A Safer Way to Play the Drug Sector

In theory, the ideal CRO offers both diversity of geography and services. Clients want to control expenses and speed up the drug-development process, so it's important for CROs to operate on many continents, especially those with developing markets. This approach gives them a cost advantage as well as the opportunity to reach more patients in clinical trials.

For services, a CRO ideally wants to offer a mixture of preclinical trials, early-stage human trials and late-stage clinical trials, along with FDA-mandated post-marketing tests that are becoming more important for keeping drugs on the U.S. market.

Animal tests and the early-stage human trials take less time, and they provide less revenue per test than do bigger late-stage and post-marketing trials. But because a CRO can conduct many more animal and early-stage human trials, these tests can provide a steadier revenue stream. In addition, the impact of a single early study's failure or a client's cancellation isn't as great as it would be for a multiyear, late-stage clinical trial.

Analysts also caution that CROs shouldn't depend too heavily on just a few clients because they could be hurt if that client is acquired by another drugmaker. "The more diversified the CRO company, the less the risk," says a recent report from Natixis Bleichroeder.

Strategic Tinkering

Of course, attempts at diversification don't always work. For example,Charles River Laboratories (CRL Quote) has been a strong player in preclinical testing in part because it is the world's largest provider of laboratory animals to commercial and academic researchers.

Charles River made several acquisitions early in the decade, including the $1.5 billion purchase of Inveresk Research Group. Charles River touted the deal, which closed in October 2004, as creating a "significant presence" in clinical trials from the early Phase 1 testing to post-marketing Phase 4 testing.

Two years later, Charles River sold most of its clinical trial business -- from midstage Phase 2 testing to Phase 4 -- because it "does not take advantage of the company's core competencies."

Charles River's stock barely budged from the day before the Inveresk acquisition was publicized in July 2004 to the day before the divestiture was revealed in May 2006. Both announcements were met with sharp one-day declines in the stock, but Charles River has recovered. In the 12 months ended Feb. 15, the stock gained 23%.

The company sold its late-stage clinical trial business for $215 million to Kendle International(KNDL Quote), another example of a CRO that has struggled to regain its footing. The stock was up 7% for the 12 months ended Feb. 15.

Analysts say Kendle, whose market cap of about $600 million makes it the smallest of the major public CROs, has had multiple problems in recent years. Above- average employee turnover and concentration of too much money from a few big clients hurt Kendle in the past, they say.

"From a $3 stock with shrinking sales and losses in 2003, Kendle ... rebounded," says a recent report by Robert W. Baird & Co. This year, the stock has traded between the low $50s and the low $40s.

Analyst Eric Coldwell tells clients that Kendle has "adjusted management and operations, diversified away most client-concentration and re-emerged as a healthy organization." Coldwell, who doesn't own shares, has an outperform rating.

Kendle is trying to improve via acquisition, a strategy that remains popular in the still highly atomized CRO market. Analysts say CROs are more inclined to make small deals to expand their geographical reach or bolster a service niche rather than tie up with larger players or invite a takeover by health-care companies.

"CRO industry mergers and acquisitions brings integration risks," Coldwell says. "It is a seller's market, and M&A precedent is poor."