An old adage warns: “Be careful what you wish for; you might just get it.”
For several years, CROs have been trying to develop meaningful, long-lasting, strategic partnerships with their biopharmaceutical clients. In doing so, they have sought to emphasize their role as drug development consultants with deep expertise, and downplayed their position as opportunistic vendors of specific non-differentiated services.
(By the way, as a service provider myself, I regard the term “commodity services” as inaccurate and inappropriate. I believe each service provider’s activities reflect its employees’ unique, collective set of experiences, capabilities and approaches to helping each client achieve its desired objective.)
CROs have been quite successful in their partnering efforts. Most large companies have multiple relationships with drug sponsors. Some involve a specific service, therapeutic category, or geographic territory; others involve multiple services across the globe. A few also include the transfer of a physical asset, along with the guarantee of work for that facility. Indeed, CROs pursuing any kind of strategic relationship expect they will yield a predictable — if not a guaranteed — flow of continuous business from each partner/client. Conferences and publications have been full of presentations and articles describing the mechanics of structuring such partnerships, and operating projects pursuant to them.
Many CROs have publicized each new strategic arrangement, frequently quantifying the addition to backlog and potential near-term revenue associated with each deal. On quarterly earnings conference calls, the managements of several publicly held CROs have often quantified for analysts the number of such partnerships under discussion, the number recently signed, and the approximate amount of revenue and/or backlog derived from them. For a time, signing more strategic partnerships seemed to be the best way for a CRO to solidify its future financial prospects in investors’ minds, thereby enticing them to pay a premium multiple for the stock.
I encourage the continued development of strategic partnerships; I think they will be good for both sponsors and service providers. But I wonder if some of the bloom has come off that particular rose. Recent financial reports have uncovered a few unintended consequences of these relationships.
Converting Backlog to Revenue Takes Longer than Before
A decade ago, investors could use the size of a CRO’s backlog as a reliable indicator of its revenue potential during the following two years. Strategic partnerships often include the awarding of large amounts of long-term work that a CRO can put into its backlog. Working through these long-term projects has resulted in a lower backlog rollout ratio (revenue as a percent of beginning backing) as calculated by analysts, and an increase in the average length of backlog as reported by managements.
Risk of Cancellations is Higher than in the Past
Cancellations are inevitable; CROs have no power to change this reality of drug development and are always assuming some risk when they add a project to backlog. However, a CRO adding long-term projects covered under a strategic partnership to its backlog is assuming a risk of cancellations that it is not assuming when adding only ready-to-go project awards to backlog.
Client Concentration is Rising
When CROs began to go public, investors expressed great concern over their client concentrations. Over time, most firms diversified their businesses to such an extent that that issue has faded. Recently, however, a few public CROs have indicated a greater reliance on their largest clients for reasonably important portions of revenue. Indeed, they have suggested this concentration will continue to increase as a result of winning larger awards from a smaller number of strategically important clients.
Please don’t overreact to my raising these concerns. Partnerships still seem worth pursuing. But company managements and outsider investors need to be fully aware of the unintended consequences these relationships can have on the financial picture of the CRO industry.
Michael A. Martorelli is a Director at the investment banking firm Fairmount Partners. For additional commentary on the topics covered in this column, please contact him at email@example.com, or at Tel: (610) 260-6232; Fax (610) 260-6285.