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.
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.
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.