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A Pickup In The Research Cycle

If biotech drugmakers weren't up in investors' faces earlier, they were after the $10.4 billion deal aced Monday, Aug. 26, by Amgen (AMGN) for Onyx Pharmaceuticals (ONXX).

That same day, the U.K.'s AstraZeneca (AZN) struck a $500 million deal to acquire Amplimmune, a Maryland company specializing in therapies based on the immune system. Later last week, eye-drug maker Akorn (AKRX) signed on to buy France-based Hi-Tech Pharmacal for $640 million.

These were only the most recent in the trend of big drugmakers spending to re-stock product pipelines as their aging blockbusters lose patent protection. In addition to driving up valuations for biotech and specialty drugmakers, the trend is also having an effect on another group of stocks: research equipment and services providers.

The research industry is showing some resurgence following years of spending cuts to government and academic research. Pharmaceutical companies are also increasing spending after a significant period of restructuring and cost-cutting, says John Kreger, an analyst for William Blair & Co.

"So you had a lot of reductions in R&D spending, which is the ultimate market that (medical research companies) sell into," Kreger said.

Now, pharmaceutical companies are moving beyond the bulk of what analysts call generic erosion — a surge in competition after a big drug loses patent protection. They are turning more to outsourced clinical trials, in part, to deal with that increased competition.

"They are able to spend more freely, so the end market is getting a lot healthier," Kreger said.

The 25-stock Research Equipment and Services group ranked 56 on Friday among IBD's 197 industry groups. It has held in the top 50 industries most of this year.

Targeting Growth Niches

Most contract research and medical equipment service firms are growing. But some are performing better than others.

Parexel International (PRXL) reported quarterly EPS growth of 52% and 47% in its last two quarters. Its revenue growth reached 27% and 15% in those two periods.

Peer Charles River Labs International (CRL) posted flat EPS growth and a decline of 3% in its last two quarters. Revenue grew by 2% and 3% over the same period.

Charles is focused on early-stage clinical trials. Companies like Parexel focus on larger late-stage tests, Kreger says.

"If you compare a Charles River to a Parexel, you see a pretty striking difference in growth rate," he said.

Illumina (ILMN), a maker of DNA sequencing equipment, posted EPS growth of 28% and 8% in its last two quarters while reporting revenue growth of 21% and 23% in the same period.

Quintiles Transnational (Q), a contract research services provider, reported EPS growth of 26% and 19% in its last two quarters, while revenue grew by 6% and 5%, respectively, over the same period.

Single- or double-digit revenue growth is common among top contract research outsource players, while life-science tool companies are in the low- to mid-single digits, says Tim Evans, an analyst for Wells Fargo Securities.

The largest life-science tools company, Thermo Fisher Scientific (TMO), posted EPS growth of 17% and 8%, respectively, in its last two quarters. Revenue growth stayed flat at 4% in the same two quarters.

Luminex (LMNX), another medical equipment services company, reported EPS growth of 27% and 13% in its last two quarters. Revenue growth reached 9% and 12% in each of the same two quarters.

Many life-science tools companies have varying products, markets and customers, says Evans.

"It's not like some industries with more similar homogenous products and services," he said. "The products and end markets for each of the companies in this space are a little bit different.

Accelerated Testing

By 2018, global contract research outsourcing revenue is expected to reach $59.9 billion, up 98.3% from $30.2 billion in 2011, says BCC Research, a Wellesley, Mass.-based publisher of technology market research reports.

Research outsourcing is necessary for pharmaceutical and biopharmaceutical firms to survive and thrive, says BCC analyst Shalini Shahani Dewan.

"Outsourcing is a competitive requirement for pharmaceutical and biopharmaceutical manufacturers to increase their performance and profit margins," she wrote in a report.

Outsourcing can help pharmaceutical companies advance clinical trials for several drugs at once. The goal is to beat rivals to market, says Kreger.

"It makes you more efficient; it makes you faster," he said.

Drug and biotech companies also rely on medical research firms to gather doctors, staff and patients for clinical trials.

Drug companies also save money by outsourcing if a clinical trial doesn't pan out, says Alan Louie, an analyst for IDC, a research firm.

"If a particular drug has a problem or the program doesn't work then you can just turn it off," he said. "You don't have any people that you still have to continue to maintain.

Acquire Or Be Acquired

Medical research firms don't face the same government regulatory hurdles that drug and biotech companies endure. Nor do they depend on government customers.

Even a clinical trial failure isn't a total bust, says Evans.

"If a product fails in the pipeline they just lose out on the service revenue; they don't lose out on future revenues or anything from the product itself," he said.

Medical equipment services companies are largely dependent on government contracts. That's a problem in a dour economy.

Thermo is an exception. Its revenue sources include drug companies and others that need diagnostic testing, says Evans.

"They participate in industrial end markets, things like metals testing, foundries and other types of atmospheres. They are very broad and diversified," he said.

Thermo is attempting to boost revenue by acquiring Life Technologies (LIFE) for $15.8 billion. Life focuses on genetic sequencing and DNA analysis.

Last year, Illumina rejected a $5.7 billion takeover bid from pharma giant Roche Holding.

This year Illumina has snapped up smaller companies to help boost its business. One company , Verinata Health, provides noninvasive tests for detecting chromosomal abnormalities.

Another company, Icon (ICLR), which provides outsourced testing services to drug, biotech and medical device companies, acquired the clinical trial services unit of Cross Country Healthcare (CCRN) for $52 million in cash plus performance milestones that could add another $3.75 million.

Earlier this month, Luminex said it is reducing its workforce by 5% and closing its Brisbane, Australia office to increase investment in its molecular diagnostic products.

Venture funding in pharmaceutical, biotech and equipment testing companies has declined from $231 million in 2011 to $97 million last year. Investments reached $87 million in the first half of 2013, says PricewaterhouseCoopers and the National Venture Capital Association.

Competition from bigger contract researchers hastened the decline, says Greg Vlahos, a PWC partner."The top 10 companies tend to get the lion's share of the contract work," he said.

Similarly, investments in biotech analytical instruments and related equipment fell last year to 17% to $121 million vs. 2011. Investments in the first six months of this year have reached $69.7 million, says PWC and the NVCA.

Reaching Into Asia

Medical research firms have specific platforms for clinical trials. Most assist in identifying the best doctors for specific tests.

Icon and Quintiles provide analytics software to allow pharmaceutical and biotech customers to monitor their drug trials.

Many are pushing their existing technology into new markets. Asia is a key target region, says BCC's Dewan.

"The huge potential of the Asian pharmaceutical market, relatively low cost and rich spectrum of diseases, have attracted big pharmaceutical companies to outsource their clinical trial studies to Asian contract research organizations," Dewan wrote.

Thermo Fisher opened a new manufacturing facility in Singapore to serve the growing biopharmaceutical market. Covance (CVD), a provider of drug development services, expanded an existing facility in Singapore.

Icon also teamed with National Clinical Trials and Research Centre in Taiwan to boost its clinical trials business there.


Medical research and equipment services companies continue to benefit from R&D spending by pharmaceutical firms and others.

Upside: Mergers among the largest drugmakers and the initial spike in generic drug competition that led to spending cutbacks appear to be over.

Many drug companies are dependent on outsourcing, says IDC's Louie.

"Because of the externalization by big pharma it's not likely that these are going to go away soon," he said.

Market conditions should also help, says Kreger.

"Product approvals are picking up from the FDA, so that gives them better revenue growth," he said.

Increased revenue also extends to the bottom line, says Evans.

"For the contract research organization group, it's fairly high revenue growth coupled with margin expansion that generates very strong earnings growth," he said.

Risks: Life science tool companies remain highly susceptible to macroeconomic issues, says Evans. "If you see greater head winds in government and academic markets, anything like the government sequestration thing, it's a threat to them," he said.

Meanwhile, contract research firms are most threatened by big drug company mergers.

Mergers often result in consolidation of outsourced services, says Kreger.

"That tends to dampen the demand for these companies — at least in the near term," he said.