Contracting out Drug Pipelines

08/26/2010 11:10 am EST


Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Elliott Gue, editor of Personal Finance, says health care stocks are dirt cheap and one contract research firm should profit from drug companies’ fading pipelines.

Health care stocks are out of favor. For years, the sector had a well-deserved reputation for consistent returns and profitability regardless of broader economic conditions.

But the past two years have challenged this reputation. The health care reform package passed earlier this year omitted some of the most damaging proposals, such as a government-run insurance option. But the bill is extraordinarily complex, and provisions will be phased in over time; health care companies have struggled to quantify the impact beyond 2010. Investors abhor uncertainty.

Although the sector faces undeniable challenges, markets often overreact to new regulation, providing attractive entry points for savvy investors and a low bar of expectations. On a forward price-to-earnings basis, health care stocks are almost as cheap today as they were at the market’s 2009 nadir—despite improved economic prospects and credit conditions.

And on a relative basis, health care stocks traditionally have commanded a premium to the Standard & Poor’s 500 index thanks to their defensive growth characteristics. In terms of price-to-sales ratio, the group trades at a 10% discount to the broader market, near historic lows.

To play the group, focus on pharmaceutical firms with a solid pipeline of new products and companies in niche sectors with long-term growth potential and little exposure to coming reforms.

New drugs can cost upwards of $1 billion to develop, and more often than not, this investment doesn’t yield a bestseller. For every treatment that makes it to market, dozens fail to meet expectations during clinical trials.

Nonetheless, drugs companies must keep a steady stream of new prospects moving through trials to replace revenue when patents expire on existing treatments. Many of the industry’s biggest players will face this problem over the next five years.

But this pain is another company’s gain. The massive wave of patent expirations will be a boon for Pharmaceutical Product Development (Nasdaq: PPDI) and other contract research organizations (CROs).

Drug and biotechnology firms hire PPDI to design, manage, and run clinical trials throughout the development cycle. Outsourcing these functions enables pharmaceuticals firms to cut costs and focus budgets on identifying new compounds for trial.

Like many businesses, CROs took a hit during the credit crunch and financial crisis. Big drug companies suspended temporarily or froze planned product development to cut costs amid the global recession, while smaller biotechnology firms slashed their budgets after funding dried up.

But the tide has turned. Cancellation rates have dropped sharply over the past two quarters, and the pace of new orders is picking up, especially for later-stage trials. Buy PPDI under $28. (It closed above $23 Wednesday—Editor.)

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