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A Safer Way to Play the Drug Sector

Even though big pharmaceutical companies are stumbling and biotechs are staggering, smart investors have been making money in the sector by thinking a bit differently -- specifically, by betting on companies that conduct tests for drugmakers.

Large drug companies are furiously cutting costs, while biotech start-ups often lack the financial cushion to conduct a full set of their own trials for experimental products. That leaves a growing niche for contract research organizations, or CROs, to which drugmakers outsource clinical and preclinical trials. As a result, many CRO stocks have soared as major drugmakers' shares have stagnated.

"Contract research organizations were flying under the radar for a long time," says Alex Morozov, who tracks CROs for the independent financial research firm Morningstar. "Two or three years ago, investors began to notice."

The two largest CROs by market capitalization, Covance (CVD) and Pharmaceutical Product Development (PPDI), both enjoyed stock gains of 31% for the 12 months ended Feb. 15. Both have market caps of just over $5 billion.

During the same period, Ireland's Icon (ICLR - Get Report), with a market cap of $1.8 billion, had a stock surge of 48%. Parexel International (PRXL - Get Report), whose market cap is $1.6 billion, climbed 61%.

Meanwhile, the Amex Biotechnology Index was down 7% and the Amex index of large pharmaceutical stocks was off 13%. The S&P 500 was down about 7%. Of seven major public CROs, only Canada's MDS (MDZ) -- down 7% -- declined during this period. Quintiles Transnational, the largest CRO, and the mid-sized PRA International are private.

Bull Market

Analysts remain cheerful about CROs' future. Wachovia Capital Markets predicts the industry will outperform the overall market for the next three to five years. Pointing out that approximately 25% of drug development is outsourced, the firm issued a report in late November saying that could rise to 35% to 40% within half a decade.

Susquehanna Financial Group predicts an annual growth rate in the CRO industry of 14% to 16% through 2010. In a December report, the firm says the industry's market value was $14 billion in 2006 and could rise to $24 billion by 2010.

"We believe CROs will be a particularly strong sector in 2008 , given that there is a clear mandate from Congress to increase testing of drugs both before and after Food and Drug Administration approval," adds UBS analyst Robert Gilliam in a report to clients. CROs are attractive because "they are not directly exposed to Medicare cuts, drug price controls or other government-related pricing pressures," he adds.

However, investors shouldn't get accustomed to spectacular, quick stock-price gains. Although "outsourcing will continue to stay strong," Morozov cautions that share prices for some companies have outrun their fundamentals.

"At current valuations, we are becoming more conservative ... and may encounter situations where we are no longer able to justify valuation to maintain individual outperform ratings," adds Eric Coldwell, of Robert W. Baird, in a research note. He doesn't own shares of companies he covers, but his firm does, or seeks to do, business with companies mentioned in research reports.

Coldwell has an outperform rating on Icon. Even though a Thomson First Call poll of sell-side analysts shows Icon with an 11-2 buy-hold ratio, Morozov gives Icon one star in Morningstar's rating system, in which five stars represents the best buying opportunity.

On a split-adjusted basis, Icon's stock has more than tripled in just over two years. It's a good company, says Morozov, but the stock is too expensive.

Buyer Beware

Also, investors should note that just about every major CRO has had some setback in recent years to affect the momentum of their sales, profits or stock price. Ill-fated acquisitions, management shake-ups, failed clinical trials, canceled contracts, strategic blunders or disputes with the FDA can derail a CRO.

"This is a very strong relationship business, especially with Big Pharma," Morozov explains. "It's hard to get your foot in the door with Big Pharma, and it's hard to get your reputation back" if a CRO bungles a major study for a prominent drugmaker.

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