CROs Highlight Toxicology Revenue; Are Mergers Non-Toxic To Bottom Line?

Covance expects its expanding toxicology research to drive double-digit revenue growth through 2003.

"We expect revenue growth to accelerate going forward and to continue to grow in double digits in 2003 when our additional toxicology capacity comes on line and our central labs volume increases," CEO Chris Kuebler told the company's July 24 second quarter earnings call.

Chief Financial Officer William Klitgaard attributed growth in the second quarter "primarily to strong toxicology results."

Net revenues for the quarter from preclinical services including toxicology studies increased 16.1% to $91.4 mil. In contrast, revenues from clinical services grew just 2.2%. Overall revenue growth during the quarter was 7.5%.

Covance's expansion work at its toxicology facilities in Madison, Wisc. and Harrogate, England is "on track," Kuebler said.

Covance is spending $27 mil. in Madison and $13 mil. in Harrogate. The company is using cash generated from the divestment of its biomanufacturing business in April 2001 to fund its toxicology expansion in Wisconsin (¹ (Also see "Covance Manufacturing Divestment To Fund $20 Mil. Toxicology Expansion" - Pink Sheet, 7 May, 2001.), p. 16).

"Some of the new space in Wisconsin has already been pre-sold, and we continue to work to sell that space in anticipation of beginning to generate revenue in October."

The expanded presence in toxicology makes Covance "very well positioned" in the CRO market, Kuebler told analysts. "We have a very different mix of businesses and a very different business profile than the businesses that are predominantly Phase II/III clinical."

In addition, "more than two-thirds of our revenues are derived from our industry leading laboratory services, which have very, very strong market positions and have significant barriers to entry."

The laboratory services business "is not an outsource business" since it "does not compete with internal capacity in the pharmaceutical industry," Kuebler said.

Inveresk, the latest CRO to go public, saw the same trend as Covance in quarterly results, with revenue growth on the preclinical side outpacing clinical revenues. Inveresk completed its IPO in June (² (Also see "Corcept To Test Sluggish IPO Market For Biotechs" - Pink Sheet, 10 Jun, 2002.), p. 21).

Net service revenue for the second quarter was up 20% to $55.5 mil. However, the company reported an overall operating loss, primarily due to non-recurring charges related to its IPO. While preclinical revenues were up 34% compared to the same quarter in 2001, clinical revenues remained flat.

Inveresk noted an increasing tendency by pharmaceutical companies to outsource their toxicology studies.

"We are seeing large pharmaceutical companies tending to outsource their longer-term toxicology studies more so now than they have previously," CFO Paul Cowen told analysts during the company's second quarter conference call July 30.

"Anything greater than 30 days, we are seeing from a number of our clients outsourced more so now than they had previously." Drug companies are choosing to outsource such services "in order to free up their facilities to do discovery pharmacology rather than safety toxicology," Cowen said.

Inveresk expects that its two expanded pre-clinical facilities - in Montreal and Tranent, Scotland - will be completely booked by the time they are functional.

The Montreal facility "has been focused on specialty toxicology services, primarily inhalation or infusion toxicology," Cowen said. Inveresk expects that the capacity in Montreal "will be pretty well spoken for by the time it is on stream on Jan. 1 next year."

"Much the same will take place in our Edinburgh facility coming on stream in the second half of next year," Cowen said. "We are seeing very strong signings and we have a high degree of confidence that those facilities also will be heavily utilized from a very early stage."

One reason for the company's optimism is its relative strength in specialty toxicology compared to general toxicology, Cowen noted. "The margins on the specialty toxicology business are significantly higher than general toxicology," Cowen said.

Inveresk estimates that the total annual investment by pharmaceutical companies in safety toxicology is about $4 bil. per year. Of that amount, "only about 20%-25% is outsourced," Cowen said.

Inveresk competes primarily with Covance for the $600 mil. to $800 mil. outsourced by drug companies in toxicology, Cowen said. Inveresk is about 25% smaller than Covance in terms of capacity for toxicology services, he added. "The next largest provider" in the toxicology area is about "50% of our size."

The increased focus on safety toxicology is "partly due to the desire of people to get more drugs in the clinical pipeline," CEO Walter Nimmo said.

Outsourced toxicology work increasingly pertains to compounds for inhalation or injection, Nimmo said. "Many of the new drugs are large molecules that can't be given conventionally orally. They have to be given by injection or sometimes by inhalation and so there is an increasing demand for inhalation or injection toxicology."

The increased investment in preclinical work may be an early indicator of a turnaround in the industry pipelines.

Investor enthusiasm for CRO stocks remains low, despite a marginal rebound in the NASDAQ-trade biotech, pharma and service companies tracked on the "F-D-C" Index (see chart: " ³ Monthly 'F-D-C' Index of OTC Drug-Wholesaler Stocks ").

Although the composite index closed up 3.1% for July, the three CROs on the index- Parexel, PPD and Quintiles - fared poorly, declining 14.7%, 11.6% and 20.5% respectively.

In addition to general concerns about the relatively empty clinical stage pipelines across the industry, CROs are also facing questions about the potential impact from another round of consolidation by manufacturers in light of the proposed Pfizer/ Pharmacia deal (⁴ , p. 6).

Inveresk's Cowen noted the importance of maintaining a "very diversified client base."

"Our largest client was only 6% [of revenues] and our top five clients accounted for just 20%," Cowen said. "Neither Pfizer or Pharmacia, for instance, are in that top five."

"We have relatively small exposures primarily to Pfizer and most of the revenues for Pharmacia were from legacy contracts from our ClinTrials days," he said. Inveresk acquired Cary ClinTrials in February 2001 (⁵ (Also see "Inveresk To Add Allergy/Immunology Expertise Upon Merger With ClinTrials" - Pink Sheet, 26 Feb, 2001.), 2001, p. 18).

"When you look historically at our preclinical, Phase I, and Phase II businesses, they have been relatively unaffected by most of the merger activities that have taken place in the past five years," Cowen said.

Covance cited a reduction in contract cancellation rates as an indicator of the strength of its clinical services. "In the second quarter, Covance cancellation rates are running somewhat below our historical norms," CEO Kuebler said.

In the case of the Pfizer/Pharmacia merger, "neither company is more than 5% of our year-to-date revenues on a stand alone basis," Kuebler said. "On a combined basis, they would represent less than 7% this year and most of that is Pfizer," he said.

"I was encouraged, as I'm sure you were, by seeing that Pfizer announced that in their merger they have no intended cuts in R&D spending and will spend $7 bil. on R&D of the combined company," he told analysts.

One CRO with substantial ties to both Pharmacia and Pfizer is Kendle. The CRO had expanding partnerships with both companies at the time of the merger, CEO Candace Kendle told a second quarter earnings call Aug. 1. "Both of those companies have chosen to continue those conversations with Kendle and they were both in the U.S. and Europe," Kendle said.

"So while we are watchful relative to the merger we feel very optimistic that we will continue to partner with Pfizer at the conclusion of the merger," Kendle said. In the second quarter, Pfizer and Pharmacia accounted for about 28% of Kendle's revenues.