During a gold rush, the way to really make money is not to bank on finding a large nugget in the river, but to be the one to sell picks, shovels and Levi's to the speculators.

Now, suppose that in addition to the supplies, you can also provide qualified miners. This scenario is essentially what contract research organizations, or CROs, do for the pharmaceutical and biotech industries.

Large and small companies alike outsource their drug trials to firms such as

Charles River Laboratories

(CRL) - Get Report

,

Pharmaceutical Product Development

( PPDI) and

Covance

(CVD)

.

Jefferies' analyst David Windley estimates CROs have captured 24% of the $60 billion drug-development business. Morningstar analyst Alex Morozov says the industry is "booming," because of Big Pharma's capacity issues and small biotechs that have no capacity.

Plus, he says, some staff at pharmaceutical companies are underutilized. "Rather than pay a Ph.D. who is only busy half the time, it's more cost-effective to outsource the work," he contends.

However, like most things in life, quality isn't cheap. To participate in this sector, you'll pay an average of 25 times forward earnings, 22 times cash flow and a price/earnings/growth rate of 1.4.

Wade Into the River

Shares of Charles River spiked 13% Wednesday after the company reported strong earnings and reiterated its guidance. Even so, sales in its research models and services business, which provides animals for testing, continue to be weak.

Charles River is considered to be the best at providing live animals for research, and the business has high margins. For the most recent quarter, the operating margin was 29%, but that's down from 33% a year ago. The tepid results were attributed to cost-cutting measures by pharmaceutical clients. At the company's preclinical services division, sales rose 14% and its operating margin increased 90 basis points to 16.4%.

Shares of Charles River are cheaper than its peers, but Eric Ende, portfolio manager of

(FPPFX) - Get Report

FPA Perennial, which owns nearly half a million of its shares, isn't concerned about the short-term performance of the research models division.

"Long-term holders know that the rats and mice business is extremely high margin and Charles River has a huge competitive advantage," he says. Ende was surprised about the market's reaction to the company's earnings. "It certainly was not a four-point earnings release," he says. "There was likely a lot of short-covering."

With the animal business sluggish, the current valuation offers investors an opportunity to buy. Charles River is a diversified company that's allocating resources in the right places. The company is expanding its facilities and should benefit from any increase in spending. An investor who insists on waiting until all divisions are operating at full throttle will likely pay a multiple more in line with its peers, rather than the discount where it currently trades.

On the other hand, things seem to be going pretty well at Covance.

It's Morozov's favorite company in the group, and it's also my favorite. Unfortunately, the stock is a bit pricey, with a price-to-earnings ratio of 27.9 and a PEG rate of 1.6.

Covance is expected to earn $2.21 a share this year, $2.67 in 2007 and $3.21 in 2008, according to consensus estimates.

Covance has business segments in toxicology, along with early-stage and late-stage drugs. The company is the global leader in toxicology, which both Morozov and Ende mentioned as the segment with the most growth opportunity in the sector.

Covance reported 14% revenue growth in the most recent quarter, partly thanks to some recent acquisitions. The market has already priced in a lot of positives at Covance, but the risk-reward ratio isn't in investors' favor. If the market sells off and Covance trades at a lower multiple -- with no meaningful adjustments to estimates -- take a second look. Until then, use Covance as a benchmark with which to compare other companies in the group.

Meanwhile, Pharmaceutical Product Development is even more expensive than Covance on several metrics. There's potentially more upside, but there's also more risk.

The company is the best in late-stage drug development, and with 8,000 employees scattered across six continents, it has the infrastructure in place to accommodate the thousands of patients required for phase III trials.

Pharmaceutical Product Development is also involved in discovery sciences, meaning it also has a stake in the game to create new therapeutic products. That could produce tremendous upside if one of its discoveries goes on to become a marketable drug. It also means the risk increases.

In the second quarter, revenue grew 26% year over year, while gross new authorizations climbed nearly 28%. Discovery sciences made up just 1.6% of revenue in the second quarter. Pharmaceutical Product Development has a prominent position in phase III development, but its lack of diversification and exposure to risk make me believe the stock should trade at a lower multiple, despite its execution in its core business.

Playing Catch Up

Another player,

Parexel

(PRXL)

, has a truly international presence, with the vast majority of its revenue coming from outside the U.S.

Just this week, the company reported a strong fiscal fourth quarter in which it posted its first operating profit in three years. U.S. sales, which had been declining, advanced 13%, and international sales climbed 21%. However, cash flow from operations was still negative.

Parexel has struggled with margins due to underutilization of its facilities and employees. Last year, management shuttered 11 of those facilities and fired more than 100 workers. Management expects a loss from U.S. operations in the current quarter, which is a sign it is still battling margin issues.

Staffing is especially tough to manage in the CRO industry: There are never enough qualified employees during the boom times, so companies are hesitant to make layoffs during slower periods. Parexel appears to be having a tougher time managing that aspect of the business than most.

Although this could be the early stages of a rebound, Parexel trades in line with its better-performing peers -- hardly a feature you want in a turnaround play. If the stock was trading at a discount, perhaps similar to Charles River, I might be more inclined to take a shot. But at 34 times cash flow and 25 times forward earnings, this company needs to show me a lot more before I become interested.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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