Nothing to CRO About

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In ancient times -- say, before the middle of 2008 -- contract research organizations such as Covance (NYSE: CVD) and Charles River Laboratories (NYSE: CRL) looked like a cure for investors who weren't happy with Big Pharma or weren't comfortable with "no P/E" biotech companies.

These companies, called CROs, flourished because they provided outsourced pre-clinical and clinical testing for big drugmakers trying to cut costs and for small biotechs that lacked the budgets to conduct all necessary clinical trials or the big-pockets partners to help them.

But the good times have stopped rolling, as CROs warn of unexpected contract cancellations and reduced demand for services. For the last 12 months, all but one of the seven major CROs trailed the S&P 500 index, but they all trailed the Amex Pharmaceutical Index, which contains the CROs' biggest clients. Although most of the CROs outpaced both indexes over a five-year period, that's small comfort to investors worried about this year's prospects.

Economy's side effects
The general economy is to blame, of course, but so are changes in the drug industry, especially consolidation. Those mega-mergers, such as Pfizer (NYSE: PFE) and Wyeth (NYSE: WYE), cannot be good for business.

On Tuesday, Kendle International (Nasdaq: KNDL) said first-quarter revenue would be so far below Wall Street forecasts that its stock lost more than half its value that day. Formal results will be published in early May.

On Wednesday, Pharmaceutical Product Development (Nasdaq: PPDI) delivered first-quarter results in which earnings per share of $0.38 missed the consensus Wall Street estimate by a penny. Revenue declined from a year-ago quarter. The company cut its full-year financial forecast.

These companies' comments prompted Morningstar to place the entire industry under review. Investors in other CROs -- including Covance, Charles River, ICON (Nasdaq: ICLR), and Parexel International -- will nervously await quarterly reports due in late April and early May.

Near-term uncertainty
Still, investors should be aware that the CRO industry isn't a one-size-fits-all business. Kendle and Pharmaceutical Product Development, for example, emphasize conducting later-stage clinical trials. These tests produce higher profit margins, are more complex, and take longer.

Cancellations, however, can cause big trouble. Kendle had a 45% cancellation rate during the first quarter, which was much higher than in similar periods in 2007 and 2008. Pharmaceutical Product Development took a big hit on cancellations, too.

Other companies offer a mixture of early-stage and late-stage clinical trials. Charles River concentrates on phase 1 and pre-clinical studies as well as providing laboratory animals and research models. Pre-clinical and early-stage clinical trials have lower profit margins, but they are less complex and take less time. Thus, the company can conduct a higher volume of tests, and a few cancellations won't cause serious revenue damage. Previously, Charles River said business would be soft at least through mid-2009.

Because medical R&D spending continues to rise, the CRO business is bound to rebound. The question is when, given the slump that started around Labor Day. Over time, there should be more business in post-marketing testing, as well, as the FDA is likely to require more. There should be even more opportunities when the U.S. finally passes a law allowing generic versions of biotechnology drugs.

For now, cautious investors should wait for next week's earnings results to determine which, if any, CRO strategy shines amidst the industry's gloom.

For related Foolishness:

• For Drug Companies, R&D Is Spelled C-R-O
• R&D Your Way to Higher Sales
• Just Say No to Drug Company Mergers