CROs poised to grow despite shift in biotech funding

Ann Hynes
Ann Hynes Senior US Healthcare Equity Research Analyst
April 4, 2022

During the past several years, a wave of biotech innovation and record levels of funding drove strong growth for contract research organizations (CROs), which help drug developers conduct clinical trials. Investors responded by driving CRO stocks to historically-high multiples in 2021. 

This year has been a different story. A shift in biotech funding is raising doubts about the industry’s growth prospects, and CRO stocks have underperformed the market. We believe investors may be overlooking positive signs. Continued innovation, high levels of capital, pent-up demand, and private equity funding in the biotech industry mean that many CROs could see continued strong growth in the coming years. And with valuations down considerably since last year, we see the potential for upside for investors who take the time to examine important differences among CRO stocks. 

All eyes on biotech funding

CRO growth and profitability are directly linked to funding for biotech companies to invest in new, innovative drugs and platforms. These drugs require extensive clinical trials and testing to receive FDA approval, which in turn drives demand for, and growth in CRO revenues and profitability.  After historically strong years in 2020 and 2021, biotech funding is weaker so far this year. IPO transaction value through early March of 2022 decreased 96% from the previous year, according to Bloomberg. When they reported 4Q 2021 results, some smaller CROs reported seeing decreased demand in 2022.  

To gauge the impact of funding changes on CRO growth prospects, it is important to consider the full context. We estimate that IPOs represented one-third of biotech funding, on average, over the last five years. Private equity has been a larger source of funding, and they appear to be continuing to invest in biotech and especially in more-established pharma companies. 

After years of record funding, many pharma companies have adequate levels of cash to fund trials over the short- and intermediate-term. While the slowdown in biotech funding is important, private equity and existing cash could continue to drive growth. 

Finding CROs with stronger positioning

Some CROs may be more heavily impacted than others by changes in the funding landscape. Larger CROs tend to generate a greater percentage of revenue from more mature biotech and pharmaceutical companies, which are generally less dependent on the IPO market for funding. Smaller CROs are more reliant on pre-revenue or small pharma companies for business and may be disproportionately impacted by changes in the funding environment as a result. 

Our industry checks confirm that CRO demand from larger pharma companies is unchanged. Along with the more limited dependence on IPO funding, a backlog of projects and some residual COVID work should support continued demand for trials from larger pharma companies. 

Our top pick among CROs is IQVIA (IQV). Over 50% of IQVIA’s revenue comes from large pharma companies — an advantage, in our view, over smaller CROs such as Medpace (MEDP), which generates 77% of its revenue from small- to mid-sized biotech companies. IQVIA also offers tech and data services that diversify the company’s revenue, which we believe should help the company generate high single-digit to low double-digit annual revenue growth from 2022-2024. We also estimate low double-digit adjusted EBITDA growth in each of the next three years.

Lower valuations and price targets, but still a buy

Overall, we believe the fundamentals should support high-single to low double-digit organic revenue growth for publicly-traded CROs. However, higher interest rates and changing investor sentiment lead us to reevaluate our valuation of the companies and price targets are down an average of 13% from prior. 

The price declines we have seen this year have brought CRO stock multiples closer to long-term averages — down significantly from the historically high multiples investors were willing to pay for CRO stocks last year. While our previous price targets implied a 25.9 price-to-earnings (P/E) ratio for 2022 estimated earnings, our new price targets reflect a lower 22.7 P/E valuation. 

The larger CROs are rated “Buy”, with forecast 20% upside to our revised price targets for ICLR, IQV, and Syneos Health (SYNH). With the favorable demand environment and available cash on hand from prior years funding, we believe the recent wide scale sell-off in CROs was an overreaction on the part of investors. 

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