Life Sciences: It pays to be the middle man
Investing in pharmaceutical companies can be a risky business where investors essentially bet on whether clinical trials will pass with flying colors, which many times isn’t the case. Many drug companies have now adopted the method of “outsourcing” clinical trial testing to firms such as Life Sciences Research, Inc. (NYSE:LSR), to assuage risk that could directly affect financial results.
The outsourcing of drug testing is becoming big business: it’s currently estimated that 25% to 30% of pre- and non-clinical testing is outsourced, and industry analysts such as Hamed Khorsand with BWS Financial believe that this percentage, as well as the absolute dollars that go toward outsourcing, will continue to grow.
Life Sciences, which has an estimated annual testing capacity of over $300 million, is in the business of teaming up with clients for Phase 1 clinical trials to independently verify results. The company is the largest provider of pre-clinical efficacy testing in the United Kingdom and Europe, and is globally one of the “big three” that include Covance (NYSE:CVD) and Charles River Labs (NYSE:CRL).
On top of assessing whether products meet regulatory and commercial requirements for human consumption, Life Sciences also tests the effect of compounds on the environment and assesses the safety and efficacy of veterinary products, though 85% of the small cap’s customers are pharmaceutical companies.
The company is beginning to catch Wall Street’s attention: Life Sciences has brought its operating margin back to the 15% to 17% range, with aggressive growth that has yet to reach a ceiling. According to Khorsand, the small cap is sitting on an approximate 26% growth capacity.
The staple of Life Sciences’ growth is a reflection of growth in the pharmaceutical industry as a whole. As more and more potential drugs are tested for market, the need for independent research jumps. Will there be new drugs for the treatment of depression, cancer, weight control, blood pressure and other ailments? Count on it. In order for the pharmaceutical industry to achieve its targeted margin growth, the industry will need to bring an even greater number of therapies to market than historically achieved thus far. That’s a lot of testing.
The company may pass the test for clients, but can it also guarantee an A+ stock price? For the first quarter ended March 31, operating income was $9.7 million, up from $6.2 million in the last quarter. New orders during the first quarter of 2008 reached $71.4 million — creating a backlog increase of $196 million, up from its $190 million in fourth quarter 2007.
Revenues alone for the quarter were $63.2 million, 16.4% higher than the revenues for the same period in the prior year. LSR also reported net income of $6.7 million for the quarter, compared with $3.5 million for the prior-year quarter. Net income per common share shot to $0.53 compared with $0.27 for the year-ago quarter, while net income per fully diluted share was $0.44 compared with $0.23 for the comparable quarter.
Khorsand wrote in a report published on May 2, 2008 that biotechnology, like pharmaceuticals, is a substantial growth segment for the company. “In 2007, LSR started to put more focus on serving the needs of biotechnology companies. The biologics pre-clinical trial business does provide LSR with a capacity outdoing the competition. This service is more expensive, which means higher growth margin for LSR,” Khorsand wrote.
But in the end, pharmaceutical companies still reign supreme for the small cap: Life Sciences’ new business growth (86% in the first quarter) is directly attributed to new pharmaceutical contracts.
The company’s management has high hopes that as Life Sciences moves to increased levels of capacity utilization, the company will improve its operating margins above the level currently earned by its industry peers.
How much can potential buy on Wall Street? Earnings estimates range from a $10 increase per share — on an operating margin of over 15% for two consecutive quarters — to speculative talk of the forward being as high as 22 times 2009 consensus earnings estimates. That’s testing growth.
