This article is part of our Rising Star Portfolios series.
A day-in, day-out cash cow, Big Pharma was once the favored domain of scientist-types and highfalutin MBAs. But in recent years, thats changed. Blockbuster drugs poised to lose patent protection and declining returns on R&D investment have prompted increasing focus on cost-containment at Big Pharma.
The best contract-research organizations, effectively outsourced R&D shops, have benefited where pharmaceuticals suffered. Although they're great businesses, they've never been particularly cheap against their prospects. But today, Icon (Nasdaq: ICLR), the world's fourth-largest contract-research organization, is. I'm buying a position worth 4.4% of my Rising Stars Portfolio's first-year capital. Mispriced earnings power coupled with a competitively advantaged business and powerful secular tailwinds provide the makings of a healthy investment.
Patently positioned
The contract-research organization (CRO) business evokes a Dickensian tone of haves and have-nots, where global scale and reputation separate the best. Icon, as the fourth-largest CRO, sits among the global elite -- a claim reinforced by a recently signed strategic contract with Pfizer (NYSE: PFE), designating it and fellow CRO Parexel (Nasdaq: PRXL) as the pharma giant's preferred clinical-trial providers.
As the bridge between drug development and the market, late-stage CROs (those that test drugs nearer to FDA approval) deal in sensitive matters: Drug trials require access to global patient populations to ensure biologically and statistically diverse trials, as well as experience navigating complex regulatory pathways. Accordingly, a reputation for quality work matters.
Building these capacities requires large investments, creating sizable barriers to entry. As organizations gather reams of data over the years, economies of knowledge enable them to more effectively navigate regulatory challenges, understand the science of drug compounds, and more effectively manage R&D costs for customers. Icon has 'em, in spades.
Practically speaking, that means CROs with global scale and deep experience -- Quintiles, Pharmaceutical Product Development (Nasdaq: PPDI), Parexel, Covance (NYSE: CVD), Charles River (NYSE: CRL), and Icon -- become more competitively advantaged over time. They win more business and are better able to reduce costs while making more money than smaller competitors doing it. The largest players benefit from a virtuous cycle, where success begets success.
Secular tailwinds, near-term headwinds
That said, it's not been easy going for Icon, courtesy of a double-punch on recent earnings miss and the credit crisis' still-evident cuts. As uncertainty lingered around health-care legislation and the economy's state in 2009, pharmaceutical companies slashed R&D spending and cancelled contracts with CROs. This, coupled with recently higher staffing costs in anticipation of improving demand and the Pfizer contract (which contributed to a second-quarter earnings miss), pushed operating margins from 13% in 2009 to 7%, at current. But for the apparent ugliness, I'd classify this as opportunity masquerading: I think the market's mispricing Icon's earnings power.
Outsourcing penetration sits at 35% to 40% of a roughly $60 billion market opportunity, according to data from Jefferies, Goldman Sachs, and IMS Health. Of that, global CROs' share of the market is 35% to 40%, depending on how you slice it. Looking forward, I'd expect the biggies to capture increasing market share, as pharmaceutical companies emphasize return on investment -- and seek to align their organizations with the best-positioned CROs. For Icon, it's hard to see this as anything but good.
Then consider $106.9 billion worth of annual, branded drugs sales coming off patent between 2010 to 2020. Pharmaceutical companies need to reinvest, to build their pipelines and find the next generation of drugs. Moreover, the health-care legislation left Big Pharma relatively unscathed, in my opinion, making it safe to spend on R&D again. These factors, in addition to Pfizer contract revenues, should contribute to improving capacity utilization, and higher margins, at Icon's labs.
By my math, the market's pricing some combination of the following: Icon fails to capture R&D market share, continuously declining R&D spend at pharmas, or permanently depressed margins. I just don't believe that's happening.
What's it worth?
With this in mind, I expect Icon to grow its revenues at about a 9% clip, and operating margins to recover to 13% within two years. While Icon's a global enterprise, and its revenues are not unduly exposed to a single country's health, it is domiciled in Ireland. I'd expect that a consequence of Ireland's fiscally unfit condition is higher taxes, and so I've modeled for Icon's annual tax rate to increase to 25%. On this basis, I estimate that the shares are worth $35.
That comes with a kicker: There's a chance Icon won't remain a public company. Private-equity buyers have shown a certain zeal for CROs of recent. One of Icon's lesser peers, Kendle, was taken out at a 61% premium in May. The industry's golden child, Pharmaceutical Product Development, recently put itself on the block, and rumors of private-equity interest swirl. Icon, with $215 million in cash on the books, could also be an ideal candidate.
Bottom line
What's healthy for people, and pharmaceutical companies' bottom line, could also be healthy for your portfolio. Icon matches a first-rate business to a great valuation, and that's why I'm buying. Join me on my discussion board to talk about it.
