Description

Life Sciences Research ("LSR") is a contract research organization ("CRO") that focuses on the preclinical/non-clinical markets.  UTAH1009 wrote the company up a little over a year ago, and I refer you back to his original write-up for additional background detail.  After rising as high as $35/shr in late 3Q 2008, the shares subsequently lost 80% of their value and currently trade for roughly 4x LTM earnings.  The Company has good long term growth prospects, modest leverage, healthy margins, huge returns on its invested capital, and has a management team that is both heavily invested and highly experienced.  The current trading multiple is a function of a challenging near-term operating environment and relatively low liquidity.

CROs provide outsourced R&D capacity to the pharma and biotech industries.  LSR's focus on the preclinical/non-clinical segment of the drug development lifecycle effectively means that it is involved in those portions of the development process that do not involve humans.  In other words, they provide animal-based testing for purposes of toxicology and metabolic assessment of the drugs/compounds under study.  Until the recent slowdown, CROs were viewed as a derivative play on the pharma/biotech industries and, as such, were assumed to be relatively immune from an economic downturn.  Given the deterioration in both announced results and visibility for the industry participants, this has clearly turned out not to be the case.  There are a couple of reasons for this.  First, a portion of the biotech customer base is reliant on continued access to public market funding.  Given the recent state of equity and debt markets, this funding avenue has been (at least temporarily) curtailed.  As such, demand from these early stage biotech customers has declined precipitously.  Second, and this is speculation on my part, as an outsourced alternative to in-house R&D functions, I believe that at least a portion of CRO demand represents swing capacity in the short-term for the customers.  Pharma companies have been busy slashing expenses, and it makes more sense for them to keep utilization rates at their fixed (internal) capacity R&D sites than at their variable (outsourced) capacity R&D sites (i.e. CROs).  Virtually all the CROs will tell you that pharma customers have been moving to a more variable cost structure over time and, as a result, have been permanently moving R&D functionality over to the CROs at a steady pace.  This is true, and CROs have garnered a steadily increasing percentage of total R&D expenditures over the past decade; however, this process takes time and not all of the CRO business can legitimately be defined as a "permanent" outsourcing from pharma/biotech customers.

As these two headwinds have impacted the CRO industry, trading multiples have compressed.  Big competitors like Covance (CVD) and Charles River (CRL) have seen their P/E multiples compress from the mid-20s to low double digits.  LSR has been negatively impacted to an even greater extent, with its trading multiple contracting from roughly 20x to the current 4x over the same time period.  There are several potential reasons for this.  First, LSR has much less sell-side support than virtually any other CRO, in large part due to activist campaign detailed in UTAH's write-up.  Second, I believe that there was probably greater shareholder concentration, which led to a harder fall from forced liquidations.  This second effect is difficult to prove, as many of LSR's large shareholders get confidential treatment on their filings so as not to become a target from the activists.

There are some recent signs that concerns over near-term demand dynamics for CROs, LSR included, may be overblown.  To-date, early stage work (LSR's focus) has been more adversely impacted than later stage work.  However, competitor CRL announced on its most recent quarterly call that it had seen some early signs of stability in February.  In addition, Covance reaffirmed that it continues to see strong LT dynamics with respect to continued market share gains for permanent outsourcing agreements by Big Pharma.

With respect to a medium- to long-term view, LSR will benefit from the continued market share shifts to outsourced R&D.  LSR is one of only three top tier providers in the preclinical space (top tier defined as capable of performing tests on all different animal models/types, using all different delivery mechanisms), so should benefit disproportionately from this shift.  As is widely known, Big Pharma is facing a raft of big patent expirations over the next few years.  R&D departments are working feverishly to plug these holes, which has led to an explosion in the number of preclinical compounds under development and associated demand for CRO services.

Although the Company derives a large portion of its revenue from its UK lab and, as such, may face some headwinds from the weakening British Pound, there are two offsets to this.  First, the profitability impact is much more muted than the top line impact as virtually all expenses are locally denominated.  Secondly, the weakening Pound has provided LSR with an unexpected ability to price contracts aggressively relative to competitors.  LSR also benefits from an extremely favorable UK tax regime that provides credits that enable the Company to book single digit effective tax rates.

There are no definitive near-term catalysts for LSR shares.  However, for a fundamentally decent business (as measured by returns on capital, cash generation, balance sheet strength) with good LT growth dynamics (10%+ annual top line), 4x EPS is just way too cheap.  If 2009 is anything short of a disaster, I think there is a high likelihood of multiple expansion for the shares, and a relatively easy double from current levels.

Catalyst

Less-than-catastrophic 2009 results, sell-side coverage, sale of company.