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- In a period of disruption in the health care industry, the CRO industry has been one of the more stable subsectors due to steady demands, relatively clear revenue visibility, and solid free cash flows.
- The industry is not wholly insulated from economic downturns. We took five negative rating actions on three sub-scale CROs from 2008 to 2010. However, larger CROs generally stabilized within 12 months.
- A lot has changed since then, and we believe the rated late-stage CROs are much stronger today than ten years ago, due to their larger scale, bigger global footprint, improved diversification, and broader set of capabilities that position them as favored outsourcing partners with clients in an increasingly complex drug development environment.
- There are ongoing risks though. Enhanced drug pricing scrutiny could affect pharma R&D decisions. CROs' greater reliance on emerging biopharma could hurt their growth if the funding environment deteriorates. New management teams' responses to a recession could vary.
- While we view the industry favorably, we see varying degrees of cushion within existing ratings in a hypothetical recession. We believe Parexel (turnaround with high leverage) and Syneos (more cyclical commercialization business with limited cushion to maintain current rating) would be more likely to see rating pressure should a recession emerge today.
Though S&P Global Ratings has negative rating outlooks on most U.S. health care subsectors (e.g., health care services and pharmaceutical manufacturers), contract research organizations (CROs) have been relatively stable due to steady demand, a reliable stream of revenue, and solid free cash flow. Furthermore, we expect CRO ratings to remain largely stable despite the potential for a recession because we believe CRO operating performance, at worst, may suffer a sharp, but short, decline in revenues and margins. However, we think they'll quickly recover due to the critical role CROs play in pharmaceutical research and development (R&D). We also base our opinion on our observations of the last recession when the pharmaceutical industry was also undergoing a period of significant disruption. Importantly, in the 10 years since then, the CRO industry has grown and matured, and its relationships with pharmaceutical clients have changed in ways that lead us to believe that it's even better situated to weather a potential combination of a rapidly evolving U.S. health care industry and a recessionary environment. Given the solid industry fundamentals, strategic or financial buyers remain active, and have, at times, invested in troubled CROs.
In our opinion, these positive credit factors outweigh risks such as heightened drug pricing scrutiny, a slower industry growth rate, and the likely slowdown in pharma R&D and biotech funding should a recession occur. Ratings of late-stage CROs have been on the upswing since 2008, driven by a combination of improved scale and lower financial leverage.
As for the potential of a recession having an impact on CRO performance, here we examine:
- How the industry fared during the last recession,
- What has changed since the last recession, and
- Our view of the CROs' resiliency against the next recession.
|Rated Late-Stage CROs|
|Ratings as of Dec. 31, 2019|
IQVIA Holdings Inc.
Syneos Health Inc.
PRA Health Sciences Inc.
Pharmaceutical Product Development LLC
Parexel International Corp.
|Source: S&P Global Ratings.|
The Great Recession: The CRO Industry Weathered A Perfect Storm
During the Great Recession, the CRO industry was caught in the middle of (1) a slowdown in large pharma R&D as they rationalized pipelines and delayed R&D decision making; (2) weakened biotech funding; (3) several mega mergers in the large pharma group (Pfizer/Wyeth, Merck/Schering-Plough, Roche/Genetech), which delayed R&D outsourcing decisions; and (4) uncertainties regarding health care reform. Large pharma and biotech clients both slowed the pace of clinical trials as they delayed project starts, rationalized pipelines, restructured R&D, and conserved cash. Cancellation rates spiked as a result. Quarterly project cancellations, which typically run 15%-20%, were running more than 30% in some quarters. Lower gross new awards and higher cancellation rates resulted in lower net book-to-bill (BTB) ratios. Some CROs reported quarterly BTB ratios as low as 0.5x at the height of the recession (see charts 1-4).
Despite this difficult backdrop, the CRO industry was resilient and largely stabilized within 12 months. The volume and size of request for proposals (RFPs), a leading indicator of industry demand, started to decline in the fourth quarter of 2008, but began to pick up as early as the fourth quarter of 2009. Booking metrics for large publicly traded CROs (Parexel, PPD, and ICON; all unrated during the Great Recession) started to feel the recessionary stress in the fourth quarter of 2008, but had also largely returned to more normal levels by the first quarter of 2010.
Revenue growth for these three large CROs, which was tracking in the 20%-plus range immediately before the recession, slowed significantly starting in the third quarter of 2008 (still positive) and worsened throughout 2009, but resumed higher growth rates by the second quarter of 2010. Importantly, the organic revenue growth rates for ICON and Parexel never turned negative during this period. Cancellation rates, which typically ran below 20% before the recession, spiked to more than 30% in some quarters. We downgraded two smaller CROs, Kendle International Inc. and PharmaNet Development Group Inc. (less than $400 million in annual revenue compared with about $1 billion for large CROs at the time), lowering each rating by one notch. PharmaNet was acquired in 2009 and Kendle was acquired 2011.
What Drove The Quick Recovery?
We think the key driver for this quick recovery, at least initially, is deeper outsourcing penetration. Annual pharma and biotech R&D spending remained largely flat from 2008 to 2010 at about $130 billion, per EvaluatePharma (see chart 5). So the pie wasn't growing. In addition, large pharma clients decided to outsource more R&D work to save costs after reevaluating their R&D infrastructure and capabilities. A wave of "strategic partnership" deals announced between large pharma companies and (mostly large) CROs helped the recovery in bookings and revenue. Also, biotech funding rebounded to $18 billion in 2009 from $11 billion in 2008, which drove the recovery of the faster-growing biotech R&D client segment (see chart 6).
Is This Time Different?
The macro setup today somewhat resembles the period immediately preceding the last downturn. However, we believe the rated CRO group is much better positioned to withstand these challenges. During both periods, large pharma R&D is growing steadily. Biotech funding is robust, which hit a record high of $67 billion in 2018, compared with $24 billion in 2007, per BioWorld. In addition, a few large scale pharma mergers and acquisitions (M&As) were announced during both periods. However, we also see a number of notable factors that exist in only one of the two periods that could help or hinder the CRO industry in the next recession.
We believe the rated CRO names are more resilient today than 10 years ago, despite some of the emerging risks we identified below. The industry has matured, and after a decade of consolidation, all of our rated CROs are at least double in size compared to 2008 (see table 2 and charts 7 and 8). They have all improved their diversification by entering into ancillary business lines such as big data and the commercialization of new pharmaceutical products. They have also bolstered their global footprint, which is an important competitive advantage because most clinical trials today need patients from outside U.S.
|CRO Industry Is Larger And More Mature|
|CRO market size||~$20 billion||~$40 billion|
|Number of clinical trials on CT.gov||~66,000||~293,000|
|Companies with active R&D pipelines||~2,000||~4,300|
|Number of compounds in development pipeline||9,217||15,267|
|Source: ISR, Pharmaprojects.com, company filings and presentations.|
In addition, we believe the industry benefits from a more conservative booking policy relative to the last recession, when most CROs included pre-contract awards, and sometimes verbal commitments, in their backlogs. In contrast, most CROs have much stricter booking policies today (e.g., they include only fully contracted awards in the backlog), though variations exist across the peer set. Still, we believe that backlog quality has improved, which should help limit cancellation rates and revenue pressure.
We also think the industry benefits from more innovative drugs and greater trial complexity. In the past decade, breakthrough therapies such as immuno-oncology have turned certain types of cancers into chronic, manageable conditions. Moreover, cell and gene therapies have demonstrated the potential to cure some of the most difficult to treat diseases with one infusion. According EvaluatePharma, there are currently 849 oncology products in development, and oncology drug R&D spending accounted for 40% of total drug R&D spending in 2018. The rise of innovative therapies such as cell/gene therapy and immuno-oncology also means more complex clinical trials. Large global CROs are well positioned to address these challenges. On the flip side, more complex trials mean longer clinical trial lengths and more time to find and recruit patients. We think this is a positive credit factor for CROs in the context of a recession, because it would be hard to cancel these long-duration trials.
What Could Change Our Thesis?
Though we think the CRO is likely to be more resilient in the next downturn, we see some risks.
The industry has less room to grow:
- Given the industry's rapid growth over the past decade, our expectation for industry growth are lower compared to 10 years ago. Outsourcing penetration has grown to about 50% today, up from about 30% in 2008. We expect the industry to grow about 4%-6% per year, compared with around 13% before 2008. Therefore, we think there would be less room for outsourcing penetration to grow today should another recession emerge. While this growth rate is still above developed countries' GDP growth rates and many investors still consider the CRO industry a "safer" health care bet, it's plausible that a more mature industry could attract less capital in the next downturn.
Drug pricing scrutiny:
- Compared with 2008-2009, we believe drug-pricing scrutiny is much more intense today. While it is very early, we think the intense social and political scrutiny on high drug pricing in the U.S. could pose risks to long-term growth. It's plausible that pharmaceutical companies could rethink their R&D budget and outsourcing decisions given that it's more difficult to set an unreasonable drug price than it was a few years ago. While one could argue this may be positive for the CRO industry because it makes outsourcing a cheaper option (compared with developing a drug internally), it could be a negative factor if pharmaceutical companies begin to reduce their R&D spending or terminate certain clinical trials because new drug economics deteriorate if they can't garner high enough prices.
Shifting client mix And the rise of emerging biopharma:
- Compared with the Great Recession period, innovations and R&D spending are now more driven by emerging biopharma companies, rather than large pharma companies. According to the IQVIA Institute, "emerging biopharma companies" (defined as having less than $200 million in estimated annual spending on R&D, or under $500 million in global revenue) now represent 72% of late-stage research, up from 61% in 2008. In contrast, large pharma (defined as having revenue of over $10 billion) now represent 20% of late-stage pipeline, down from 31% in 2008.
- It's hard to predict whether the next recession will hit large pharma or emerging biopharma more severely. Emerging biopharma companies are better funded today than a decade ago, with at least three years of cash on hand today due to broad-based investment in the sector, which coupled with therapeutic breakthroughs, should support ongoing funding in another recession. On the other hand, we still expect biotech funding to drop in a recession, particularly for those companies in the third year of investment without showing promise. Therefore, CROs' greater exposure to the biotech segment today could mean they may experience more topline pressure if biotech funding weakens.
Different management teams and ownership structures:
- All of the rated CROs have a different CEO and chief financial officer today versus 10 years ago. Because of the leadership changes, many CROs took on new strategies that resulted in different business mixes, capabilities, and scale. Financial policies are heavily influenced by the ownership structure. The predecessors of publicly traded IQVIA and PRA were owned by private equity (PE) firms during the recession, whereas PPD and Parexel were publicly traded in 2008 but have since been taken private.
M&As Provide Some Downside Support To Creditors
The CRO industry has had an excellent track record of attracting both strategic and financial buyers, including several transactions completed for assets that were underperforming or facing financial stress (see table 3). In fact, two of the weakest CROs that we covered in 2008, Kendle International Inc. and PharmaNet Development Group Inc. were acquired by PE firms. Other prominent leveraged buyout (LBO) transactions, which were more motivated by taking advantage of temporary dislocation in public equity prices than addressing real distressed scenarios, include Quintiles (2003), PPD (2011), and Parexel (2017). The acquisition multiples were generally in the low-teens area, implying a significant equity cushion below prevailing debt levels.
In our opinion, most of the favorable characteristics that CROs offer (e.g., steady revenue growth and reliability and stable cash flow) remain intact today versus 10 years ago. While naturally all covered CROs have grown significantly since the last recession, large transactions can still be pulled together. LabCorp's $6 billion takeover of Covance in 2015 and Pamplona Capital Management's $5 billion LBO for Parexel in 2017 are two recent examples.
|Selected CRO M&A Transactions|
|Date announced||Acquirer||Target||Enterprise value ($ mil.)||EV/LTM EBITDA|
|July 31, 2017||Laboratory Corp. of America Holdings||Chiltern||1,200||12.6x|
|June 20, 2017||Pamplona Capital Management LLP||Parexel International Corp.||5,100||14.1x|
|May 10, 2017||INC Research||inVentiv Health||4,600||12.6x|
|Nov. 13, 2914||Laboratory Corp. of America Holdings||Covance Inc.||5,600||13.3x|
|Feb. 24, 2014||Cinven||Medpace||915||9.7x|
|June 24, 2013||KKR||PRA Health||1,300||12.0x|
|Oct. 3, 2011||Carlyle and Hellman & Friedman||Pharmaceutical Product Development LLC||3,900||11.8x|
|May 4, 2011||INC Research||Kendle International||342||12.7x|
|Dec. 28, 2010||Warburg Pincus||ReSearch Pharmaceutical||257||15.5x|
|Feb. 3, 2009||JLL Partners||PharmaNet Development Group||190||8.7x|
|July 25, 2007||Genstar Capital||PRA International||
|April 10, 2003||One Equity Partners||Quintiles Transnational Corp.||1,141||6.7x|
|EV--Enterprise value. LTM--Last 12 months. Source: Company reports.|
Which CROs Have Ratings That Are Most At Risk In The Next Recession?
We've ranked the CROs we rate by how well we think they're situated at their current rating level to withstand a hypothetical recession similar to the Great Recession (see table 4). This exercise should be taken in the context of our view that the CRO sector is more stable today than a decade ago. Importantly, a company that we're more likely to downgrade in a hypothetical recession doesn't necessarily mean it's weaker than its peers. It could simply mean that it has less cushion at the current rating level (i.e., metrics are stretched for a given rating).
Additionally, credit ratings are highly dependent on an individual company's financial policy. Because all of the leading CROs have changed their management teams since the Great Recession, we can't predict how new management teams may respond in the event of financial stress.
|Likelihood for rating downgrade in a recession||Company name||Performance in the last recession||Key changes since the last recession||Rating implication in the next recession|
|Higher||Parexel International Corp. (B-/Stable/--)||*Greater exposure to large pharma clients enabled it to fare relatively well during the last recession *Organic revenue stayed in the high-single-digit area during calendar year 2009 and 2010 and BTB stayed above 1x throughout the recession except calendar 3Q 2009||*More than doubled in scale to $2.1 billion *Lost sizable market share in the large pharma client segment over the past few years *Taken private in 2017||*In an operational turnaround *An economic recession could derail the already frail prospect for sustained revenue growth *Credit profile could weaken rapidly in a recession given high leverage and sponsor ownership|
|Higher||Syneos Health Inc. (BB/Stable/--)||Syneos’ predecessor INC Research was privately owned in 2008||*Larger in scale *More large pharma exposure with the acquisition of inVentiv Health *Unique CRO/CCO model enhances value proposition||*CCO (~30% of total revenue) is more susceptible to a recession *Limited cushion at current rating, which is predicated on our expectation that adjusted leverage will stay in the 3x-4x range in the long term. We expect adjusted leverage to decline to 4.2x and 3.8x by the end of 2019 and 2020, respectively|
|Medium||Pharmaceutical Product Development LLC (B/Stable/--)||PPD suffered unusually high cancellations, which led to three consecutive quarters of sub-1x BTB ratio from 2Q 2009 to 4Q 2009||*More than doubled in scale to $2.8 billion in revenue in 2018 *Taken private in 2011 *Achieved deeper penetration in the small and midsize biotech client segment, which today represents nearly 40% of consolidated revenue, compared to 31% in 2008||*Since the 2011 LBO, PPD has largely maintained its status as a pure-play CRO with a sizable laboratory business (20% of total revenue) *Credit profile could weaken rapidly in a recession given high leverage and sponsor ownership|
|Medium||IQVIA Holdings Inc. (BB+/Stable/--)||Ratings for IQVIA’s predecessor Quintiles (PE owned during the Great Recession) remained at BB--/Stable/-- during the Great Recession, despite having an aggressive leverage of between 4x and 5x||*More than 3x larger in scale *Strong leadership position in two segments: CRO (52% of 2018 revenue) and technology and analytics (40% of 2018 revenue)||*Aggressive financial policy and limited cushion to maintain current rating (4.5x leverage vs. downgrade trigger of 5.0x) *Largest in scale ($10 billion revenue) vs. other rated CROs (under $3 billion revenue) provides more stability *Technology and analytics solutions segment revenue is 70% recurring with high stickiness|
|Medium||PRA Health Sciences Inc. (BB/Stable/--)||Ratings for PRA’s predecessor (PE owned during the Great Recession) remained in the 'B' range during the Great Recession||*7x larger in scale *Increased exposure to large pharma clients significantly *Symphony Health Solutions acquisition in 2017 (~9% of total revenue), further improved the service line diversity||*No publicly stated leverage target and has expressed a willingness to do acquisitions and/or share repurchases *Solid cushion to maintain the BB rating with estimated adjusted leverage of low-3x in 2019 versus the downgrade trigger of 4x|
|Lower||ICON PLC (BBB--/Stable/--)||*Organic revenue stayed flat to low-single-digit range during 2009-2011 period *Quarterly net BTB ratio dipped below 1x in 3Q 2009 but has stayed above 1x since then||*3x larger in scale *More client concentration though has been diversifying *Top five clients accounted for 39% of total revenue in 2018, compared to 29% in 2008||*Less likely for a downgrade in a recession due to its minimal leverage (maintained throughout the Great Recession) and conservative financial policy. *The current rating allows for significant headroom in financial metrics to support potentially sizable acquisitions|
|BTB--Book to bill. CRO--Contract research organization. CCO--Contract commercial organization. Source: Company filings and S&P Global Ratings.|
- Full analysis: PRA Health Sciences Inc., June 19, 2019
- Full analysis: PAREXEL International Corp., Nov. 21, 2019
- Full analysis: Syneos Health Inc., Nov. 5, 2019
- Full analysis: ICON PLC, March 22, 2019
- Full analysis: IQVIA Holdings Inc., April 29, 2019
- Research update: Pharmaceutical Product Development LLC 'B' Rating Affirmed, Outlook Stable; New Debt Rated, May 7, 2019
This report does not constitute a rating action.
|Primary Credit Analyst:||Ji Liu, CFA, New York (1) 212-438-1217;|
|Secondary Contacts:||Arthur C Wong, Toronto (1) 416-507-2561;|
|Amy Martin, Dublin + 353 (0)1 568 0606;|
|Matthew D Todd, CFA, New York + 1 (212) 438 2309;|
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