Contract Organizations are the Sell of the Season

In the business and financial environment we are currently enduring, one wouldn't expect investors to be anxious to buy companies with somewhat uncertain prospects. Yet, that is what is happening in the pharmaceutical services industry. Private equity investors are lining up to own all or a piece of a contract research or contract manufacturing organization (CRO or CMO), and the depressed stock market is creating opportunities for them to get in at very attractive valuations.

Jim Miller

The hot interest in pharmaceutical services is slightly different from what we saw two years ago. For one, acquisition prices are a lot lower today. Consider 2007, when the Blackstone Group acquired what is now Catalent (Somerset, NJ) for $3 billion, financing the deal with $2 billion in debt. The price was 1.6 times Catalent's revenues for that year and 10 times the company's pretax cash flow. Premier Research Group (Crowthorne, England) was taken private by ECI Partners (London) last year for a similar multiple. By contrast, today's prices are likely to be less than one times revenue with less than half of the purchase price borrowed.

The lower valuations reflect the restricted availability of debt (when debt was cheap, companies could afford to bid up) and the less certain outlook for the biopharmaceutical and pharmaceutical industries overall. Still, private investors appear confident that the pharmaceutical services business is a long-term winner.

At the same time, major biopharmaceutical and pharmaceutical companies seem to be committed to outsourcing an ever-larger share of their drug development and manufacturing activity. In addition, they are increasingly depending on early-stage companies to do their discovery and early development work, and then in-licensing or acquiring the most promising candidates. This means early-stage companies will continue to get funding to feed their dependence on contract services.

PharmNet deal

One recent big deal is the ongoing acquisition of PharmaNet Development Group (Princeton, NJ) by JLL Partners, a private equity firm that is also a major investor in CMO Patheon (Research Triangle Park, NC). The total value of the deal will be nearly $250 million, comprised of $100 million for the outstanding PharmaNet stock (valued at $5.00 per share in the transaction) and $144 million to retire PharmaNet's outstanding convertible debt.

PharmaNet provides Phase I–IV clinical research services as well bioanalytical laboratory services. The original PharmaNet Development Group was founded in 1996 by a team that included the founders of what is now Covance (Princeton, NJ), and was acquired by publicly-traded SFBC International in late 2004 for $245 million. SFBC International changed its name in 2005 to PharmaNet following a scandal surrounding operations at its Phase-I operations in Florida. It had revenues of nearly $360 million (net of passthroughs) in 2008, putting it among the top 10 clinical CROs by revenue.

PharmaNet's stock price dropped from more than $40 per share in March 2008 to under $1.00 by December 2008. The cataclysmic price drop reflected the overall decline in CRO stock prices (Covance dropped from more than $90 a share to under $35 per share during the same period) and a sharp reduction in revenues and backlog during the second half of 2008. A complicating factor was the company's inability to get holders of the senior convertible debt to agree to redeem those notes for debt with new terms.

In a sense, PharmaNet is a victim of the changed financial environment, which starved many of its customers of capital while cutting off its ability to refinance debt. At the same time, however, the company is a victim of its own problems. The convertible debt was originally issued in 2004 to allow SFBC to acquire PharmaNet, and the subsequent legal problems surrounding the Florida Phase-I sites probably distracted management's attention from creating a more sustainable business model the way competitors such as Covance and PPD have been able to. The sale to JLL will give PharmaNet's management team, which is well respected in the industry, the opportunity to improve the company's operations and possibly expand its capabilities through selected acquisitions.

More to come

Private equity investors may get another bite of the top 10 CRO apple in coming months if the directors of MDS (Toronto), the parent company of MDS Pharmaceutical Services (MDSPS), decide to test the market. MDS has formed a committee of independent directors to review alternative ways to improve shareholder value.

Like PharmaNet, MDSPS, which had revenues of $482 million in 2008, has faced some particular challenges. Its early development business has been hurt by the reputational and operational implications of quality problems at its Montreal bioanalytical laboratory, which was cited by the US Food and Drug Administration in 2004 for inadequate investigation of contaminated samples. MDSPS' management reports that the problems are largely resolved and that the company is attracting clients back to the bioanalytical business. In the Phase II–IV segment, however, MDSPS continues to lose market share to larger competitors, including Quintiles Transnational (Research Triangle Park, NC), PPD (Wilmington, NC), Icon (Dublin), and Parexel (Waltham, MA). The company also suffers from a smaller scale and a more limited global footprint, even though its revenues put it among the top 10 CROs.

MDS has ample cash and little longterm debt, so it is not compelled to sell. However, its board and management have been under investor pressure to consider strategic alternatives. With three distinct businesses in its portfolio (MDS also has business units that make analytical instruments and radiopharmaceuticals), the company does have some interesting options, including selling one or more of its business units to strategic or private equity buyers.

Still picky

Although publicly held CROs represent the highest profile targets for current investment, we are aware of several well-known privately-held CMOs whose owners have put them on the block and which are attracting considerable interest from investors. Private investors aren't the only buyers, either. Publicly-held CROs such as PPD, which recently acquired the Eastern European CRO AbCRO, are also taking the opportunity to pursue deals that flesh out their capabilities.

This doesn't mean investors aren't being picky, however. Many investors are focused on CROs with strong market positions and viable business models, mindful that the services industry will experience a shakeout in the coming months.

The lesson here is that despite the doom and gloom in the financial media, there are still good businesses to invest in and institutions with money to invest in them. The smart money seems to be saying that pharmaceutical services will be a great business well into the future.

Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903, fax 703.383.4905, info@pharmsource.com, www.pharmsource.com.