Most academics and analysts consider increasing specialization a sign of maturity and efficiency within an industry. Luminaries like Henry Ford and Steve Jobs may have had visions of controlling every part of the manufacturing process, but more and more companies take the approach of focusing on a narrow part of the process and outsourcing everything else.

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Enter the CRO
The pharmaceutical and biotechnology industry is no different. While most companies do maintain in-house R&D capabilities, more and more they look to outside firms for critical steps in the process. One of the biggest industries to spring up to serve the pharma sector is contract research organizations (CROs). CROs help firms research new compounds, optimize lead candidate identification, conduct early-stage testing and facilitate the late-stage clinical trials that the FDA requires for approval.

There are now believed to be more than 1,000 CROs worldwide, and this sector captured about 20% of the global bio-pharma research budget in 2008. Given the exceptional costs of conducting clinical trials, as well as the complexity and intricacy of patient management and data analysis, it is fair to assume this percentage is going to increase. Simply put, bio-pharma companies are skilled at developing compounds and (particularly in the case of big pharma) marketing them, and conducting their own trials is a hassle that many organizations have learned they just do not need. (For more see, Measuring The Medicine Makers.)

Who Stands to Benefit?
Along the lines of my introductory paragraph, even the CRO industry has segregated itself along certain specialties. For instance, Charles River Labs (NYSE: CRL) is an acknowledged world leader in research models (industry-speak for lab mice and rats), and gets the majority of its revenue from preclinical non-human testing. Still, Charles River is tapping into yet another industry trend; in acquiring China's WuXi PharmaTech, Charles River is participating in a large migration of the CRO business to Asia, where costs can be 20% of those seen in the U.S.

Parexel (Nasdaq:PRXL), too, is looking to expand both its early-stage business and its presence in Asia. To a large extent, this focus on early testing makes good economic sense - it takes a lot of money and a lot of trial and error to develop a drug before it can even begin Phase 1 testing. In other words, it is a large market. Moreover, late-stage testing is more sensitive to the vagaries of current business trends and prior success. Early-stage testing is always going on, but late-stage testing is only done when earlier tests work out. (For more, see Stocks On Drugs: What It Takes To Get High.)

Of course, late-stage testing has its perks as well; namely, companies offering these services can typically charge quite a bit more for them. Pharmaceutical Product Development (Nasdaq:PPDI) is a specialist in late-stage testing and boasts a long relationship with Merck (NYSE:MRK) as well. Elsewhere, Kendle (Nasdaq:KNDL) has a shakier history, but is also focused on late-stage testing and has used the acquisition of Charles River's late-stage testing business to give it a competitive critical mass.

The Complete Package
Then there are the companies that have succeeded by offering a comprehensive one-stop shopping experience for clients. Covance (NYSE:CVD) and Ireland's Icon PLC (Nasdaq:ICLR) boast an ability to serve needs ranging from basic research to late-stage trials. Both of these companies enjoy quality relationships with major bio-pharma players (Lilly is a major Covance client) and the infrastructure and experience that are required to serve big pharma's needs constitute a considerable barrier to new entrants. After all, big pharma is not going to trust a multi-billion dollar drug candidate to a mom-and-pop start-up with no reputation in the business.

The Bottom Line
The CRO industry is one that I believe is poised for years of growth, particularly now that big pharma is thawing out its R&D budgets and responding to imminent patent expirations with more and more research. That is step one for any investment, as it is difficult to hold on to a multi-year winner if the industry is falling apart.

Among this group, I am most intrigued by Charles River, Covance and PPDI. The valuations here are quite reasonable, the reputations are solid and the companies are looking to position themselves in China and India for the inevitable migration of clinical testing to these cheaper countries. Investors need to test these out for themselves, but there is something to be said for making a bet on the bio-pharma sector that has little to do with specific drugs and more to do with a general increase in R&D spending over time. (For further reading, check out The Ups and Downs of Biotechnology.)

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Tickers in this Article: CRL, PRXL, PPDI, MRK, KNDL, CVD, ICLR

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