Pharmaceutical Product Development: Time for Another Spurt?

Pharmaceutical Product Development got 2006 backwards. The stock (symbol PPDI) aced the first half as earnings rose 25% in the first quarter from the same period a year earlier and 55% in the second. At its July peak, PPDI shares were up 35% year-to-date. Then, just as the stock market got moving, PPDI went into reverse. The stock, which closed November 29 at $31.47 (up 0.7% for the day), is flat for 2006, a weak showing when compared with PPDI's smaller, lesser-known competitors.

The stock's performance this year is puzzling because PPDI has excellent finances, a monster backlog of orders for research projects and strong support from analysts. Analysts hope that CEO Fred Eshelman and other executives call for a banner 2007 -- and sound convincing about it -- when they discuss the company's outlook in December. If they do and they turn out to be right, the stock has an excellent chance to reach the one-year price targets of $40 and $41 that various analysts have assigned -- perhaps even the $44 that Standard & Poor's forecasts. The price-earnings ratio, PEG ratio (price-earnings dividend by the earnings growth rate) and other yardsticks tell you this is a super time to buy PPDI.

But we're getting a little ahead of ourselves. What is this company all about anyway? Why should you expect this to be a high-growth business?

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Research outsourcers are behind-the-scenes contractors for big and small pharmaceutical and biotech companies. Their primary job is to conduct clinical trials, the series of steps a drug company must go through to confirm that a chemical is safe and effective and the prerequisite for winning government permission to sell it. This is a long and arduous process. Although the likes of Johnson & Johnson, ALZA and other major global drug companies could conduct the trials themselves, they find it more sensible to pay PPDI, which is a specialist, to do the work.

PPDI's fortunes thus depend in part on how much the drug industry spends on developing new products. Right now, they're spending like crazy all over the world. PPDI's backlog of projects went over $2 billion for the first time earlier in 2006, a figure that's been rising at an annual compounded rate of 30% since 1999. Revenue has climbed 21% a year, and earnings per share have risen 25% annually over the same period. That kind of rapid growth won PPDI a price-earnings ratio of more than 30 for many years. Investors willing to pay these rich prices have been amply rewarded, as the shares have climbed nearly ten-fold since the start of 2000.

But with the stock having fallen from about $40 in mid-July, it now sells for only 24 times the past 12 months' earnings. This is curious because PPDI isn't known to be facing any crises, such as a government investigation. The company, which is based in Wilmington, N.C., isn't sensitive to rising interest rates, and its few acquisitions and investments are too small to present much risk. PPDI did disclose in October that its rate of growth in new proposals declined a little in the third quarter of 2006 from the second, but the rate is still high and could reaccelerate soon. A small segment of PPDI called Discovery Sciences (about 3% of revenue), which performs original research, is struggling to replace some business that ended in 2005. But that shouldn't torpedo PPDI's stock.

So expecting some positive words when the company delivers 2007 guidance seems reasonable. The argument for investing in PPDI is that it allows you to participate in the long-term structural and demographic growth of the pharmaceutical business without taking on the risks that come with investing in the drug manufacturers themselves -- for example, the risk of Merck getting sued over Vioxx or a company facing strong competition from generics as it loses patent protection. You could look at one of PPDI's smaller rivals, such as Icon (ICLR, $35.74) or Parexel (PRXL, $27.75), but you'll pay more for the stocks on a valuation basis and not get the same track record of growth in earnings and revenues. Some glory stocks that hit the wall are washed up. The betting here is that PPDI isn't one of them.