After PharmaNet‘s (Nasdaq: PDGI) first quarter news that it had again lost $30 million in contracts—the same thing happened to the company in the last quarter of 2007—Standard and Poor’s (S&P’s) revised its outlook on the contract research organization (CRO) from stable to negative.

It wasn’t just the loss of $60 million in business over six months. It was also the loss of the company’s $45 million revolving line of credit, which was triggered by the contracts heading south.

Negative Outlook

“We view that as a drying up of liquidity,” said S&P credit analyst Alain Pelanne. He added that, while PharmaNet isn’t completely dependent on the revolver for its operations, if it suddenly needed it, and it wasn’t there, it could spell big problems for the company. S&P doesn’t like to see a firm in such a potentially vulnerable state.

And so, for now, Princeton, N.J.-based PharmaNet’s outlook is considered negative. But its B+ rating remains intact. That’s S&P giving it the benefit of the doubt.

Bad Luck?

“We didn’t outright cut the rating to a lower level because these things do happen in this industry,” said Pelanne. “It’s possible, as the company states, these contract cancellations are really more bad luck than anything else. They were the results of drugs being pulled by drug companies—[PharmaNet] didn’t lose the contracts to competitors.”

Still, is the analyst community’s reaction to PharmaNet’s recent woes a harbinger of what’s to come? Is the CRO industry slipping out of favor?

Industry Dynamics

No, says Pelanne. “We think the dynamics [in the industry] are still positive. Our view on CROs hasn’t soured in the last quarter or two,” he said.

That said, there are some traits of the CRO sector that are troubling. One is turnover. Another is all the contract ups and downs, as showcased by PharmaNet. Pelanne says the two go hand in hand; it’s hard to hire and keep employees when your workload dips and soars so dramatically. The number of workers needed at any given time is always changing. Therefore, layoffs and turnover are endemic.

Fierce and Severe

Another issue? Competition. The CRO industry is fiercely competitive and that is not really a good thing for a large company’s health. “Whenever there’s severe competition, your pricing may be hurt,” explains Pelanne. “You often see a smaller CRO agree to do a project for less money.”

And since the CRO industry exists exclusively to serve the pharmaceutical and biotechnology industries, it will always be a reflection of those sectors, for better or for worse, says Arthur Wong, director of corporate rating for S&P.

R&D Trends

Right now, it’s for worse. The most volatile part of the pharmaceutical industry is R&D—“lots of money is spent and you don’t know what’s going to come out of there,” says Wong. CROs sit squarely in the pharmaceutical R&D space, and now is not the best time for R&D.

“They used to be loose about everything, but now the big pharmas have found religion again about cost-control,” said Wong. “They are laying off salespeople, and R&D—which used to be sacred cows. They are shopping price, and using leverage with vendors. So a CRO now has to be larger, a leading player, and must also offer a lower price.”

Shake Out

As a result, Wong says there’s likely going to be some shaking out and reordering in the CRO industry. How, exactly? He says it’s too soon to tell. But for now, he says, “Each one has to tailor their pitches a little better, and jockey a little harder to even get a position at the table to talk to these big pharma companies.”

Complicating things further is the fact that big pharma is canceling projects earlier in the process, rather than spending a lot of money on late-stage trials before figuring out a compound isn’t going to make it. “New technologies have come on line that enable pharmaceutical companies to identify better candidates than others earlier on,” said Wong.

Late-Stage Surge?

One result of this is far more early candidates in the pipeline now, which would naturally lead to a large amount of late-stage trials down the line. Maybe.

“The industry is hoping for a bolus of later-stage prospects just given the increased number of candidates in Phase I right now,” said Wong. “But will there be a later-stage boom? We hope so. But with R&D you just never know.”

Private vs. Public

The pure-play CROs that S&P keeps a close eye on, in addition to PharmaNet, are Kendle (Nasdaq: KNDL), and the privately held Quintiles and PRA International, both of which used to be public.

Which is a better environment for CROs—the public market, or private ownership? Because of the inherent unpredictability in CROs’ business, the private markets may actually be a better place for them. For now.

“Quintiles has been private for awhile, and views it as much easier to manage the business,” said Wong. “With public companies, there’s lots more focus on quarter-to-quarter results, and these can be volatile. You don’t have to be an expert to see that these stock prices move pretty violently.”

—by Suz Redfearn

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