Big pharmaceutical companies like Merck (NYSE:MRK) are facing a major hurdle- it takes a lot of work and money in order to get a new drug to market. From beginning research to running clinical trials, creating new therapies is a daunting task. That task becomes even more daunting as robust cash flows from blockbuster drugs begin to dry up as they go off patent.

In order to save on expenses and costs, biotech and drug manufacturers have started outsourcing various steps in the process to independent lab firms. Growth in these contract research organizations (CROs) has been staggering as more and more healthcare firms begin to use their services.

For investors, the CROs offer a unique play on the drug industry.

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Dwindling Internal Spending, More Outsourcing

With more than $106.9 billion worth of annual branded drugs sales coming off patent, from now until 2020, Big Pharma needs to reinvent its pipeline. However, R&D budgets are failing to keep with rising expenses. According to analysts at investment bank Jeffries, R&D spending by large pharmaceutical firms only rose by tiny 1.2% in 2011. Scary still was the 1.1% contraction last year as drug manufacturers wrestled with Obamacare changes. The bank expects drug makers to increase their spending by only 0.7% in 2013.

Yet it still takes a lot of work to get new drugs to market.

That’s where the CROs come in. These labs are hired by drug developers and medical device makers to offer research services such as overseeing preclinical and clinical testing of healthcare products during various stages of development. Given the mandates to reduce R&D costs while decreasing the time it takes to launch new drugs, business at the CROs is booming. Jefferies expects to see a 6% rise in outsourcing spending this year to reach nearly $26 billion.

The long term picture is rosy as well.

The industry has started to adopt a strategic partnership model that will ultimately benefit both pharmaceutical firms and CROs. This has allowed major drug makers to pair up with leading CROs as long-term partners in research and development. As such, healthcare intelligence company GBI Research estimates that the CRO industry will grow at a compound annual growth rate (CAGR) of 12.8% and reach $56 billion in size by 2018.

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Adding The CRO Winners
Given the potential growth in the industry, investors may want to make a play for the contract research players. With stagnant R&D budgets and rising costs, the CROs are in a sweet spot to profit as various biotech and drug makers tap them to run more and more clinical trials. While some broad-based healthcare funds- like the First Trust Health Care AlphaDEX (NYSE:FXH) –do provide exposure to some CROs such as Covance (NYSE:CVD). That exposure is muted. For investors, individual picks are best.

And one of the best could be Ireland-based ICON (Nasdaq:ICLR). The firm wears the crown at signing long term deals with some of the world's largest drug makers. Back in 2011, ICON- along with rival Parexel (Nasdaq:PRXL) -signed a five-year deal with healthcare giant Pfizer (NYSE:PFE) to conduct clinical trials. Later that year, ICON was selected by Bristol-Myers Squibb (NYSE:BMY) as its preferred provider for pharmacology studies. Those partnerships have expanded the firm’s backlog by 20% and increased earnings by an astounding 92% in 2012.

Another interesting choice could be Albany Molecular Research (Nasdaq:AMRI). The small-cap firm recently reversed a year-ago loss by posting a larger profit than analyst expectations. Perhaps more importantly, the firm’s small size could make it an attractive buy-out target now that it is profitable.

Private equity buyers have shown a certain enthusiasm for CROs of late and started to gobble them up at premiums. Private equity firm, the Carlyle Group (NYSE:CG) purchased Pharmaceutical Product Development for $3.9 billion back in 2011, while Bain Capital recently did a recapitalization of industry leader Quintiles from the private equity arm of JPMorgan Chase (NYSE:JPM). Albany could be on the radar on some other firm.

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The Bottom Line
The pharmaceutical industry is under pressure to do more with less. That means it will be farming out many of is mundane clinical trial and lab work. This outsourcing will be a big win for the contract research organizations like Charles River Laboratories (NYSE:CRL) and its investors.

At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.
Tickers in this Article: CVD, ICLR, PXRL, AMRI, MRK, CRL, CG, JPM, BMY, PFE

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