This article is part of our Rising Star Portfolios series.
I first bought shares of Icon (Nasdaq: ICLR), the fourth-largest late-stage contract research organization, for my Rising Stars portfolio on this premise: It's a competitively advantaged business suffering short-term travails, tethered to some mighty secular tailwinds -- drugs and outsourced R&D. The shares have since taken a serious beating, as CEO Peter Gray announced his retirement, and concerns over the eurozone's debt crisis and a stagnant U.S. economy roiled markets. An Irish company, Icon has not been immune.
I take it for the gift it is: Icon shares now trade at just 10 times my estimate of normalized cash flow, in effect assuming the company will never grow. I just don't think that's the case. Pharmaceutical companies face declining returns on R&D investments, a huge patent cliff, and the resulting need to economize. Icon is well-positioned to serve pharmaceutical companies' needs as they re-evaluate their R&D strategies and invest to rebuild drug pipelines.
That's why I'm buying more Icon, in an amount equal to 2.9% of my Rising Star Portfolio's first-year capital.
An all-weather vehicle
In the past year, Icon has signed strategic agreements to run trials for Pfizer (NYSE: PFE) and Bristol-Myers Squibb (NYSE: BMY). These contract awards aren't blips, but two in a marked trend in which large pharmaceutical and biotechnology companies outsource elements of their R&D to trusted partners. Pharmaceutical companies are turning to a select group of contract researchers, for good reason: They possess sizable enough scale to save time and money; access to vast, hard-to-duplicate patient networks; and deep experience conducting drug trials across large patient populations. This isn't easy work, and the cost of screwing up is immense.
More important, there's still a very compelling growth story here, which I expect to continue. What's better: We're not paying anything for that potential, from today's prices. That's exactly why I'm not concerned about Icon's recent earnings stumble, the economy, or management departures. Read on.
On earnings declines: Icon's developed a reputation for doing these things well, culminating in the contract wins. But it's also come with near-term pain, as the company's upped staffing at its laboratories in anticipation of higher business volumes. The revenue's not yet followed, forcing the company to cut current-year earnings guidance in half. In doing so, the Street's seriously underpriced Icon's earnings power. Icon's margins should recover as revenues follow, and if they don't, Icon can cut staff.
On concerns over the economy: Despite the possibility of declining R&D budgets in a slowing economy, it stands to reason that Icon's value proposition would actually improve. The proof is in the numbers: Even as R&D investments contracted during the credit crisis, Icon's grew revenues throughout. Moreover, as $106.9 billion in drugs come off patent, pharmas need to rebuild. Outsourcing R&D to a trusted partner affords substantial time and cost savings.
That gets to my second point: Icon's a company whose fortunes are tied to global pharma and biotechnology. But for its Irish domicile, the market's tagged it a European company. It's not. While Irish tax rates may increase, today's valuation more than accounts for that possibility -- as I've detailed before.
On the CEO departure: On the matter of Peter Gray's retirement, I don't see much to worry over. He's staying on as vice chairman to facilitate a transition, longtime CFO Ciaran Murray's assumed his role, and the transition appears orderly.
Where's that leave us?
There's been one additional interesting development since I last bought shares. Carlyle made a $3.8 billion buyout for Pharmaceutical Product Development (Nasdaq: PPDI), affirming the fundamental value of the best CRO's service offering, competitive advantage, and relative mispricing of their earnings power. That doubles for Icon, which holds 25% of its market cap in cash. For Icon shareholders, the job is simple: Wait for the market to realize what Carlyle already knows.
