In a struggling economy, businesses that can help companies control costs, improve efficiency, and provide flexibility stand to hold up relatively well and should be well positioned to benefit when the economy eventually gets rolling again.

Among these service businesses with a strong outlook are the global drug contract research organizations (CROs), which have experienced substantial growth because of increased research and development outsourcing by the biopharmaceutical industry.

CROs and their customers
CROs provide a wide range of drug development services to the pharmaceutical and biotech industries, including Phase I-IV clinical trials, preclinical testing, regulatory submissions, consulting, and data management and biostatistics.

Typically viewed as a defensive sector that does well in a weak economy, health care companies have not been totally immune to the recession, and many pharmaceutical companies, including giants such as Pfizer (NYSE:PFE), Merck (NYSE:MRK), and GlaxoSmithKline (NYSE:GSK), have been cutting costs and laying off staff.

The efforts to contain costs are a long-term positive for the CROs because pharma companies are likely to outsource more R&D. In the near-term, however, a slowing in new projects and some cancellations and delays have hit the CROs hard as pharma companies rationalize and modify their product pipeline plans, often focusing on drugs in later-stage development that are close to potential regulatory approval while delaying or cutting early-stage projects.

In addition, the tight credit and equity markets have caused some biopharma companies -- especially smaller biotechs with limited resources -- to hold off or drop projects to conserve cash. An indication of this came earlier this month when Parexel International (NASDAQ:PRXL) cut its quarterly guidance because a customer facing financing problems stopped payments on a large, late-stage development contract.

Another recent pressure on CROs has been the strong U.S. dollar, which has hurt overseas results. Both Kendle International (NASDAQ:KNDL) and ICON (NASDAQ:ICLR) recently said that the strong dollar had adversely affected their quarterly results. Of course, in times when the dollar is weak, these companies should benefit.

A growing market despite recent weakness
According to Standard & Poor's, global pharma R&D spending was near $65 billion in 2007 and had grown at around 8%-10% a year over the last decade. The market for CRO services is estimated at around $16 billion, or about 22%-23% of pharma R&D spending. Some industry analysts expect that CROs will grow to approximately 35% of industry R&D spending to around $30 billion in the next five years, suggesting mid-teens annual growth.

Many factors should drive this expected growth, including the continuing trend toward outsourcing, increasing regulation requiring more patient studies and data, the need to get new drugs to market quickly to help offset losses to off-patent generics, and the need to expand the markets for existing drugs.

The chart below presents some of the key numbers for the CROs mentioned here:

 

Kendle

Covance

ICON

Parexel

Market Cap

$289.5 million

$2.33 billion

$1.09 billion

$524.1 million

Enterprise value

$474.3 million

$2.15 billion

$1.04 billion

$758.1 million

Revenue*

$671.9 million

$1.80 billion

$825.8 million

$1.27 billion

P/E*

9.5

11.7

15.5

9.5

Op. Margin*

9.1%

14.5%

11.2%

6.2%

Return on Equity*

20.1%

18.2%

18.0%

17.9%

CAPS Rating

****

*****

*****

***

Source: Capital IQ, a division of Standard & Poor's, company earnings releases, and CAPS. *Trailing 12 months.

CAPS is on the case
Although underfollowed by the financial media, CROs have been noticed by Motley Fool CAPS members, with many CROs holding four- and five-star CAPS ratings -- the two highest. Commenting on Covance (NYSE:CVD), CAPS All-Star EldrehadsPicks observed nearly a year ago

If, however, you are looking for a way to capitalize on the overall uptrend in the pharmaceutical industry without taking on risks that can, and often do, border on speculation, Covance may well be a candidate worthy of serious consideration.

After all, "selling pickaxes to gold prospectors" may seem like an overly used analogy in the business and investing world, but finding these kinds of companies can be a great way to boost your portfolio's returns without taking on the speculative risk of doing the prospecting on your own.

Small-cap CRO to watch
One CRO worth a closer look is Kendle International, a small-cap with global operations concentrated in late-stage development services. Late-stage projects accounted for 88.9% of Kendle's net service revenue in the third quarter. By contrast, industry leader Covance recorded only half its revenue from late-stage projects in the same quarter. This late-stage concentration should give Kendle an edge under current conditions, as most cancellations and delays have been in early-stage projects.

In terms of the financial health of its customers, the vast majority of Kendle's backlog looks solid, with 65% of backlog from large multinational biopharma companies with over $1 billion in revenue and 25% from mid- to small-size companies that have large pharma partners.

Kendle has delivered strong growth, with both earnings per share and revenue growing more than 40% annually over the last three years. In its third quarter (ended Sept. 30), net service revenue increased 25% year over year, and EPS increased 69.8% (excluding charges in the '07 quarter).

On the downside, Kendle's balance sheet requires some close attention. The company carries around $200 million in debt, and its debt-to-capital ratio (at 0.54) is higher than that of most of its competitors.

On Jan. 12, Kendle lowered its 2008 full-year guidance slightly, primarily because of the effect of the strong dollar. Even with this revision, the low end of the new guidance range still suggests year-over-year EPS growth of 69%.

Like other CRO stocks, Kendle has been pounded over the last year, and it now trades at a P/E of 9.5, at the lower end of the group.

With a reasonable valuation and slowing but still significant growth, a concentration in late-stage services, the diversity and relative financial strength of its customers, and strong long-term prospects for continued growth in drug R&D outsourcing, Kendle offers a defensive investment in a growing business with a decent risk-reward. This one is worthy of investors' attention, especially if earnings season volatility brings a further drop in the stock price.

Related Foolish medicine:

Fool contributor Brian Bauer eats his own cooking. He owns shares of Kendle International and believes that a "spoonful of sugar helps the medicine go down." Pfizer is both an Inside Value and an Income Investor recommendation. Glaxo is also an Income Investor selection. The Motley Fool owns shares of Pfizer and has a disclosure policy.