Profit from big pharma's outsourcing drive

Developing drugs is a tough business. It starts with a simple target a cell or protein implicated in a disease. Chemists spend months bombarding it with molecules in the lab, searching for a single promising chemical. If they find it, the chemical is usually far too costly for mass production. An age follows, as the chemical is doused with catalysts and reagents to find a way to make it cheaply. It then has to pass a battery of efficacy and safety trials before it reaches the drug authorities, who can bring a decade of work to an abrupt end in rejection only one in 5,000 putative drugs eventually succeed. No wonder the pace of drug discovery is slowing by the year.

But help is at hand. By farming out the tasks of research and testing drugs to specialists, big pharmaceutical firms have found a way to relieve the pain and expense of bringing a drug to market.

A full-scale support industry has sprung up, with 500 research groups now battling it out for deals with big pharma. "These clinical research organisations (CROs) offer a one-stop shop for drug research and development," says Heather McMeekin, an analyst at Turner Investment. They are there at the start in pre-clinical trials conducting chemistry and animal-testing in their labs before the drugs are tested on humans. In clinical trials, they're involved in everything from recruiting and monitoring patients, to testing the effectiveness of new drugs on volunteers. They've already taken on around $18bn (or 26%) of the $70bn of research work in the industry.

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This is saving big pharma a fortune. Just like the car industry in the 1970s, the big players have realised that the key to their survival is deciding what they can do best internally and what is best outsourced to expert suppliers. Dealing with the drug approval authorities is one activity they're happy to farm out. Faced with a mounting regulatory burden, it's useful to have a specialist on hand with dedicated labs and computer systems to track all the relevant drug data through trials. Keeping a marketing team on hand to launch drugs once or twice a year no longer makes sense either. CROs also give drug makers more flexibility. "If a project needs to be trashed because it becomes clear the drug doesn't work, the firm isn't sitting around with employees waiting for the next project," says Motley Fool's Brian Orelli. And they seriously speed up the time drugs spend in the pipeline. CROs employ scientists located across the world, explains Paul Hill in his Precision Guided Investments email letter, allowing them to keep projects operating around the clock.

But the industry isn't immune to the global slump. With small biotechs struggling for credit and big pharma delaying early-stage projects, CROs are likely to face a slew of cancellations this year. When industry giant Covance aired its fears in December, the market sold off CROs across the board. The main risk is that consolidation among big pharmas and failing biotechs will leave a smaller customer base after the recession.

Even so, the CRO market is still expected to grow 8%-9% this year, reports ClinicalTrials Today. The handful of giant CROs (see below) that dominate the industry will take a great deal of market share as smaller outfits suffer, says Hill. The difficulty involved in securing regulatory approval and developing a global presence regulators worldwide prefer drug companies to conduct multi-centre international drug trials will mean they face little by way of competition. And as patents expire, research work should pour in. CROs will play a huge roll in bolstering big pharma as it serves a greying Western population.

The best bet in the pharmaceutical support sector

Covance (NYSE:CVD), the granddaddy of the industry, will continue to set the pace in the CRO market, according to Paul Hill. The firm is spread across 20 countries and has grown its earnings by 20% a year for the past seven years. The risk for Covance is that early-stage testing projects (which account for 47% of revenues) will be hit as big pharma curtails its activities this year. Late-stage testing contributes about 17% of revenue, with bio-manufacturing, lab services and clinical packaging making up the remainder of sales. The strengthening of the dollar against the euro has also hurt as most of Covance's business comes from European firms. So it's perhaps no surprise that Covance's stock has been hit hard in recent months, despite the group reporting a quarterly profit increase of 14.6% to $51.1m before Christmas.

However, the sell-off has left the company on an attractive forward p/e of 9.6. It's in great financial shape, with just $23m in short-term debt. On top of that, only 10% of its revenues stem from the cash-strapped biotech/speciality pharma segment. Covance will also grab a lot of market share over the next year or two, says Hill, with few rivals able to challenge its dominance in the market.