Firms That Aid Drug Companies Draw Interest: FDA Approval or Not, They Keep Getting More Business

By Kathleen Gallagher, Milwaukee Journal Sentinel

Apr. 10–When a Food and Drug Administration advisory panel voted last month not to recommend Cephalon Inc.’s new drug for treating attention deficit disorder in children, it underlined the harder look the agency is taking at new compounds.

The panel recommended sending Cephalon’s new drug, called Sparlon, back to the company for more testing.

The recommendation was bad news for Cephalon, but better news for investors in contract research organizations.

Contract research organizations, known as CROs, help pharmaceutical and biotech companies with several functions involved in bringing new drugs to market, including study design and management, clinical data management, statistical analysis and writing.

In an environment where it takes $800 million to $1.8 billion to bring new compounds to market, and only 1 in 10,000 compounds under development ever make it to market, CROs have become critical to the process, said Bill Gray, principal and equity portfolio manager at Reinhart Mahoney Capital Management Inc. in Mequon.

“It can take up to 12 years and nearly $2 billion to develop new therapies, so pharmaceuticals and biotech companies are outsourcing to reduce their costs and risks,” Gray said.

He says the major drivers pushing drug and biotech companies to outsource to CROs are:

— The emergence of biotech companies and the resulting explosion in new compounds under development has bolstered business for CROs. The number of pre-clinical compounds has grown at an average annual rate of 15% over the last five years. Research and development budgets of the six biggest biotech companies have grown at an average annual rate of 20% over the last three years.

“It’s too costly for them to do anything but outsource,” Gray said.

— In-house facilities at many big pharmaceutical companies are technically obsolete and aren’t equipped for new routes of drug delivery, like infusion or inhalation. Nor are they set up for toxicology testing with large species, like monkeys or pigs. That’s pushing them to close, like Merck & Co. did in November, pre-clinical facilities and outsource to CROs.

— Clinical trials are becoming more complex and multi-national. In the last few years, the larger CROs have been gaining market share in countries where drug trials are expanding to Eastern Europe, Latin America and Asia.

— There’s a growing need for sophisticated regulatory expertise and post-FDA approval monitoring. That was demonstrated in September 2004, when Merck was forced to pull its arthritis drug, Vioxx, from the market after a study showed the drug doubled the risk of heart attack or stroke if taken for 18 months or longer.

— It takes as many as 12 years to develop drugs. Drug makers want to move their compounds to market as quickly as possible to maximize patent protection that lasts for 20 years.

“CROs are very efficient at getting drugs through clinical trials,” Gray said.

Some investors say CRO stocks have already had their run-up, but Gray sees room for growth.

CROs at the end of 2005 had 6.35 million square feet of toxicology-testing capacity. That is expected to grow 14% to 7.25 million 2007, Gray said. Meanwhile, drugs in development are increasing at a rate of 15% a year.

That’s incentive for drug developers to initiate strategic partnerships with CROs, rather than just hiring them on a study-by-study basis, Gray said.

CRO industry backlogs hit an all-time high in the fourth quarter, he said, and companies are signing on customers at a faster rate than they can do the work. “This is likely to go on for a while,” Gray said.

Reinhart Mahoney Capital Management has two CROs in its client portfolios:

Charles River Laboratories International Inc. (CRL, $48.48), Wilmington, Mass., provides rats, mice and other research tools and support services to help drug discovery and development. The company has a $3.5 billion market capitalization and 100 facilities with 8,000 employees in 21 countries.

Charles River has top market share for research models like rats and mice. And it generates about 43% of revenue from pre-clinical services, giving it the second-highest market share for that segment.

Covance Inc. (CVD, $58.37), Princeton, N.J., provides a wide range of product development services. It has a $3.7 billion market cap, 7,300 employees and offices in 18 countries.

Covance in 2005 had its fifth consecutive year of growing earnings-per-share 25% or more and increased operating margins in each of those years. The company has a strong balance sheet, no debt and about $2.50 a share in cash, Gray said.

Covance has the top share in the pre-clinical toxicology market and leads the lab testing market for clinical trials. The company has 1.45 million square feet of space for toxicology testing, and this year is adding 250,000 square feet in a facility that partially opened in Madison late last month. There is talk that Covance will build another facility on land it bought last year in Chandler, Ariz., Gray said.

The biggest risk Gray associates with these stocks is the possibility that the companies won’t be able to hire enough qualified workers to keep up with demand, he said.

Gray began buying Covance shares for client accounts in February 2005 and has full positions. He would buy these shares at current prices and says they could go as high as $68 in the next 12 months.

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Copyright (c) 2006, Milwaukee Journal Sentinel

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