Several CROs are undervalued at current prices, have positive moat trends, and possess key characteristics to rise above the pack, say Morningstar's Matt Coffina and David Krempa.
Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by David Krempa, who is an equity analyst on our health-care team, and we're going to talk about clinical research organizations, or CROs.
David, thanks for joining me.
David Krempa: Thanks for having me, Matt.
Coffina: I don't think this is a business that everyone is familiar with. Can you explain to our listeners what are CROs, what do they do, and why would a pharmaceutical company choose to outsource its clinical trials to a CRO?
Krempa: CROs help biotech and pharmaceutical companies with all aspects of the drug-development process. This mostly falls into two buckets: First, the early stage, which would be drug discovery, preclinical testing in animals, and also small Phase I studies. We think this is the less-attractive area of the market. There's not many moats in this area. There's a lot of small competitors and very little differentiation among the competitors.
Then the second bucket would be the late-stage trials. These are the large Phase II and III trials that have thousands of patients, that are happening in multiple countries simultaneously, and this is where we think it's a lot more conducive to moats, and this is really the attractive area of the market when we look at the CROs.
And the reasons why you would outsource from the pharmaceutical standpoint is both time savings and cost savings. The cost savings largely come through better asset utilization. When a pharma company is doing internal R&D, it's rather lumpy. One year, they might have three or four Phase III trials, the next year they might only have one.
So they're going to have a lot of employee downtime in the down years or they're going to be scrambling to hire new employees in a year that there's high demand. CROs are able to pull from multiple pharmaceutical companies at once, and they can even out that demand volatility.
In terms of the time savings, CROs help drug companies pick where they want to locate their clinical trials. They're more in touch with the regulatory affairs. For instance, in China right now, it's taking up to a year for clinical trials to get approved versus some parts of Eastern Europe might only take a month or two. So the CROs really help the pharma companies pick exactly where to locate the trials, and they help them get them approved by regulators as quickly as possible.
And they also help them with patient enrollment. The clinical research organizations have patient databases; they also have existing relationships with physicians, so they're able to locate these patients with a specific, sometimes a very rare disease faster than pharmaceutical companies would be able to strictly on their own.
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Coffina: So there are really three components to the growth story for CROs? The first one's not all that inspiring. What's your expectations for overall growth in research and development spending by pharmaceutical firms?
Krempa: That's right. Global R&D spending on drug development isn't all that fast right now. We looked at it from a bottoms-up analysis. We took our Morningstar analysts' explicit forecast over the next 10 years for these drug companies, and we rolled up the top 18 drug companies. We found that they made up about 70% of the estimated $115 billion in global R&D spending, and based on these companies we only forecast a 1% to 2% growth rate in global R&D spending over the next five years. That alone is not too attractive of a growth rate.
Coffina: But that said, do you think that the CROs can grow significantly faster than that due to increased outsourcing penetration? Can you elaborate?
Krempa: Over the last decade or more we've seen a trend where pharmaceutical companies have increasingly outsourced a growing amount of their R&D spending to these CROs, and more recently with the patent cliffs that pharmaceutical companies have been facing the last couple of years, they've really focused on cost-cutting even more. We've seen a lot of pharma companies cutting their internal capacity and going more toward CROs, most recently with Merck, but we've seen it across all of the industry. We expect them to outsource an increasing portion of their R&D spending over the next five years. If we looked at last year, we estimated about 33% of R&D spending was outsourced, but by five years from now, we expect 43% to be outsourced. That alone would be a 6% annual growth rate for the industry.
Coffina: The last piece of the puzzle here is that we expect the largest CROs to gain market share from some of the smaller CROs that are out there. This is due to increased strategic partnerships between pharmaceutical firms and CROs, which we think also has implications for moat trends of CROs. Can you explain what's going on here?
Krempa: Historically, the projects were outsourced on individual trial basis. Every time a pharmaceutical company had a trial they would reach out to all the CROs to get bids on the work. But more recently within the last couple of years we've seen pharmaceutical companies and CROs increasingly come to strategic partnerships where they rely on just one to two CROs for the majority of their work. Most notably Pfizer talked about this. They went from 17 CRO partners down to just one or two, so this shift, putting all their business onto just one or two CROs is really going to help the largest, the most established CROs that have that geographic scale to handle a big company like Pfizer's R&D spending.
If you look at this outsourcing trend to the big players, we think they can add an extra 4% CAGR over the next five years as they increasingly take share from the smaller players that can't compete for these strategic partnerships. Then if you roll in all three of those growth drivers that we've talked about, you end up with an 11% compound annual growth rate over the next five years for the four largest publicly traded CROs that we cover, which would be Quintiles, Covance, Parexel, and ICON.
Coffina: What about the moat trends of these companies? We have positive moat trends on all four of those companies that you just mentioned?
Krempa: Right. For the four late-stage players, we give them positive moat trends. We think this trend of strategic partnerships is increasing their competitive advantages. It's creating a barrier to entry in the market, as the small players don't have that geographic scale to compete for these large contracts like these big players do and these big players already have the established infrastructure, they've got the track record that pharmaceutical companies can trust them.
Coffina: We're looking for top-line growth in the double digits. Do you think that operating income can grow even faster than that? What makes you think that operating margins are going to expand for the large CROs in the next few years?
Krempa: It's going to be due to a couple of factors, but most notably the strategic partnerships in my opinion. The strategic partnerships are going to be more efficient for both parties. But from the CRO standpoint they're not going to have to bid out for every individual trial they're working on. Secondly, they should see better asset utilization because their workloads can be more predictable. They know when their clients are going to have drugs moving into Phase III trials. So, they can more accurately adjust their workflow and to balance that out and increase margins. Then secondly, you're just going to see some natural operating leverage as they can spread their SG&A costs across these larger revenue bases.
Coffina: There aren't a lot of opportunities out there in the market right now. CROs are one area where we do see some stocks that are undervalued. What are your top picks in this space?
Krempa: My top picks are ICON and Quintiles. ICON is one of the best pure plays on the late-stage business. They get more of their revenue from the late-stage business than any of their competitors. They should be best positioned to capitalize on these positive moat trends and the rapid growth in the industry. And Quintiles is the largest player in the market. They have revenue of twice the next-largest competitor. We think they are the most established player. As CROs are increasingly utilized more for their expertise and less for just their ability to complete tasks, we think Quintiles is going to be one of the winners going forward.
Coffina: Great. Thanks for joining me, David.
Krempa: Thanks for having me.
Coffina: For Morningstar StockInvestor, I'm Matt Coffina.
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