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), with a market cap of $1.8 billion, had a stock surge of 48%. Parexel International ( PRXL), 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.

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) 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), 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."

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