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The Cheapest Way to Buy Big GrowthBy Dr. George HuangFriday, October 31, 2008 Research and development was once the sacred cow.
In previous economic downturns, pharmaceutical and biotech companies rarely scaled back R&D budgets. Regardless of economic conditions, the drug business is innovation. But times have changed...
Merck recently announced it would cut 7,200 jobs and shutter three research sites... That's in addition to the 10,000 jobs the company killed in December 2005. AstraZeneca is trimming 7,600 jobs, 11% of its roster. Bayer is parting with 6,000. Johnson & Johnson is slashing 5,000. GlaxoSmithKline and Bristol-Myers Squibb have recently doled out 5,000 pink slips, too.
But don't get the wrong idea. Drug R&D hasn't stopped. In fact, one type of research business is facing unprecedented backlogs and accelerating demand. And it's the cheapest it's been in five years.
Drugmakers are cutting costs by sending their research to outside firms, which can do the work faster and cheaper. These outside firms are called contract research organizations (CROs).
CROs are experts in toxicology, drug metabolism, and chemistry. They perform, track, and report the laboratory and clinical research that every drug is required to pass according to U.S. Food and Drug Administration rules. Heck, they'll even design new drugs for you.
Last year, drugmakers spent roughly $60 billion on R&D – 25% went to CROs. That number is expected to double in five years. Now here's the great part for CROs: They book profits whether a drug makes it to market or not.
The top two CROs already have more work than they can handle. Their combined backlog is more than $5 billion in pending sales. But if you had a look at the top CRO stocks, you would think the outsourcing business is dead.
At first glance, these CROs might not look that cheap, especially when you consider the blue-chip names selling at five times earnings. But these research companies have huge pricing power and enormous growth potential.
Each company continues to post solid quarterly numbers. All have strong backlogs. And their clinical trial and research projects span multiple years, which means revenue won't fluctuate as much as it does in most industries.
But most importantly, this group will increase revenue and earnings at double-digit rates over the next five years. Take a look at what's driving growth...
• Major drug companies have to cut costs.
• Many new biotechs lack development infrastructure and regulatory expertise.
• New technologies coupled with data from the "genomics revolution" have expanded the number of new drugs that need testing.
• The FDA is demanding more complex clinical trials.
• An aging U.S. population needs new drugs, devices, and technologies.
Let Big Pharma shoulder the risks involved with new drug discovery. I'll take the sure bet by investing in CROs, who get paid either way.
At these prices, the downside is limited. But shares will remain volatile in the near term. I recommend building your positions by accumulating shares slowly over the next 12 months.
Good investing,
George Huang
Further Reading:
China Will Kill For Your Drug-Development Work 
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