NEW YORK (Dow Jones)--Covance Inc. (CVD) Chief Executive Joseph Herring sees the fundamentals at contract research organizations, which perform clinical trials, remaining solid as Big Pharma increases its outsourcing in coming years.
But in the near-term, the sector is attempting to recover from a remarkable turnaround in investor sentiment that has crushed the once high-flying stocks.
Herring believes Covance, the largest in the sector, will benefit from pharmaceutical companies cutting costs and improving development efficiency as they deal with pipeline and patent pressures. Furthermore, he expects the industry to actually get some benefits from recent consolidation.
"We don't look at these three mergers with much fear," he said in an interview Tuesday, referring to Merck & Co. Inc. (MRK) buying Schering-Plough Corp. (SGO), Pfizer Inc.'s (PFE) deal for Wyeth (WYE), and Roche Holding AG's (RHHBY) acquisition of Genentech Inc.
He expects the combined companies to make some adjustments to their pipelines in the three to six months after the deals close, but doesn't see a major impact on the contract research organization industry.
Because Wyeth doesn't outsource its preclinical work and Schering-Plough doesn't outsource much overall, he expects the acquiring companies to send trials from their the newly acquired assets to contract research organizations.
"I can't predict the timing, but it feels to me like there is some upside there," he said.
"Upside" is not a word that has been associated with the contract research organization sector in the past year as the stocks of the major players are all down more than 50%. Those companies include Pharmaceutical Product Development Inc. (PPDI), Charles River Laboratories International Inc. (CRL), Parexel International Corp. (PRXL) and Icon Plc (ICLR).
The sector has long benefited from Big Pharma's increased outsourcing of clinical work, a sentiment that drove gains of more than 50% in the sector in 2007.
But the companies took a hit as the overall economy hurt drug makers, causing ambitious expectations and growth to moderate for contract research organizations.
Herring notes that Covance's stock was trading at 30 times forward earnings in late September, compared to its current multiple of 15.
He admits that the sector may have been irrationally valued at the time, especially for a service company without any intellectual property portfolio.
"Now I think it has now swung the other way... the truth is probably somewhere in between," Herring said about the sector's current market value.
Helping fuel the previous valuation was Covance's $1.6 billion deal with Eli Lilly & Co. (LLY) in August to provide broad drug development services over 10 years and assume control of Lilly's early drug development facility and related workers.
At the time, many thought the ground-breaking deal would yield many more like it. Although that hasn't happened, Herring is confident more deals will come and notes that chief financial officers at major drug makers have approached Covance out of curiosity.
He described the Lilly deal as a "win-win" and expects drug makers to close major research facilities in coming years in order to increase their efficiency.
But in the near-term, Covance has hit some bumps in the road. Last week, it lowered its 2009 financial projections, a move mirrored by others in the sector.
The shortfall stemmed from slowing early-stage workflow, paired with a decision to maintain its work force and "weather the storm."
Herring notes that later-stage work remains strong, and he expects early stage work to pick up in the second half as companies restart delayed projects.
Furthermore, Covance's top-five clients are under contract to conduct a certain amount of work for the year, and they are expecting to meet those minimums, Herring said.
Despite some worry that pharmaceutical research and development spending is shrinking, Covance projects it will grow by 2% to 4% for the next three to five years, at the minimum.
Even if that projection is wrong, Herring notes that the industry can maintain healthy growth as long as outsourcing continues.
He stresses that large pharmaceutical companies will turn to contract research organizations to cut costs, become more flexible with remaining expenses, and accelerate the development of their pipelines.
"I think outsourcing is going to substantially increase," Herring said.
