Generally, exposure to pharma R&D is an interesting thematic for investors:

Especially when you can start selecting niche picks & shovels providers with high exposure to the high growth therapies:

However, post the covid lifesciences boom, biotech R&D went into a cyclical downturn with growth rates coming to a halt (chart on the right):

With new clinical trial starts going into a downturn:

Since then, biotech funding (raised capital) started recovering in recent years:

And this has already started to translate into improved order flow and book-to-bill ratios for the bioprocessing providers:

Sartorius Stedim (DIM.FR) is a good quality player in this space, and the downturn post covid is well illustrated in its forecasted EPS chart below. Forecasted EPS have now started to gradually recover and with improved order flow commentary. So, it looks like we’re past the trough now and can start moving into a new upcycle in the coming years:

Nvidia mentioned at the JP Morgan conference that they’re seeing high AI spend in the health care sector overall, with AI usage growing at three times the rate of the overall economy. Again, this is a positive indicator for future innovation potential in this space.

Lonza is somewhat similar to TSMC in the semiconductor industry, as the company is a leading manufacturer of biologics for pharma and biotech customers. In the biotech supply chain, these types of fab players are called the CDMOs (Contract Development and Manufacturing Organizations). So, Lonza typically has some of the best insights when it comes to the outlook for the overall industry. This is the CEO at the JP Morgan conference this week:

“First of all, the underlying pharma market itself is an attractive one, not very cyclical, growing at 6% to 7% a year in terms of value. Then there is the increase of outsourced manufacturing of pharmaceutical companies to partners like Lonza, which adds incremental growth of 1% to 2%. Lonza has active market selection where to invest, into which technologies and subsegments, adding another 1% to 2% of growth increment. This leads to a growth of 8% to 10% on average over time to the CDMO market addressable by Lonza. Then there’s the Lonza Engine, which adds to our capability and actually enables us to outgrow by another 2% to 3%. So, there is a growth potential of 10% to 13% for us available.

The clinical pipeline of more than 7,000 molecules is growing at 9%. We cover services from early phase discovery through clinical phases and to commercial large-scale manufacturing. We are able to address above 90% of the innovative pipeline in pharma. We see that the number of innovative molecules being contributed by small biotechs and midsized companies in this pipeline is actually at 75%. Why is that relevant? Because biotechs actually don’t invest in their own manufacturing capabilities, and every dollar they spend is in terms of innovation. And we also see a relevant trend in terms of pharmaceutical companies outsourcing manufacturing to capable CDMOs. There will likely be a preference of the pharmaceutical companies to create additional capacities in the US. Lonza is operating a well-diversified global manufacturing network. So, we see ourselves in a good position to help our customers regionalize their supply chains.

70% of our business is commercial business although clinical and early-stage biotechs work is important for us to have this pull-through and learn about what’s going to be needed in the future. It’s a business that we want to do and nurture, but it’s not a big growth driver for us upwards or downwards depending on how the biotech industry goes. Usually, when you see an uptake in funding, this takes 2 to 3 quarters to actually materialize. Why? Because companies need to review their development plans, issue RFPs, and then CDMOs have to come back. So this takes time. And the earlier the phase, the smaller these amounts are. There’s a lot of redevelopment work and batch manufacturing that is involved in this. But, it’s usually a healthy sign for the industry.”

Also Goldman sees attractive growth in the coming years:

“In EU Life Science, our analysis suggests that end markets in Biologics continue to look attractive with new therapies and new classes driving growth. In addition, recent news flow suggests US policy risk could have lessened, which, despite the EU names not having significant exposure here as a percentage of revenues, is a positive for sentiment. We continue to believe the underlying Bioprocessing market is in a strong position to deliver growth in the mid-term.”

So, the question now becomes where to position? We never invest in the drug manufacturers or biotech names themselves. This is a hugely complicated and competitive landscape where only highly specialized analysts that read medical publications on a daily basis are well positioned to make stock picks on which drugs they’re going to invest in.

While we’ve seen some investors argue that patents provide a ‘formidable moat’, we note that the effective time that a pharma company can exclusively sell a particular drug molecule is only 10-15 years. So, pharma and biotech companies continuously have to face patent cliffs with generic competitors coming in to sell a discount version of the same molecule. In our view, pharma companies have to continuously reinvent the wheel in order to find new revenue drivers as their products go off patent. At the same time, drug development costs keep exploding and it becomes ever harder to actually successfully bring a drug molecule to market. At the same time, competition is innovating as well and can bring to market new drug molecules with better efficacy or side effects profiles, posing a continuous risk of disruption for even gold standard treatments. This is something that Novo Nordisk investors found out last year.

So, we prefer to invest in the picks-and-shovels providers supplying the plethora of competition in the biotech and pharma space. These are industries which are much more similar to other tech industries such as semiconductors for example, where you regularly have a limited number of leaders that dominate a particular niche. At the same time, you get exposure to rising drug development R&D which provides an automatic tailwind.

Post the JP Morgan conference, we came across a handful of highly-specialized niche leaders and with attractive market positions that we haven’t reviewed before. In this article, we will dive into the first name. This is a smaller company, but with high margins and with high long-term growth potential, including some opportunities that the market is missing. Finally, we’ll also discuss our current biotech picks & shovels portfolio.

A Niche Leader in the Biotech Supply Chain

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Looking at the supply chain for the biotech industry, there are a lot of similarities with semiconductors. At the center of the semi supply chain are really the foundries, where chip design houses send their blueprints to have their silicon manufactured. In biotech, these types of fabs are called the CDMOs, or Contract Development and Manufacturing Organizations. Large pharma companies source their biological drugs from the best quality CDMOs, who got their drugs through the trials, making it hard for new entrants to take share. Just like in semis, there can be a mix between in-house and outsourced manufacturing. For in-house manufacturing, the pharma company produces 30% or so of its needed volumes in-house, mainly for risk diversification and to get some leverage in pricing negotiations. For outsourced manufacturing, Lonza is typically regarded as the highest quality player with the best product and reputation. A sort of mini-TSMC of the biotech industry.

Manufacturing plants have to be filled with manufacturing equipment. In the case of semis, we have blue chip names such as ASML, Applied Materials, and Tokyo Electron supplying the most advanced equipment to the foundries. Similarly for bioprocessing, this is a fairly consolidated industry with Danaher, Thermo Fisher, Sartorius, Merck (the European one) and Repligen being the highest quality providers. An attractive difference with semicap is that bioprocessing suppliers have a much larger exposure to recurring revenues, as they sell a lot of continuously needed consumables for the manufacturing process. For example, Danaher estimates that more than 80% of their bioprocessing business comes from recurring revenues. For semicap on the other hand this is typically only around 20 to 25% of revenues, increasing the cyclicality of the business.

In semi land, ASIC designers have to get silicon developed for customers—they design the chip blueprints, get the tape-outs at TSMC, and then schedule the wafers and packaging at TSMC. In biotech, CROs (contract research organizations) have to get the new drugs through the development pipeline. They provide specialized services ranging from drug discovery to running clinical trials and getting ultimately the regulatory approval. A former executive at Icon, one of the leading CROs, describes the harsh landscape the biotech supply chain currently is facing:

“The reality is that pharma is cautious right now. They are being extremely methodical around spending, and that's both on development and even where manufacturing will be. In my 30-year history in this sector, outside of some of the patent cliff-related issues that you saw in the early 2000s, this is probably the most tumultuous time within pharma, and specifically within R&D. Traditionally, you have seen pharma growth being at around 4% or 5%, with biotech being anywhere between 8% and 11% and large pharma being around 3% and 4%. There have been outlooks earlier this year and last year that that would continue. If you talk to most leaders, we'll see no more than 2%-3% growth in pharma R&D, and there is some question as to whether or not it will be flat for 2025 and 2026. You've seen most of the CROs earlier in the year saying that pharma is going through reprioritization, but that the back half of the year is looking optimistic; most have now adjusted that thinking. The cancellations that are happening are really tough for the CROs. Primarily the mid-sized pharma and biotech, they're awarding work that is sitting on the CRO's backlog, but they're not starting. They're delaying for two quarters to see how things work out around the tariffs and other things. That's what's creating these large cancellations.

The other thing I can tell you is that near term, it is a knife fight out there. I have never seen such repricing negotiations. In the COVID days, CROs couldn't get enough staff, and so you charge a premium. Now, you can find staff left and center. It is a rough business development, you have the large CROs that are knife fighting and you've got the mid CROs that are undercutting. Pharma and biotech know it, they can get multiple bids. They can go back three or four times on pricing. So it's rough, there's just not enough work out there. The question you should really be asking yourselves is, as pharma prepares for budgets for 2026—which we will start to hear about in the August, September time period—will it be the same spend as previous years, or are they going to cut back? I don't think anyone has a great answer on that right now, there are too many unknowns. A couple of things have to get sorted out to have pharma feeling as though the return is going to be there. They're going to continue with R&D spend, but they're certainly going to be more thoughtful about which therapeutic areas and which products.

I don't see how pharma is going to make up some of these patent LOEs (loss of exclusivity). The replacement of new products is not happening fast enough to replace major things that are happening in the market. Steve's comments on the call were like, "Pharma can't restructure its way out of this. They'll have to grow, they'll have to come back and develop at some point." I think Steve is right, once the IRA issue will be sorted, the tariff issue will be well understood, pharma's smart, they're going to figure it out. That will happen, and the only way to do that is they're going to have to do more investments. That's the reality. I think that gives organizations like the IQVIAs and the ICONs the ability to offer through the continuum of FSP (functional service provider) to FSO (full service outsourcing) solutions, which is very much needed.”

We do suspect that current cancellations and reductions in drug development investment were due to macro fears that became widespread following President Trump’s tariff announcement. Markets sold down heavily in early April, after which a macro downturn became the consensus view of most market pundits. However, since then, markets have been rallying sharply over the last three months, which is generally good for business confidence. Thus, after a weak Q2 for some of the picks-and-shovels names in biotech, especially those heavily exposed to new drug development, the outlook should be much better already heading into Q3. A lot of those projects which got cancelled in April-May could already be coming back in the coming months.

The bioprocessing names have high exposure to drug manufacturing and thus less cyclical consumables revenues, although Goldman is also more bullish on future equipment orders after hosting Sartorius at their conference:

“Sartorius stated that after 2 strong quarters of order intake and sales progression, the bioprocessing recovery is clear in consumables, with a recovery being seen in all geographic regions. The company highlighted that this consumables recovery is driven by real underlying demand post the destocking period with no extraordinary or one-off impacts they can see (i.e. no pull forward of orders). On equipment, the company noted the demand picture remains muted, however, the increase in consumables is indicative that the equipment installed base is being utilised more. This should eventually lead to more equipment orders down the line (as capacity utilisation increases across the industry) however the timing of equipment orders picking up again is uncertain. Sartorius noted while equipment spend is always more volatile than consumables, the company does not see any seasonality or cyclicality in equipment CapEx other than the Covid-19 impact.

Sartorius highlighted after an exceptional period of orderbook dynamics during Covid-19, the order intake is now becoming a good forward indicator of revenues again (emphasizing the importance of looking at order intake on a 12 month rolling average basis given the relative volatility). Sartorius stated the split of recurring/non-recurring revenues is 80:20 and the recurring revenue portion does come at a higher margin. With recurring revenues slightly elevated and growing faster than nonrecurring revenues (previous split was 75:25), Sartorius noted there will be a mix effect, but the main profitability driver is volume growth.

The company noted despite the numerous headlines and general sentiment on R&D budgets and spend, there is still strong innovation and new therapies that will eventually drive manufacturing volumes, especially if the new modalities or therapies require more advanced tech processes where Sartorius can add value. The company noted funding constraints would result in a refocus and optimisation of industry pipelines on the most promising assets which could even have a positive effect on manufacturing volumes and so does not expect any potential ‘air pocket’ down the line. Sartorius highlighted in clinical stages, single use penetration is very high, however penetration in commercial manufacturing is only c.10-20%. Going forward Sartorius expects single use to outpace stainless steel in the commercial setting with a key driver of this including (1) better cost modelling for single use vs stainless steel, (2) better yields from processes meaning single use starts to become more economical.

Sartorius noted while the cell and gene market is relatively young, it is important for the company to entrench early to be a relevant player later. The company highlighted their very strong footprint with roughly half of every drug in the gene therapy pipeline using Polyplus transfection technology. The company stated M&A is still a big part of their strategy and their focus is to acquire important technologies the company needs to effectively compete and take market share in bioprocessing.

Sartorius highlighted China experienced more pronounced overcapacity compared to other regions with the region still experiencing weakness. While Sartorius was impacted by local competition during COVID (for less technologically advanced products), the company noted in the past year some customers are reshifting some orders back to Sartorius, and innovation will help the company compete with local players.”

While we think that AI will be the largest opportunity in the market for investors in the coming 5-10 years, it’s worth keeping an eye on the biotech space as there similarly is a high pace of innovation with truly revolutionary technologies, especially in genetic editing. The leading player in the CDMO space, Lonza, illustrates how certain types of therapies are expected to grow at high teens CAGRs and potentially above:

Thus, we see the biotech supply chain as an interesting ground for long term stock pickers. Similar to how dominant providers in the semi supply chain were able to reap the rewards from the massive growth in chips—examples include TSMC, Cadence, ASML, Arm etc. Long term, demand in the biotech supply chain should be attractive—we have an aging population in all developed countries, combined with plenty of innovation potential across the supply chain. Sartorius is a good example here. The company was the pioneer in single-use bioreactors, which make use of disposable bags, so that you don’t have to clean out anymore a steel bioreactor with high precision. This is obviously difficult and costly, as it has to be perfectly clean to prevent contamination in the next manufacturing batch. So, Sartorius is seen as the strongest player in upstream bioprocessing technologies.

To add some further background, in bioprocessing, cells are grown in upstream bioreactors where they then produce the needed biological therapeutic molecules such as proteins, mRNA, viral vectors etc. The simplest method to understand is fermentation. Here you grow genetically modified bacteria, or other cells, in a bioreactor, then feed them sugar and other nutrients, so that they produce the biological molecules you've edited their DNA for. Thus, thanks to genetic editing, we can put sugar into the bioreactor and bio-molecules come out. Subsequently, you purify and filter these molecules out of this soup and voila, you have the active pharmaceutical ingredient (API).

For premium subscribers, we will dive into three smaller names in the biotech supply chain, where we see the outlook as attractive given accommodative valuations, a strong market positioning, and the potential to grow at attractive top line CAGRs long term.

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Looking at the supply chain for the biotech industry, there a lot of similarities with semiconductors. At the center of the semi supply chain are really the foundries, where chip design houses send their blueprints to have their silicon manufactured. In biotech, the fabs are called the CDMOs, or Contract Development and Manufacturing Organizations. Large pharma companies source their biological drugs from the best quality CDMOs, making it hard for new entrants to take share. Just like in semis, there can be mix between in-house and outsourced manufacturing. For in-house manufacturing, the pharma company can produce 30% or so of its needed volumes in-house, mainly for risk diversification and to get some leverage in negotiations. For outsourced manufacturing, Lonza is typically regarded as the highest quality player with the best product and reputation. A sort of mini-TSMC of the biotech industry.

Manufacturing plants have to be filled with manufacturing equipment. In the case of semis, we have blue chip names such as ASML, Applied Materials and Tokyo Electron supplying the most advanced equipment to the foundries. Similarly for bioprocessing, this is a fairly consolidated industry with Danaher, Thermo Fisher, Sartorius, Merck (the European one) and Repligen being the highest quality providers. The difference with the semiconductor equipment providers is that bioprocessing suppliers have a much larger exposure to recurring revenues. This is because they sell a lot of continuously needed consumables for the manufacturing process. For example, Danaher estimates that more than 80% of their bioprocessing business comes from recurring revenues. For semicap on the other hand this is typically only around 20 to 25% of revenues, increasing the cyclicality of the business.

A procurement manager at one of the largest pharma companies in the world gives further background on the bioprocessing space, this is an expert available via Tegus:

“The biologics market has been developing tremendously over the past 10 to 15 years. Traditional medicines, i.e. small molecules, are simple to manufacture. You manufacture them at a low cost and at high volumes. Biologic products are the total opposite. They are extremely complex to manufacture and they need to go through 25 to 35 different processing steps. In small molecules, we can make them within five to 10 steps. So biologic products are low volume, highly complex and have high value. For small molecules, we produce tons of product yearly whereas for biologic products, we only produce kilograms. But every kilogram is worth at least 30x of what a small molecule is worth. And these volumes will continue to increase due to the increase in demand.

We have a well established supply base for bioprocessing equipment. Even though those vendors are able to provide more or less the same level of quality, compliance and capacity; we do see some differences between them. For instance, we know that Sartorius can offer us a fully integrated solution for bioprocessing lines, and that their equipment is just state of the art. If I compare head-to-head a bioreactor of Sartorius with one from any of the other competitors, the Sartorius bioreactor will have a lifetime of at least 25 years with the proper maintenance and repair. Whereas their competitors' equipment would only have a lifetime of probably 15 to 18 years with the same level of service and maintenance.

For bioreactors and fermenters, the most costly bioprocessing equipment and components, Sartorius would have with us somewhere between 35% and 45% of our total need. For other equipment, such as lab and chromatography, Thermo Fisher and Danaher have somewhere between 50% and 55% of our wallet share. For fluid management equipment, filters, centrifuges and all those kinds of things, Sartorius would have between 40% and 50% of our wallet, with the balance being provided by other suppliers.

Ideally, we would like to have only two vendors. One for bioprocessing equipment and the other for lab components. If that's the case, then you are able to standardize your equipment across the globe. So every single bioprocessing line would look exactly the same. But obviously the pharma industry is far away from ideal. So that share of wallet I mentioned is not steady, it changes based on projects and opportunities. Sartorius can have the highest product quality in bioreactors, but if that equipment is extremely expensive compared to Thermo Fisher's or Danaher's, then we will question that.

Prices are usually fixed for one year and then based on raw materials and PPI indexation, suppliers are able to request a price adjustment on a yearly basis. During the pandemic, there was a very special case in which those players were getting a lot of price increases. Before the pandemic, let's assume that prices for bioreactors, lab equipment et cetera were at 100. By the beginning of 2022, prices for that same equipment would have gone up from 100 all the way to potentially 120. And right now, prices have significantly gone down again from 120 to 108 approximately. So prices have been decreasing, but they have not achieved that 100 level of before the pandemic.

What is the prediction for the next three to five years? Well based on our market intelligence, prices for the same reactors and lab equipment are forecasted to continue to increase from 108 over the next three to five years. We are seeing that already. We know that all these guys are going to come back to us in January 2025 and that they are going to request a price increase of at least 2% or 3%.”

In bioprocessing, cells are grown in upstream bioreactors where these cells can produce the needed biological molecules such as proteins, mRNA, viral vectors et cetera. The simplest method to understand is fermentation. Here you grow genetically modified bacteria or other cells in a bioreactor, feed them sugar and other nutrients, and then they produce the biological molecules you've designed them for. Subsequently, you purify and filter these molecules out of the soup and voila, you have the active pharmaceutical ingredient (API).

Obviously purity is very important here and Danaher is especially strong in downstream chromatography, i.e. the separation of mixtures. On the other hand, culturing the cells as we described above is called upstream bioprocessing. Sartorius was the pioneer here in single-use bioreactors, which make use of disposable bags, so that you don’t have to clean out anymore a steel bioreactor with high precision. This is obviously difficult and costly, as it has to be perfectly clean to prevent contamination in the next batch. So Sartorius is seen as the strongest player in upstream technologies.

That said, each of the major competitors — i.e. Danaher, Sartorius, Thermo Fisher and Merck — provides a wide portfolio of equipment and can typically fulfill most of a CDMO’s needs. Repligen on the other hand is more of a niche player focusing on specialty technologies. Danaher illustrates how after the acquisition of Cytiva, they can provide the key upstream and downstream equipment for a bioprocessing line:

Just like large parts of the semi market, the bioprocessing market has been going through a strong cyclical correction post the covid electronics and life sciences booms. In the case of bioprocessing equipment and consumables, the drivers were really the same as in semis. During covid, customers became anxious if they would be able to get supplies, causing them to over-purchase and start hoarding excessive inventories.

Once the cycle turned and end demand started declining, customers began sourcing components from their inventories as opposed to placing new orders with the manufacturers. This brought in the strong cyclical downturn for the providers of bioprocessing equipment and consumables. This can easily be seen in the EPS cycle of Sartorius as shown in the green line:

And also for Danaher, although this is a more diversified life sciences player with also large diagnostics and lab equipment businesses, making it suffer less in the cyclical downturn:

These types of down cycles usually continue until customers have worked down their inventories sufficiently and have to start placing more orders again with the manufacturers. And once end demand picks up, usually inventory levels have to be increased again, creating a new strong bull cycle.

Looking at the case of Sartorius, it looks like we’re now close to entering this new bull cycle. Firstly, a key customer just told us that pricing will be moving up for the first time in three years. Secondly, if we look at the EPS trendline in the chart above, it looks like we’re now substantially below the normal trendline if we strip out the covid boom. Finally, also the company’s order intake has been on an upwards trend again, eyeing the last six quarters on the gray line below:

Similarly, also Repligen is seeing a return to growth. This is the company’s CEO at the recent JP Morgan conference:

“For those of us who have been in the business for a long time, we remember the good old times where a bad year was 8% growth and a great year was 12% growth. I don't see reasons why this shouldn't go back to the same pattern. What has been the real game changer for us in quarter 3, was to see the CDMO business being back. The health of CDMOs is showing you the overall health of the ecosystem. And we had our orders and sales going up more than 20% in quarter 3 with CDMOs. This is exactly the last piece we were missing to feel very comfortable that the turnaround is here.”

So Sartorius is a name we like here. We should be close to the bottom of the cycle, the company has a great market positioning and growth outlook, and the business model is attractive with around 75% of revenues being recurring with the sale of consumables. The current valuation is already capturing a certain amount of the recovery, although investors can still make an attractive IRR in this name. For example, putting 2028 consensus EPS of EUR 8.2 on a 35x forward PE gives an IRR of 14%, factoring in some share buybacks.

This looks like a reasonable multiple given that Sartorius has traded most of the time between 30 to 40x forward EPS, it rarely has gone below and actually regularly above. Leaders that dominate their niches and who are exposed to attractive growth rates tend to trade on premium multiples, as long term investors are frequently unwilling to sell them.

Looking at picks-and-shovels types of stocks for the biotech space is an interesting ground for stock pickers. Investors get exposure to the attractive themes of the health care sector such as an aging population, pricing power and advanced high growth therapies. While you don’t have to deal with the patent cliff and the highly competitive landscape that the pharma and biotech companies find themselves in.

Mini-TSMC Lonza provides a nice overview of the expected growth rates for the various types of pharma therapies:

For premium subscribers, we will do a deep dive on a strongly positioned player who is a pure-play supplier to the biotech industry for some of these high growth therapies. We came across this company via a scientist at a major pharma company who mentioned how he is relying on this company, and that they are the premium player in their space with the highest pricing. It’s a name we had never even heard of and we don’t believe that there has ever been a write-up on this name. While actually, it’s a straightforward investment case which should bring in a high long-term IRR for investors, much higher than Sartorius. It’s a good quality company, with a solid business model and practically all of its sales coming from recurring revenues.

An Under the Radar Opportunity

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