the industries that may benefit from acting ahead of regulators may be contract research organizations.
Facing the patent cliff, big drugmakers are increasingly embracing R&D outsourcing to cut costs. That has helped the CRO market jump to $13.6 billion, up 10.2% from 2011.
CRO demand should continue to grow given that drugmakers are targeting margin-friendly orphan disease and biologics, two areas of research that are both complex and costly. Drugmakers' interest in emerging markets and a flood of public and private funding for biotechnology companies should also translate into revenue growth for CROs.
If so, sales at Quintiles, the largest CRO, could continue to climb. Quintiles already helps more than 400 drugmakers worldwide and more than 65% of its sales are generated abroad. That global reach has the company expecting to deliver over $4 billion in revenue this year, but Quintiles will pay a stiff tax on that revenue given that Quintiles' effective tax rate hovers around 30%.
Covance is another large player in the global CRO market, with $2.4 billion in revenue last year. Like Quintiles, Covance gets a big chunk of its annual sales abroad. About 53% of its revenue was generated internationally last year, including 16% in emerging markets. Overall, Covance's effective tax rate was 21% last year.
Given that these CROs are generating considerable sales abroad and have significant tax bills, it wouldn't be shocking to think they may be looking at inversion strategies.
If so, Icon may be one of the companies that acquirers could be considering. Icon's sales climbed 20% to $1.3 billion in 2013 and Icon expects sales could reach as high as $1.54 billion this year, translating into earnings per share that could total as much as $2.40. Importantly, Icon's effective tax rate is just 15%, which is significantly lower than Quintiles and Covance.
Fool-worthy final thoughts
Investors shouldn't buy companies solely because they may or may not become acquisition targets. Instead, it's best to focus on solid business models that are producing solid and profitable growth. That said, Icon operates a growing business in a growing market and offers tax friendly advantages that may make it attractive to suitors. And for those reasons, I think it's an intriguing opportunity that merits a closer look.
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Todd Campbell has no position in any stocks mentioned. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may or may not have positions in the companies mentioned. Todd owns Gundalow Advisors, LLC. Gundalow's clients do not have positions in the companies mentioned. The Motley Fool owns shares of ICON plc (ADR) and Medtronic and recommends Covidien. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.