Pharma contractor service providers like Cardinal Health (NYSE:CAH) and Pharmaceutical Product Development (NASDAQ:PPDI) have something to celebrate in the recent initial public offerings (IPOs) of biotech companies Acusphere (NASDAQ:ACUS) and Advancis Pharmaceutical (NASDAQ:AVNC).

At first blush, the entrance of two relatively small biotech firms into the public market may appear insignificant. Pharmaceutical outsourcing is a multi-billion dollar industry. Companies in this arena perform the behind-the-scenes work of drug development and manufacturing, such as managing clinical trials, developing drug formulations, and filling syringes.

These recent IPOs are important, however, for their symbolic value. Acusphere's and Advancis' stocks have not performed particularly well since they started trading, but as the first biotech IPOs in more than a year, they are likely to give a boost to biotech fundraising in general. And due to the nature of drug development and the dynamics of the biotech industry, a nice chunk of whatever cash biotech gets from investors ends up as revenue for contractors.

Most pharma contractors rely on the biggest pharmaceutical companies ("big pharma"), such as Pfizer (NYSE:PFE) and Wyeth (NYSE:WYE), for the bulk of their business. After all, big pharma still is the source for most of the dollars spent on drug research and development.

Biotech business growing for contractors
However, as pharma outsourcing has matured, projects from biotech clients have become an increasingly large portion of contractors' business (as much as 25% to 30% of revenue) and an important growth area. In most cases, biotech companies lack some of the necessary infrastructure and expertise needed to develop a new drug and have little alternative but to outsource. As a result, contractors have the leverage they lack with big pharma to negotiate higher-margin deals.

While this makes biotech firms attractive customers, other factors weigh against the industry. Drug development is a very, very lengthy and expensive process. The Tufts Center for Drug Development puts the average time to take a drug from discovery to the market at 12 years and the average cost at $802 million. Having few or no products on the market to generate revenue, biotech companies are dependent on venture capitalists, debt and equity markets, and big pharma partners to foot their bills until they can get new drugs approved by the Food and Drug Administration. For contractors, this means biotech companies that are great clients when capital is plentiful can quickly become liabilities when funds are scarce.

Biotech companies raised unprecedented sums in 2000 in public and private securities sales. But from mid-2001 through the spring of 2003, the public markets gradually soured and the door for biotech IPOs closed. Over this period, the torrent of funds from VCs to biotech slowed until it became a trickle, as VCs waited for the IPO door to reopen before jumping back into biotech in a big way.

According to biotech financing data compiled by PharmSource Information Services, a publishing and consulting firm that monitors pharma outsourcing, monthly totals from June 2002 to May 2003 for all financing types (public and private) were consistently between $500 million and $600 million. By contrast, the average monthly haul in 2000 was around $3.25 billion. In recent quarters, this funding slowdown has hit contractors' results and their stocks.

But after a long drought, contractors may have a surge of new business waiting for them on the near horizon. It appears the biotech funding tide shifted in anticipation of the recent IPOs. Total monthly funds raised jumped from $600 million in May 2003 to $2.7 billion in June and exceeded $3.5 billion in September. The public markets are again ready to accept IPOs and follow-on offerings and VCs are responding by loosening their purse strings. With this new influx of cash, biotech companies are sure to begin spending more heavily on outsourcing.

Investors can take advantage of a bump in business for contractors by buying now. The business flow may not fully materialize for another couple quarters, but with the money biotech has recently raised, it's sure to come. Don't expect these stocks to be barnburners, but a healthy 15%-20% gain is certainly not out of the question. Granted, not all contractors are created equal and there are a few that are more likely to see the benefits of the biotech upswing than others.

Pharmaceutical Product Development Inc.
Pharmaceutical Product Development Inc. (PPD) long has been a star performer in the contract research space. The firm's year-over-year revenue growth over the past four quarters has been in the double digits, although the rate slowed from 38% in the fourth quarter of 2002 to 14.1% in the third quarter this year. PPD's solid performance has kept its stock price steady, so any gains its shares make won't be as dramatic as for those of less consistent firms. All the same, as a strong company, PPD will certainly benefit from any uptick in biotech spending, so it's a good conservative play on the trend.

Cardinal Health
Cardinal Health has been moving aggressively into the drug development businesses over the past few years. The vast majority of its revenue still comes from drug distribution, but after several smart acquisitions, the company now boasts a powerful stable of specialty drug development and manufacturing services.

Cardinal's recently announced plans to acquire Intercare plc, a large, well-established European sterile manufacturing services provider, is just the most recent manifestation of this strategy. The firm's pharmaceutical technologies and services division (PTS), which provides development services, has been its fastest-growing for several quarters. With more robust biotech spending, this growth should accelerate.

At the moment, Cardinal's stock is under some pressure due to concerns about profitability in its wholesaling business. The company plans to reduce its inventory of drugs and redeploy its capital into acquisitions, manufacturing capacity, and stock buy-backs. Cardinal also recently announced an SEC request for information on the accounting treatment of $22 million recovered by the company from vendor overcharges. The amount is small, but the situation bears watching. If Cardinal is cleared of wrongdoing (Cardinal insists there has been none) and continues to reposition itself, PTS's performance over the coming quarters will likely push the stock higher.

Covance and Iveresk
In recent quarters, spending on earlier-stage drug studies has lagged outlays on later-stage trials. This is because biotech companies have been concentrating on getting their most advanced products on the market to begin generating revenue. With fresh capital, though, biotech companies are more likely to begin spending on entirely new drug projects.

Two plays on this angle are Covance (NYSE:CVD) and Inveresk Research (NASDAQ:IRGI). These firms specialize in earlier-phase testing services on animals and in smaller studies on humans. Of the two, Inveresk has been growing more rapidly, although the company's performance has been somewhat uneven. The firm also made a sizable acquisition earlier this year into the later-phase area, so Inveresk is positioned to benefit from spending on advanced trials as well. Inveresk's stock is also currently weighed down from a proposed equity follow-on offering. Covance is the larger, more established player but its growth has been anemic. These stocks represent riskier plays on the resurgence in biotech financing, but both are well-capitalized and hardly high risk.

In the end, the pharma contract services industry might not be the sexiest segment. Don't expect to impress anyone with your vanity license plate "PPD4ME." And the gains you are likely to see probably won't make you rich. But with the recovery in the broad markets still relatively uncertain, the segment is a good medium-term bet on the recent upswing in biotech financing.

Curious about investing pharmaceutical contractors? Find out what other Fools are saying on the Pharmaceuticals or Biotechnology discussion boards.

Now what?
Curious about investing pharmaceutical contractors? Find out what other Fools are saying on the Pharmaceuticals or Biotechnology discussion boards.

Brian Gorman is a freelance writer. He welcomes your feedback at The Motley Fool is investors writing for investors.