Pharma's silver lining

In the business and financial environment we are currently enduring, you wouldn't expect investors to be anxious to buy companies with somewhat uncertain prospects, but this is what is happening in the pharmaceutical services industry. Private equity investors are lining up to own all or a piece of a CRO or CMO business, 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 has some features that make it different from what we saw 2 years ago; for one, the acquisition prices are now a lot lower at the top of the leveraged buyout frenzy. Back then, Blackstone Group (NY, USA) acquired what is now Catalent (NJ, USA) for $3 billion (€2.4 billion) and financed it with $2 billion (€1.6 billion) in debt. The price was 1.6 times sales and 10 times pretax cash flow. Premier Research Group (UK) was taken private by ECI Partners (UK) 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 the price up) and the overall uncertain outlook for the bio/pharmaceutical industry. As I've discussed in previous columns, the industry is experiencing a sharp cutback in pipeline development activity as earlystage companies struggle for financing and major companies restructure to improve earnings and cash flow.

Still, private investors appear confident that the pharmaceutical services business is a longterm winner. Major companies appear committed to outsourcing an ever larger share of their drug development and manufacturing activity. Furthermore, they will increasingly depend on early-stage companies to do the discovery and early development work, and then in-license or acquire the most promising candidates. This means that the earlystage companies will continue to get funding to feed their dependence on contract services.

PharmaNet deal

The biggest deal to hit the news recently is the acquisition of PharmaNet Development Group (NJ, USA) by JLL Partners (NY, USA), a private equity firm that is also a major investor in CMO Patheon (NC, USA). The total value of the deal will be nearly $250 million (€196 million), comprising $100 million (€78.4 million) for the outstanding PharmaNet stock (valued at $5.00/€3.9per share in the transaction) and $144 million (€112.9 million) to retire PharmaNet's outstanding convertible debt.

PharmaNet provides Phase I–IV clinical research services, as well as bioanalytical laboratory services. The original PharmaNet Development Group was founded in 1996 by a team that included the founders of what is now Covance, and was acquired by publicly traded SFBC International in late 2004 for $245 million (€192 million). SFBC International changed its name in 2005 to PharmaNet following a scandal surrounding operations at its Phase I operations in Florida (USA). It had revenues of approximately $360 million (€282.1 million) (net of pass throughs) in 2008, putting it among the top 10 clinical CROs by revenue.

PharmaNet's stock price dropped from more than $40(€31.3) per share in March 2008 to less than $1.00 (0.78) by December 2008. That cataclysmic price drop reflected several factors, including the overall decline in CRO stock prices (Covance dropped from more than $90 (€70.5) a share to less than $35 (€27.4) per share during the period), and a sharp drop 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; under the terms of the notes, the debt holders could force redemption in August 2009 at face value and were in a position to take control of the company if it could not redeem them.

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In a sense, PharmaNet is a victim of the altered financial environment, which starved many of its customers of capital while cutting off its own ability to refinance its debt. At the same time, however, it 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 attention from creating a more sustainable business model the way competitors such as Covance and PPD have done.

The sale to JLL will allow PharmaNet's management team, which is well respected in the industry, to focus on improving the company's operations and, possibly, expand its capabilities through selected acquisitions. In the time it has been an investor at Patheon, JLL has shown itself to be a patient and long-term investor, helping Patheon management complete a necessary, but painful restructuring. JLL has also offered to buy more of the outstanding shares of Patheon, but at a price that may not be attractive to existing shareholders.

More to come

Private equity investors may get another bite of the Top 10 CRO apple in coming months if the directors of MDS Inc. (ON, Canada), parent of MDS Pharmaceutical Services (MDSPS), decide to test the market. MDS announced that it has formed a committee of independent directors to review alternative ways to improve shareholder value. The committee will work with outside advisors to review a broad range of options, from doing nothing to sale of business units or the entire company. The company says there is no timetable for the review to be completed.

As with PharmaNet, MDSPS, which had revenues of $482 million (€377.7 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 Montréal (Canada) bioanalytical lab, which was cited by FDA in 2004 for inadequate investigation of contaminated samples. Management reports that the problems are largely behind it and that it is attracting clients back to the bioanalytical business. In the Phase II–IV segment, MDSPS continues to lose market share to larger competitors, including Quintiles, PPD, Icon and Parexel (NC, USA). It suffers from smaller scale and a more limited global footprint, even though its revenues place it among the Top 10 CROs.

MDS has ample cash and little longterm debt, so it is not compelled to sell. However, the company's board and management have been under investor pressure for some time to consider strategic alternatives. With three distinct businesses in its portfolio (MDS also has business units that make analytical instruments and radiopharmaceuticals), the company would seem to have some interesting options, including selling one or more of the business units to either strategic or private equity buyers. However, as one analyst told me, the board could find that what buyers are willing to pay for the businesses in the current financial environment is well below what they believe they are worth.

Still picky

While publicly held CROs represent the highest profile targets, we are aware of several wellknown 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 (NC, USA), which recently acquired the Eastern Europe CRO AbCRO (Bulgaria), are also taking the opportunity to make deals that help flesh out their capabilities.

This doesn't mean that investors aren't being picky, however. Investors are focusing on CROs with strong market positions and viable business models, mindful that the services industry will experience a shake out in coming months. We know of several highprofile companies that have been unsuccessful at finding private investors in the last year.

The lesson 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.