Clinical trial demand makes early-stage biotech contract researchers look interesting, Jefferies says

By Ronda Fears

Nashville, Oct. 14 - Ongoing strength in the phase I clinical trials market prompted Jefferies & Co. analyst David Windley to identify opportunities among biotechnology contract research organizations.

In his new report, Windley also looked at trends in phase I capacity and post-second quarter qualitative and quantitative biopharma research and development.

Highlighted in the report were Albany Molecular Research Inc., Charles River Laboratories International Inc., Covance Inc., Icon plc, Kendle International Inc., Parexel International Inc., Pharmaceutical Product Development Inc., PDI Inc., PRA International, SFBC International Inc. and Ventiv Health Inc.

Preclinical operations growing

Preclinical and toxicology activity is enjoying continued solid growth, Windley noted in the report, citing what he referred to as "Goldilocks capacity expansions."

"This sector remains a hotbed of activity," the analyst said.

Notwithstanding a setback from a brief preclinical study delay in the third quarter for Charles River Labs, he said the company is operating its toxicology facilities at or near capacity.

Both Charles River Labs and Covance are expanding their toxicology facilities and would like them to come online sooner rather than later, Windley noted. In 2004 and 2005, expansions were biased toward privates. In 2006, he said, "the big boys are adding."

Spot bookings visibility also remains high, he added.

Jefferies has a hold rating on Charles River Labs and a buy on Covance.

Phase I expansions up 18%

Phase I expansions reflect strong demand, Windley said, but noted that U.S. acquisition targets seem hard to come by in the early-stage research group.

"The large number of compounds completing preclinical testing in the last four years has led to a strong environment for phase I services," the analyst said in the report. "Trial sponsors continue to utilize more thorough earlier stage clinical programs to weed out weak candidates before costly later phase trials."

U.S. demand remains strong and is reinforced by contract research organizations, or CROs, scouting for acquisition opportunities, he said, noting that Covance made one recently.

Jefferies estimates that 2005 capacity expansions resulted in 18% growth in bed capacity at early stage clinical research units among the contract research organizations that the firm covers. Among those, Windley said, SFBC has the largest phase I operations by far, with an estimated 1,075 beds currently in operation.

Jefferies has a buy rating on SFBC.

Early-stage targets in demand

U.S. phase I acquisition targets are in high demand, but it has been a tall order and thus far with little success.

"Setting up a new early stage clinical research unit also calls for the buildup of a patient database, which is not a trivial task. Patient recruitment remains a key bottleneck," Windley said. "So, CROs typically look to acquire operations that have strong 'healthy volunteer' databases already in place."

Moreover, he said, operations with a first-in-man focus and the requisite scientific expertise afford acquirers with better margin opportunities compared to generic bioequivalence-focused shops. With uncertainty over implementation in Europe and continued strong phase I demand, quality U.S. phase I operations have been much sought after.

Charles River Labs, Icon, PRA International and Covance all expressed interest in phase I acquisitions, he said, but of those, only Covance has been successful so far with its recent acquisition of GFI Clinical Services, an 80-bed clinical research facility located in Evansville, Ind., for $5.7 million cash.

Parexel, meanwhile, has seen all its growth come from operations outside the United States, he noted. In keeping with that theme, Parexel acquired Qdot, a 32-bed phase I clinical research facility in South Africa to expand services there. The company already operates a 90-bed Phase I facility in Bloemfontein.

Phase II and III new business up

Phase II and III bookings strength should continue, Windley said, "as drug candidates slowly but surely continue their crawl through the development pipeline."

Confirming this trend, he noted that Icon reported robust bookings for the first quarter of fiscal 2006 with an overall 1.42 book-to-bill figure, suggesting new business was again strong. Central lab book-to-bill was spectacular at 2.6 times, he added, and, equally important, management maintained its breakeven target in the first half of fiscal 2006 for the lab.

"That said, we could also hear renewed commentary about the slower award-to-revenue conversion cycle," Windley pointed out. "The consensus explanation for slower conversion is sponsors' earlier planning to compress timelines and stretch R&D dollars. Patient recruitment and heightened scientific rigor may also contribute."

Jefferies has a buy rating on Icon.

R&D spending on the rise

Biopharma R&D spending - by Big Biotech as well as Big Pharma - is expected to accelerate through the second half of 2005, the analyst said.

"We believe that biotechs outsource at least twice the percentage of their R&D spend compared to Big Pharma," Windley said. "As a result, stronger biotech R&D growth has a compounding effect."

Despite Big Pharma's recent woes, R&D spending as a percent of sales has held steady at 14.1% for the first half of 2005 compared to 14.2% last year, he remarked in the report.

Several Big Pharmas expect accelerated R&D spending for the second half of 2005, he said, while others look to gain R&D efficiencies.

"Is this code for outsourcing? Refilling pipelines remains the theme for Big Pharma," Windley said. "Small biopharma funding, a key driver of growth in 2005 is on par with 2004. As a reminder, 2004 was the strongest year for biopharma funding since a record 2000."

In addition, Big Biotech is boosting R&D spending. Jefferies defines Big Biotech as the six largest biotech companies by revenue that comprise about 48% of biotech R&D spending. As expected, this group grew R&D spending at a faster rate than Big Pharma. For the first half of 2005, while Big Pharma R&D spending grew about 6.3% year-over-year, Big Biotech R&D spending increased 19.5%.

Contract sales names in contrast

Contract sales organizations Ventiv and PDI seem like "studies in contrast," the Jefferies analyst said. Contract wins - in quality and quantity - remain the prime driver for these companies, he said, and noted that fourth quarter is a seasonally strong period for resource planning.

Ventiv "has been enjoying a good run with its contracts. Ventiv also expanded its service offering by making its largest acquisition to date, inChord Communications, for $185 million," Windley said. "PDI, meanwhile, suffers from low visibility on contract renewals and is in the throes of an arduous turnaround."

PDI continues to be challenged by across-the-board problems in its business units, the analyst said. Some large contracts are coming up for renewal in the sales services segment in the next year, he added, and at the same time management is continuing to make significant investments in the business - including new management - which is pressuring profitability further. He said further new contract wins is "the only way out for PDI." Still, he noted that net cash per share remains high at $7 to $8.

Ventiv's contract sales operation is performing steadily, Windley said, and "fears of risk from a Sanofi-Aventis contract running dry seem to be overdone." The company does have exposure to Allegra and was impacted given the at-risk generic launch by Teva and Barr, he said, but management remains "confident that there are replacement products in the bag and/or replacement contracts in the pipeline."

Jefferies has a hold rating on PDI and a buy on Ventiv.

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