The Real Winners of Drug Experimentation

Drug industry executives often point out that it costs more than $800 million to bring a compound from the laboratory to the marketplace. And of every 5,000 to 10,000 screened compounds, the industry's top trade group says, only five will make it to clinical testing, and only one will be approved by regulators.

Those are daunting figures for drug and biotech companies, whose stocks can bounce around depending on whether an experimental compound is a blockbuster or a bust. However, for companies that provide R&D goods and services to drugmakers, nothing succeeds like trial and error.

These companies, such as Sigma-Aldrich ( SIAL) and Invitrogen ( IVGN), can do quite well whether a drugmaker such as Pfizer ( PFE) produces a hit like Lipitor or a failure like torcetrapib, a cholesterol drug that never made it to market.

These companies make chemicals, reagents, bioassays, cell cultures, test tubes, diagnostic kits and other so-called life-sciences tools. As long as R&D budgets grow, so should sales for companies like Applied Biosystems ( ABI) and Qiagen ( QGEN).

Among drug industry executives and analysts, pharmaceutical companies like Merck ( MRK) and Genentech ( DNA) often have been likened to miners during the California Gold Rush. In following that mining analogy, life-science tool firms are akin to the Gold Rush merchants who sold picks, shovels and assay equipment.

The mining analogy has become a cliche, but truth is a foundation for cliches. Many Gold Rush merchants fared better than the miners they supplied, and many of today's pick-and-shovel firms have fared better than their clients.

Sigma-Aldrich's stock gained 40% for the 12 months ended March 20, while the Amex pharmaceutical index, which represents large drug companies, was off 13%. The Amex biotechnology index was down 5%, and the S&P 500 fell 6% over the same period.

Over the past five years, St. Louis-based Sigma-Aldrich's shares gained 167% on a split-adjusted basis, while the S&P 500 rose 52%, the biotechnology index climbed 102%, and the big-drug stock index barely broke even during the same time frame.

Other picks-and-shovels players have done well, too. Over the past 12 months, shares of Qiagen, Applied Biosystems, Invitrogen and Thermo Fisher Scientific ( TMO) each outpaced the biotech, drug and broader stock indices. Over five years, shares of these companies are up between 109% and 220%.

However, these stocks aren't slam-dunks for consistent returns. On a split-adjusted basis, Qiagen climbed to $57 by mid-2000, then lost more than 90% of its value in just over two years. It has rebounded to trade in the high teens or low $20s. Shares of Millipore ( MIL), were down 7% for the 12 months ended March 20, although the stock has doubled over five years.

Aside from company-specific problems, analysts say the major hurdles to picks-and-shovels firms maintaining solid growth rates are extensive drug-industry consolidation, cutbacks in pharmaceutical R&D and slowdowns in government research activities.

Wall Street's worries will be reduced for companies that can expand their products and services in foreign markets, especially developing countries. Survival of the fittest also may mean survival of the biggest in an industry for which consolidation continues.

The Wall Street Angle

"Sigma-Aldrich's substantial pricing power and topnotch sales and distribution model have helped the company earn steady profits for more than a decade," says analyst Ben Johnson of the independent research firm Morningstar, in a recent report. " Its winning streak will continue for years to come."

He notes that the company sells a whopping 145,000 products for medical, scientific and industrial uses to commercial, academic and university clients. No customer accounts for more than 3% of sales. Johnson's greatest concerns would be a "softness" in clients' R&D spending due to cutbacks in government funding and the currency risk for a company that gets more than half of its revenue from foreign markets.

He gives Sigma-Aldrich a two-star rating -- five stars represents the best buying opportunity -- indicating its recent price in the high $50s has outrun his fair value estimate of $51 a share. Among sell-side analysts, four have buy ratings while five are neutral, says Thomson First Call.

Johnson adds that Sigma-Aldrich has a "rock solid balance sheet" thanks to disciplined management. "Despite a large cash balance, the company has refrained from overpaying for acquisitions in a pricey market," Johnson says.

Aggressive expansion tripped up Invitrogen for a few years, and the company is still paying on Wall Street where there are eight hold ratings vs. four buy recommendations, says Thomson First Call. However, Invitrogen posted a 30% stock gain for the 12 months ended March 20 and a 160% gain for the past five years.

"Only two years ago, the words 'predictable' and 'consistent' were the antithesis of Invitrogen's business and performance," says Ross Muken of Deutsche Bank, in a March 18 research report. Invitrogen had been plagued with "numerous mistakes and miscues including failed acquisitions and technology missteps," says Muken, who raised his rating to buy from hold in February.

Invitrogen's "current business is the envy of many managers," says Muken, who doesn't own shares. His firm says it does -- and seeks to do -- business with companies mentioned in research reports.

Morningstar analyst Jeff Viksjo says the stock is still too expensive, even though the price is down from the high $90s in December to the low $80s in March. He gives Invitrogen two stars and he pegs a fair value at $68 a share. In February, he told subscribers that even though Invitrogen has a "wide collection of top research brands," it still "must make its operations more efficient to create value for shareholders."

Because Invitrogen competes with many companies selling similar products, there is "little opportunity to raise prices," he says. "There are almost no barriers to entry in the industry, and start-up firms routinely develop new technologies that challenge existing ones."

A Diverse Business Model Pays

In the picks-and-shovels universe, Invitrogen and Sigma-Aldrich focus on chemicals and 'consumables,' the products that researchers use and then throw out. Some companies concentrate on instruments, and others offer a mixture.

Diversified companies include Qiagen, Applied Biosystems and the biggest publicly traded life-science tool company, Thermo Fisher Scientific. Its market cap of $23.7 billion is triple the size of Sigma-Aldrich. Created in 2006 by the merger of Thermo Electron and Fisher Scientific, the Waltham, Mass.-based giant has unanimous buy ratings by the 10 analysts polled by Thomson First Call.

Thermo "does not see an economic slowdown impacting the industry," says a February research report from Thomas Weisel Partners. Fourth-quarter results beat Wall Street expectations for the fifth consecutive quarter since the merger, says analyst Peter Lawson, who has an overweight rating. "Thermo's outlook for 2008 appears solid." He doesn't own shares; his firm says it expects to seek or receive investment-banking compensation from Thermo in the next few months.

Thermo takes diversification well beyond its peers, providing products and/or services not only for medical and scientific R&D but also for industries as varied as beverages, coal mining, petroleum, semiconductors, cement and metals.

"The company's diversified revenue base, which includes a large recurring stream of consumables routinely used in labs, lessens its exposure to pharmaceutical capital spending cycles," says Morningstar analyst Alex Morozov in a recent research report.

"It does not appear that recessionary fears have affected its U.S. business," Morozov adds. "Its Asia Pacific business is growing gangbusters."

However, with shares recently trading a just few dollars under Morningstar's fair value estimate of $59, Morozov breaks with the buy recommendations of sell-side analysts, by advocating a neutral three-star rating for Thermo.