Outsourcing Gains

The drug development process is dauntingly complex. It often takes years of laboratory work to identify a potentially promising compound, which then must endure at least a few years of preliminary testing before clinical trials are even started.

In all, it typically takes an average of 15 years for a drug to go from lab to market, according to a recent study by Tufts University.

Consequently, drug companies have taken to outsourcing several steps in the process, particularly clinical trials which are often handled by a contract research organization (CRO).

Given their scale and expertise, CROs are able to significantly reduce the cost and the time of trials. Several also have the ability to run concurrent trials to comply with the regulatory requirements of different countries. That, in turn, allows drug companies to focus on their own areas of expertise, namely discovery and marketing.

Quintiles (NYSE: Q) is the world’s largest CRO, with revenue of $4.9 billion last year and $1.3 billion in the most recent quarter, with a market cap of $5.8 billion.

Founded in 1982, Quintiles was taken private in 2003 by a consortium of private equity investors for $1.7 billion after two decades of profitable operation. In May, the consortium cashed out in an initial public offering (IPO) that raised a greater-than-expected $947 million.

The company operates in two basic segments: health care product development and integrated health care services.

Product development handles Phase II–IV clinical trials and doesn’t offer Phase I services. As a result, the company hasn’t taken as hard of a hit, as drug companies better target their initial efforts and are more selective about launching Phase I trials. The division also provides product development consulting and management services and contributes about three-quarters of the company’s revenue.

Integrated h! ealth care offers market development services such as providing contract sale forces in various geographic segments and late phase observational work and generates about a quarter of revenues.

The IPO was well planned, hitting the market just as the CRO industry’s business was beginning to rebound. It has also taken advantage of the shifting payment schemes in the industry, which have been evolving from single contracts for one trial to strategic partnerships, with the CRO providing a growing array of services while bearing a portion of the costs in return for a cut of any profits.

That’s an extremely profitable arrangement for Quintiles, which already has well entrenched relationships with the major drug makers. The company has helped develop more than three quarters of the most successful drugs introduced during the time it was privately held. It’s also worked with all of the top 20 biopharmaceutical companies in each of the last 10 years and has worked with more than 400 companies in all.

Given the company’s sheer size and scale, it’s extremely difficult for smaller CROs to compete for major contracts.

As a result, in its first quarter as a once-again publicly traded company, Quintiles grew revenue by 2 percent while margin shot up to 13.1 percent. The product development segment in particular experienced solid growth, with revenue up 6 percent.

Over the trailing four quarters, net new business grew by $4.8 billion while the company’s total backlog hit $9 billion with an average book-to-bill ratio of 1.21 times.

The total drug development market is valued at $91 billion, but only about 36 percent ($18 billion) of that is currently outsourced. The company believes that a further $49 billion of projects could be up for grabs out of the total market, with growth projected at between 5 percent and 8 percent annually.

As CROs become increasingly critical partners for drug companies, Quintiles is in position to win a large! percenta! ge of that business.

But since it is once again a new business, it’s currently trading at a price-to-earnings growth ratio of 0.9. A reading under 1 implies that you’re buying future growth at a discount. At the same time, analysts forecast strong growth this year and next, with 2013 earnings per share of $2.05 expected. That’s 34.4 percent year-over-year growth, with a further 14.6 percent earnings growth anticipated in 2014.