A Stable Niche in Big Pharma

Many investors would love to experience the explosive upside that biotech and pharmaceutical companies can offer when major blockbuster drugs get approved, but don't have the stomach for the risk that the drug might crash and burn, dragging the company's stock down with it. You're probably familiar with stories of entrepreneurs such as Levi Strauss, who struck it rich in the California gold rush not by hitting gold, but by selling picks, shovels, and his eponymous jeans to prospectors. In a similar manner, contract research organizations (CROs) offer exposure to increased levels of drug discovery with considerably less risk.

CROs do a lot of the drug industry's dirty work. In order for a biological or chemical compound to get regulatory approval, a drug company has to jump through a series of hoops to prove the compound's safety and efficacy. At the earliest stages of drug development are preclinical services, where the main focus is to screen a compound's toxicity, primarily via animal studies. If a compound is proven fit for human testing, then it's run through a series of clinical trials. These are known as Phase I-IV trials, and the completion of each phase results in a more complex and extensive trial involving more patients in order to prove a drug's safety and efficacy.

It doesn't make much sense for  Coke  (KO)or Pepsi  (PEP) to own their bottlers, nor for  McDonald's (MCD) to own potato farms. In a similar logic, we think the outsourcing model that CROs employ makes sense. Traditionally, big pharma has kept a lot of drug development capacity in-house. But any downtime in the drug pipeline results in idle capacity, and the company has to eat the costs. To prevent this inefficiency, many drug companies increasingly look to outsource functions such as toxicology and clinical trial management. Many biotech companies (known as virtual companies) lack any clinical development infrastructure whatsoever and have embraced the outsourcing model, allowing CROs to share in the biotech industry's growth. Global drug R&D is estimated to grow in the 9%-11% range. Industry estimates indicate that CROs capture roughly 22% of global spending on R&D. If outsourcing increases, CROs can continue to take market share. We think that CROs that can specialize in clinical development as a core capability and cut idle capacity should pick up more drug R&D dollars.

CROs offer various types of exposure to the spectrum of drug discovery. Investors who foresee a pickup in the earlier stages of drug discovery would probably be interested in the two dominant players in preclinical services,  Charles River (CRL) and Covance . Charles River has roughly half the market for animal research model production, and both of these companies dominate toxicology, the preclinical testing of a compound's safety. If successful drug discovery leads to productive drug pipelines, then investors might want to take a look at CROs that participate in lucrative Phase II-IV trials. Phase II-IV trials are the meat and potatoes of most CROs, because they involve hundreds or thousands of patients and result in hefty paychecks. However, the field is also more competitive, with the most profitable (publicly traded) player being PPD , followed by smaller competitors PRA International , ICON   and Parexel .

Although we're generally positive on the CRO industry, unfortunately we can't recommend any bargains here, because strong recent results have resulted in fairly rich valuations. We think investors should wait for softening drug R&D budgets and negative investor sentiment before investing in CROs. If we could ever invest at a discount to our fair value estimates, we'd gladly pick up shares in some of our favorite CROs, including Covance, Charles River and PPD.