Have contract research organizations (CRO) turned the corner? Is the current downturn about to pass? Those were the questions we put to Michael Martorelli, director, Fairmount Partners.

Martorelli is a savvy Philadelphia-based observer of the CRO industry. By constitution, he is a plain-speaking and numbers-oriented guy who helps to find buyers and sellers for CROs; his firm has completed 65 transactions in the health care arena over the years.

The contract research industry, he says, has an unusually heterogeneous mix of companies involved in mergers and acquisitions. Some of the activity is from companies with only peripheral ties to clinical trials. Their interest in research can wax and wane. Buying a larger research presence, or selling a disappointing franchise, is an evergreen activity, giving Fairmount a large number of potential deals to explore. That level of activity, Martorelli notes, is unusual and not found even in the IT sector.

Martorelli tracks the value of projects reported as canceled by four big, publicly traded CROs. The picture is mixed. Yes, the aggregate dollar value of cancelled trials has shrunk by approximately half, from half a billion dollars quarterly to just a quarter of a billion dollars. And the number appears to be returning to some normal, routine level of cancellations. "I think and I hope it is on its way back down," he says of the cancellation rate.

Cancellation Decline

"I don't think the companies like cancellations, but that is the risk of the business," Martorelli explains. "There was a spike in cancellations for unusual reasons, pipeline re-prioritization and pipeline pruning."

His judgment is that CRO cancellations should be gauged against contractual backlogs. By that measure, they amount to a minimal slice of the future work CROs will be asked to do. "I don't know that 4 percent or 3.5 percent [of backlog] is a particularly horrible number," Martorelli says. The figure had edged close to 6 percent in the recent past. The number might still inch up in a particular quarter for one company, and down for another.

At the moment, the cancellations appear to be more rooted in the customary uncertainties of clinical research, not some epoch-defining life science reset to lower levels of research. "Failures in clinical trials are a permanent part of the drug discovery business," he says matter-of-factly. "They go up and down. Should that be scary and shocking? I don't know."

Martorelli says it is premature to actually announce the bottom has been touched and the industry is rebounding. It's just too early to say. But he can spot a few darker dynamics. "I still am not sure the drug companies are going to go back and spend with reckless abandon like they did in earlier years," Martorelli says. "They're not increasing their R&D dollars as much as they had been."

Scaling Up

For some sponsors of research, he says, the imperative to outsource is now the default way of looking at the world. "The big pharmas are more willing to outsource than they have ever been," Martorelli says. "It's taken them a long, long, long time to realize that. That's good news."

Indeed, there seems to be a steady trickle of massive, long-term, strategic deals between a major pharma and a major CRO. "You see the biggest drug companies hooking up with the biggest CROs," he says. "The evidence suggests the globalness and the full service are important."

It is absurd, Martorelli suggests, to think that the full-service outsourcing model is going to vanish. The recent long-term strategic contract that Sanofi recently awarded to Covance, he says, is emblematic of the ability of a few large CROs to offer any needed service. "I don't think that model is going away," he says. "They can do every service."

Specialization Strategy

Citing Icon, PPD, Parexel and Quintiles, Martorelli said those firms were probably gaining market share at the expense of smaller rivals.

"The little guys will point to a contract here and a contract there," he says. "But I bet that contract isn't from Pfizer, it's from small pharma or emerging pharma. Pfizer and Lilly are going with the big guys, who are more capable of doing more things, if not everything, around the world. Trying to pick up the crumbs of a project here and there is going to get harder for the smaller guys." Even when smaller firms hang on to a discrete area of clinical trial activity here or there, he adds, it will be natural for big sponsors to allow big CROs to take over those contracts, too, as they lapse.

CROs specializing in a therapeutic or geographic niche, he reports, are in the driver's seat at the moment. The large CROs are looking to invest in them. "The interest is tremendous. The valuations are very, very, very good," he says.

Advising such firms is easy, Martorelli says. "Most of the small companies have some service, some customer base, some specialty that is disproportionately growing and profitable. Expand that. Or buy some other company smaller than you. Make yourself attractive to one of the big guys. Don't diversify all over the place," he says.

Big=Better

For CROs with a more generalized approach, he says, there is a tougher message. "We don't take on the mission of selling what I call a generic CRO," Martorelli says. That's because the biggest CRO that would typically acquire such companies will not be interested in buying what he terms "more arms and legs."

In some cases, Martorelli says, low interest rates are one factor in triggering private investors to purchase CROs, as Avista Capital did in acquiring Inc Research in August of this year for $600 million. "They are buying them to grow them, focus them and sell them to someone else," Martorelli says of private investors sniffing around CROs.

Another example: United Biosource (UBC), which invested $150 million to build a portfolio of companies around epidemiological and late phase research. UBC was acquired for $730 million by pharmacy data firm Medco in September of this year.

And for mid-sized CROs? Martorelli isn't sure if those companies will be big enough to compete across the globe. "Will there be a permanent place for a solid mid-sized CRO? I don't know what the answer is to that question," he says.

He sounds a bit concerned about Kendle. He is impressed that the Ohio firm's new bookings have recovered from sharply depressed levels, but even the new higher numbers are below the typical awards of a few years ago. "Kendle, I think, is finding itself missing out on a few things," Martorelli says.