Financial Analysis

Half Full or Half Empty?

By Michael A. Martorelli | March 7, 2011

Judging the nature of the proverbial glass

Half-Full Guy (HFG) opens a conversation by noting that PPD Inc. provided 2011 revenue and earnings guidance that was quite upbeat, and a bit higher than Wall Street analysts had developed on their own.

Half-Empty Guy (HEG) responds by reminding his colleague that Covance suggested its first quarter earnings would be weaker than analysts expected, and PAREXEL lowered its previous guidance for the foreseeable future.

Let's pick up their conversation at that point. (HFG's comments are in boldface to make them easier to differentiate from HEG's.)

HFG: Despite PAREXEL's comments, the near-term outlook for CROs seems better than it's been in several quarters. Analysts and managers are predicting decent revenue and earnings growth for most companies in 2011. After the experiences of the past year, I suspect many of them are being overly cautious in their predicted growth rates.

HEG: After two terrible years, it would be really bearish for the industry if those folks were not expecting some pretty good rebounds in those growth rates. But the stocks just don't seem to be reflecting any broad-based expectations of the sharp rebounds that may occur. Also, I'm a bit worried about the near-term impact of some recent comments by a few large drug companies. Pfizer is reducing its R&D spending this year, Roche is lowering its estimate of peak sales for a key product, and Merck has withdrawn its earnings guidance for 2012 and 2013. These and other companies have also noted the high costs of complying with ObamaCare this year.

HFG: Drug and biotech companies are certainly facing many short-term financial pressures. But in meeting those challenges, more of them than ever before are signing important strategic alliances with CROs. Drug development firms of all sizes are finallyrecognizing that CROs can really improve the process of drug development.

HEG: But CROs are telling investors that the revenue flow from those alliances is slower than they thought, so it's taking longer to convert backlog into revenue. We now know that a CRO that puts the revenue associated with a large partnership alliance in its backlog is particularly vulnerable to cancellations, re-sizings and delays. That experience is the reason for PAREXEL's lowering of its guidance. Across the industry, the backlog rollout ratio is still declining, while cancellations are still near historically high levels.

HFG: Well, investors just have to get used to the fact that predicting near-term revenue and earnings results is extremely tough. They should not base their evaluations of CRO stocks solely on the prospects for the next quarter. They need to pay more attention to strategic growth opportunities. In the long term, alliances with large firms should result in more revenue for the largest CROs, not less. A growing number of mid-sized drug and biotech firms are increasing their dependence on outsourcing, and many are still using small and mid-sized providers. Finally, many types of CROs will benefit from helping drug development firms work on biosimilars.

HEG: I appreciate the long-term prospects for the industry. But I think the short-term prospects are still uncertain. I hope to see every CRO report better-than-expected numbers throughout 2011, and to hear their CEOs talk optimistically about the near term as well as the long term. I'll be more than happy to join you later in the year in proclaiming that the proverbial glass we've been discussing is definitely half-full.

Michael A. Martorelli is a Director at the investmentbanking firm Fairmount Partners. For additional commentaryon the topics covered in this column, please contact him at, or atTel: (610) 260-6232; Fax (610) 260-6285.

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