This is a student paper from the 2009 final projects in the NIH Foundation for Advanced Education in the Sciences’ TECH 366 — Biotechnology Management. The students were asked to tell a story based on the course lectures, and to expand with general lessons on biotechnology company management.
The changing roles of CRO
Contract research organizations (CRO) have played significant roles in the research and development (R&D) of biotechnology industry ever since its first appearance in the late 1970s. CRO provide important services in clinical trial management, safety monitoring, formulating and manufacturing, laboratory services, data management, NDA writing and filing as well as other regulatory affaire support, etc. The CRO industry had shown stable and increasing revenue on the global scale in recent years despite the weak growth of global economy. For instances, CRO shared $15 billions of global biotechnology R&D market in 2007 and $18 billions in 2008. In the United States, approximately $9 billion, accountable for 15% of total of R&D funds flowed to CRO in 2007. Even under the impact of global financial crisis, CRO revenue increased to approximately $10 billion when the total U.S. R&D increased to $65 billion in 2008 (Fig 1).
In recent years, the biotech industry has generated several lines of biomedical products that are sold over billion dollars each year, giving more room for CRO industry to grow. In 2008, for instances, monoclonal antibodies sales reached $33 billion, TNT blockers reached $18 billion, and erythropoietin reached $9.5 billions. The global sales of biotech drugs jumped from $75 billion in 2007 to $125 billion, almost 16% of global drug sales, in 2008. This fast growth (Fig 1) of biotech revenue may encourage R&D expenditure in biotechnology and therefore expand the market size for CRO in the near future.
Fig 1. Global sales by CRO and Biotech industries. (data source: reference 1, 2, 3, 4.).
Today’s CROs may operate either as local niche services or on international scales. Several CROs, such as Quintiles translational corporation, Covance Incorporated, Pharmaceutical product development, Charles river labs and MDS incorporated, have generated over billion dollar revenues each in 2008. Out sourcing to CRO has become an attractive strategy for many biotech firms because CRO may provide services that are not available in-house for start-up firms. In some other cases, CRO may provide services with more competitive quality and better-targeted milestones than in-house research department for some large biotech firms. CROs are often used because their ability to reach out for regionalized patient populations and ability to efficiently manage international clinical studies. In any cases, however, the conventional role of CRO is to merely act as the “extra capacity” to facilitate R&D projects of the sponsors. By saving time, capital, labor, and/or space using specialized skills and/or research facilities of CRO, sponsors can focus more on the “core skills” and the growing regulatory demand that are relevant to their products.
Compared to other types of biotech firms, CROs have much better success rate as business entities either as small privately owned companies or as large international corporations. One of the important reasons is that CROs are less dependent on external funds such as VC than other biotech firms. CROs may survive on the service fees when external funds are not available for expansion. However, CROs usually do not request for the right of the potential intellectual property (IP) that may be generated from the services it provides. The matter of fact is that, most often, the part of the R&D project that CROs are involved are unlikely to generate any IP. The fact that the CRO is unable to claim for the right of the IP that may be generated through their own activities is probably the most obvious “downside” of the CRO business, especially when IP rights after Bay-dole act are usually claimed by research organizations even if the research might had been sponsored by the other parties. Therefore, CROs may be characterized as “low risk, low return” type of business and may be less attractive to investors who are looking for high return opportunities.
The global financial crisis may have created an opportunity for CROs to break the “low risk, low return” formula and enter the arena to compete for IP titles. As the financial support for start-up and early stage biotech companies quickly reduce to the very minimum, the so-called “valley of death” would become more “deadly” . As the result, new IPs are unlikely be developed to relatively maturation stages where the large and well-funded firms can see promising products and to invest further R&D efforts. Soon will see a shortage of relatively mature biotech drug candidates to supplement the inheritably insufficient in-house R&D of the established biotech firms. Having the infrastructures and funding in place for research and development, the profiting CRO may invest in early stage biotechnologies and seek for higher returns. CROs may not necessary become the replacement of small biotech firms, but an extra funding mechanisms for the desperate industry that is not on the “bail-out” list of the government.
Initiatives should be launched to invite CROs to invest in early biotechnologies. It is a risky idea for CROs to invest in early stage biotechnology. But the potential benefit of this initiative is not for CROs alone if “we” are seriously considering the challenges caused by lack of funds for early and small biotech firms. Here, I define “we” as the local government and established biotech firms because the pressure won’t be on the small and vanishing biotech firms’ shoulders alone if “we” are not going to do anything about the development pipelines that will soon be more broken in the “valley of death”.
Then the question comes to how to invite CRO to the IP hunting arena. The Maryland technology development corporation (TEDCO) had provided a good model by collaborating with Johnson & Johnson (J&J) to establish a co-managed funding agreement in 2005. This funding awards seed biotech companies with funds to develop technologies that are potentially of interest for J&J. TEDCO matches the J&J funds. J&J has opportunity for equity investment as the technologies mature (reference 5).
To invite CROs to joint collaborative research agreement, funding should be established by pooling money from government and sponsor companies to fund part (eg. 2/3) of a specific R&D project. CROs will identify and license the IP of interest and provide the rest (eg.1/3) of projected cost. Collaborations of the like will significantly increase the pipeline portfolio of early stage technologies for the sponsor with reduced risks without significant increase in R&D costs. CROs will obtain opportunities for generating IP assets without exhausting the profits earned from the contract works.
Local government, especially the state government, should take the initiative to invite CROs invest in early biotechnologies, not just to benefit CROs, but to stimulate the biotech industry and the economy of the state. Historical data showed that states that paid more attention to the biotech R&D received more returns from the industry. When the relative efforts in biotech R&D by states (national ranking of state expenditure in 2006) were plotted against the relative benefit received by states (national raking in patent number, VC investment, and NIH funding received), a clear positive correlation was seen between the state’s effort in R&D and the benefit the state received in a long run (Fig 2). For instance, California invested $6.5 billions (13.6% of total U.S. investment) in biotech R&D, ranking number one in the U.S. in 2006, indicating the involvement and focus of the state government. At the mean while, California received 24,293 patents between 2002-07 (nearly 20% of the national total), $20.7 Billion CV investment between 2002-07 (40.5% of national total), and $3.2 billion of NIH funding in 2007 (15% of national total), all ranked in number one on the national list.
State involvement and policy in biotech development play no doubt the most critical roles nurturing the growth of local biotech industry, including the CRO industry. Investing $1.7 billion in biotech R&D, North Carolina ranked in number eight on the national list in 2006, and now hosts two of the world-top-10 public-traded CRO companies, Quintiles transnational corporation and Pharmaceutical product development, making $3.57 billion of revenue in 2008. The state attracted capital investment from several internationally operating pharma/biotech companies. Recently, Novartis announced to build a $267.5 million vaccine manufacturing and Merk announced a $100 million expansion on its vaccine facility in the state. Constella Group, a private CRO company in Durham North Carolina grow from a statistical consulting service to a $200 million revenue-making bioinformatics firm in 2007 by assisting life-science clients.
In conclusion, encouraged and appropriately guided by the local government, CROs may deliver great value to the local economy. It’s important to recognize that the value of a CRO does not only exist in the revenue it generating, but also exists in its readiness to help the biotech industry overcome the current financial challenges.
Fig 2. The correlation between the state R&D expenditure and the returns (number of patents, VC investment, and NIH funding to the state). The colored trend lines are regression lines corresponding to the data points of the same color. The Y-axis is the national ranking of the state with smaller numbers indicating the top states. (data source: reference 6)
1. US Pharmaceutical Industry Report, 2008-2009: www.reportlinker.com/p0118600/US-Pharmaceutical-Industry-Report-
2. Business insights: www.globalbusinessinsights.com/content/rbcr0001m.pdf
3. Global market review: http://knol.google.com/k/krishan-maggon/global-biotechnology-market-review/3fy5eowy8suq3/16#
4. IMS health: http://www.imshealth.com/portal/site/imshealth/
5. Maryland TEDCO: http://www.marylandtedco.org/tedcoprograms/ fundingopportunities.cfm
6. Biotechnology Industry Organization: http://www.bio.org/speeches/pubs/er/statistics.asp
Guest content from Turner Investment Partners‘ Heather Flick McMeekin, Frank Sustersic, Vijay Shankaran, and Theresa Hoang:
Contract research helps keep drug pipeline flowing
Imagine a new-product development process that typically lasts 10 to 15 years, has only a one in 5,000 chance of succeeding, and costs at least $800 million. That’s the daunting reality that biopharmaceutical companies face in seeking to bring a new drug to market.
To help them navigate the time-consuming, risky, and costly waters of new product development, biopharmaceutical companies are turning to contract research organizations (CROs). The large CROs offer two kinds of services that in effect provide one-stop shopping for drug R&D: 1) preclinical services, which include chemistry and animal-testing services in laboratories to assess the safety of a drug candidate before it’s introduced to human patients; and 2) clinical services, which involve such functions as project planning and management, patient recruiting, and trial monitoring and analysis to test the safety and effectiveness of new drugs given to volunteer human patients.
500 CROs worldwide
Currently about 500 CROs compete around the world, with the smaller ones tending to specialize in either preclinical or clinical services. Most CROs work under fixed-price contracts. Preclinical contracts are typically smaller, $2 million or less, and shorter in duration, lasting for months. Clinical contracts, in contrast, can total $100 million or more and run for years. In general, preclinical contracts have been the most profitable.
The drug-development process has become so time-consuming, risky, and costly in part because of a growing risk aversion and preoccupation with safety by the Food and Drug Administration (FDA). The FDA in recent years has intensified its focus on safety and has shown a diminished tolerance for side effects in new drugs.
Consequently, last year the FDA approved just 19 new drugs, the fewest in 24 years, and issued more than 70 new or revised “black-box” warnings about potential side effects, twice the number in 2004. Also, the number of “approvable letters,” which typically require biopharmaceutical companies to submit more data before the FDA makes a decision on a drug, increased by 40% last year, as reported by Sagient Research Systems, which monitors drug approvals.
Drug applications slump
In turn, as the approval bar gets raised higher and higher, biopharmaceutical companies are submitting fewer new-drug applications to the FDA. In the past two years the number of applications submitted by the companies declined by more than 20%. And as the FDA requires more and more tests of new drugs, the development cycle is becoming more elongated. All of this has helped exacerbate financial and operational problems for biopharmaceutical companies — problems that the outsourcing services of CROs are proving uniquely able to address.
For instance, it was widely expected that pharmaceutical companies would launch a slew of new drugs to offset the revenue lost from their existing drugs that are going off patent. Obviously, that hasn’t happened, and the resulting financial pressures have compelled pharma companies to cut costs across the board. Pfizer, for instance, has reduced its number of R&D centers from 15 to 10 over the past three years. But here’s the challenge: pharma companies must innovate to survive, which means that while they are striving to control costs, they also need to keep spending on research and development to create profitable, proprietary new drugs and replenish the pipeline. R&D spending has in fact been increasing 8-10% annually over the past five years and should rise at a similar rate going forward, in our estimation.
In essence, pharma companies are turning to CROs as an outsourcing solution in an effort to optimize their R&D spending. The CROs can develop drugs faster than the pharmaceutical companies can, with comparable quality, the Tufts Center for the Study of Drug Development found. According to the pharma companies themselves, CROs deliver genuine value — a high level of technical expertise, improved productivity, and cost savings.
Smaller customers fuel growth
Another problem that CROs are helping to solve is that relatively small biopharmaceutical companies are hard-pressed to fund all the internal capabilities, laboratories, and equipment critical to developing new drugs, especially in the preclinical phase of development. As a result these smaller companies have found it more practical to pay CROs for their internal capabilities, laboratories, and equipment to handle preclinical testing. The volume of outsourcing from small firms has been central to CROs’ rapid growth. For instance, biotechnology companies now furnish more than 30% of CROs’ revenue, up from 21% in 2003. As we see it, that percentage should continue to rise steadily over the next few years.
What’s more, regulators worldwide prefer biopharmaceutical companies to conduct multi-center international drug trials. Also, it’s often much easier to enroll patients in certain types of clinical trials overseas. These trends are benefiting CROs that have dozens of international locations. Today more than 40% of CROs’ revenue is generated outside the U.S., according to industry data. Kendle International, a leading CRO, anticipates that more drug R&D will migrate from the U.S. to Europe, Asia, and Latin America, with the company’s revenue there rising to 60% by 2010.
So we think there’s a great deal of growth both domestically and internationally for CROs to pursue. Altogether, less than 25% of all drug R&D spending is outsourced, in our estimation. Managers at Covance, another leading CRO, say the company and its competitors may perform 50% of all drug R&D in the future.
Market poised to grow
In short, the CROs are in a fast-growing, highly profitable global business. The CRO market should grow at a 12.6% compound annual rate through 2011, to $29.4 billion, up from $16.3 billion in 2006, according to Goldman Sachs. And Goldman Sachs calculates that earnings before interest and taxes at CROs are more than $20,000 per employee — one of the highest rates in any industry. That level of profitability is even more remarkable in light of the heavy hiring that CROs have done since 2004; during that time the six largest CROs have increased their employee headcount by 57%, to 37,300 people. What’s more, the largest CROs have boosted their book-to-bill ratio to about 1.4 over the past year. Such a high book-to-bill ratio, in our judgment, provides high earnings visibility, i.e., a good picture of CROs’ favorable future profit trends.
Among CROs, we think five of them possess especially good growth prospects over the next two years: Covance (market capitalization: about $5 billion), Icon (about $2 billion), Kendle International (about $540 million), Parexel International (about $1.5 billion), and Charles River Laboratories International (about $4.4 billion). All five provide both preclinical and clinical services to varying degrees.
Covance, headquartered in Princeton, New Jersey, has been a profit pacesetter: its earnings growth has exceeded 20% annually for the past seven years. Its annual revenue exceeds $1.4 billion, and its services are as comprehensive as any in the industry. The company is currently involved in more than 14,000 clinical trials worldwide. A program-management service that’s designed to accelerate the early development of drugs is highly regarded in the medical community and generates revenue of more than $200 million per year.
Icon: an international presence
As international drug development becomes the norm, Icon would seem to be especially well-positioned: the company is based in Dublin, Ireland, and more than 40% of its $870 million in annual revenue is produced outside the U.S. To beef up its international presence further, the company in 2007 opened 18 new offices in six countries, including Japan, which it considers a potentially lucrative market. In customer surveys, Icon consistently ranks highly for the quality of service.
Kendle International, based in Cincinnati, derives about 54% of its $570 million in annual revenue overseas. The company expects much of its growth will be in Asia, where its customers’ R&D spending on drugs is expected to reach $20 billion by 2013 — nearly double the current level, according to the Frost & Sullivan consulting firm. By its own analysis, Kendle assisted 44 of the 50 largest biopharmaceutical companies in developing more than 600 new drugs last year, and its clinical business is growing at twice the average rate of the industry.
Parexel International gets 59% of its more than $740 million in annual revenue in foreign countries, a higher percentage than that of any competitor. Parexel’s clinical services account for more than 70% of revenue. The company does business in 51 countries and is admired for its skill in training new employees. Over the past five years the company’s net income has increased by 250%, powered by its expertise in four fast-growing fields of drug R&D: cardiovascular, central nervous system, infectious disease, and oncology. Based in Waltham, Massachusetts, and founded in 1982, Parexel was one of the first CROs to venture overseas.
Charles River Laboratories International is another CRO pioneer: its history dates to 1947. Through acquisition the company has built a far-flung network of preclinical operations, which account for most of its annual revenue of more than $1.2 billion. Headquartered in Wilmington, Massachusetts, the company plans to add about 1 million square feet of preclinical-laboratory space between 2007 and 2009. Its Charles River Dedicated Resources Unit, providing staffing and laboratory space to customers, has been a prime source of new business.
In sum, as long as the drug-development process remains costly and risky, as long as drug R&D spending continues to increase, and as long as cost control and outsourcing remain priorities with biopharmaceutical companies, we think CROs should flourish. In our analysis, if they fail to flourish going forward, it would likely be due to these reasons: a diminishing customer base, caused by consolidation among biopharmaceutical companies; an inability of early-stage, unprofitable biotechnology companies to obtain capital; or a surge in contract cancellations (which have averaged less than 6% annually).
But we think none of those risks are great in the near term, and we anticipate that CROs will continue to help their biopharmaceutical customers and apply technical expertise to the drug-development process in a highly cost-effective way.
The views expressed represent the opinions of Turner Investment Partners as of the date indicated and may change. They are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. Opinions about individual securities mentioned may change, and there can be no guarantee that Turner will select and hold any particular security for its client portfolios. Earnings growth may not result in an increase in share price. Past performance is no guarantee of future results.
Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm that manages more than $26 billion in stocks in separately managed accounts and mutual funds for institutions and individuals, as of June 30, 2008.
As of June 30, 2008, Turner held in client accounts 730,308 shares of Covance, 656,980 shares of Icon, 454,973 shares of Kendle International, 1.8 million shares of Parexel International, and 2.3 million shares of Charles River Laboratories International. Turner held no shares of Pfizer.