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During the most recent economic downturn, many biotech, medical, and pharmaceutical companies turned to outsourcing as a way to boost bottom-line performance. In times of economic weakness, some companies will instinctively react by implementing cost-reduction strategies. Unfortunately, these cuts typically yield only short-term benefits, and often come at the expense of long-term potential. As the economy recovers and business activity ramps up, these companies fall behind, having divested too much of their internal capacity – or so the story goes. Within the biomedical research world, however, the sub-segment of contract research organizations (CROs) and contract manufacturing organizations (CMOs) have seemingly changed the rules of the game. These developments bear watching, as they may have significant implications for the investment community.

Given the current trend towards greater accountability in the business world, R&D departments face some intrinsic challenges when it comes to competing for a company’s limited budgetary dollars. Quality biomedical research can often result in unexpected overruns in time and money, things that are especially precious during the troughs of business cycles. On the other hand, activities of more operationally-inclined departments like manufacturing, sales, and marketing, tend to generate results that are relatively easier to measure and control.

Research seldom “goes according to plan,” and unexpected costs can pop up even during the more routine clinical testing stages of development. While other departments can precisely detail how budget cuts will affect overall revenues and earnings, R&D operates on a long-term time frame, and with the exception of its incurred costs, rarely makes contributions to the organization’s near-term financial performance.

In times of crises, a company may look to downsize its research unit to ease short-term cost pressures. As business conditions improve, funding is then restored, and the company continues along its merry way. That said, during the 2008-2009 recession, some leading companies actually took the opportunity to streamline and expand their research budgets. Citing the importance of innovation in their turnaround plans, these companies worked to ensure that they would be well-positioned for the eventual ride back up.

According to Booz & Company’s 2012 Global Innovation 1000 study, the top three global innovators, Google (GOOG), Apple (AAPL), and 3M (MMM - Free 3M Stock Report) have expanded their research operations; yet they are only ranked 26th, 53rd, and 86th, respectively, in terms of total R&D spending. So, clearly, efficiency matters when it comes to R&D spending.

Companies operating in the biomedical research sector are no exception to this, and have made some surprising changes to the way that they handle research. A recent trend towards outsourcing and forming partnerships defies the traditionally secretive nature of these companies, especially when it comes to proprietary research and intellectual property. However, in the quest to improve bottom-line performance in an ever-more volatile business environment, a growing number of these companies have undoubtedly realized the need to maximize efficiencies wherever they can.

The degree of volatility within the biomedical space can vary greatly from company to company. Global pharmaceutical giants like Merck (MRK - Free Merck Stock Report), Novartis (NVS), and Pfizer (PFE - Free Pfizer Stock Report), have well-established and stable revenue streams, while biotechs like Dendreon (DNDN), Enzo (ENZ), and Incyte (INCY) have Beta volatility levels that reside well above the market average. One strategy that seems to be gaining favor is the outsourcing of some of the risks and uncertainties that normally accompany leading-edge research. Indeed, the CROs that win these outsourcing contracts, like Albany Molecular (AMRI), Covance (CVD), Icon (ICLR), and Parexel (PRXL) all have much higher Beta metrics than their customers within the pharmaceuticals industry.

Although contract research organizations have existed for quite a while, the most recent recession prompted a number of companies to farm-out the inefficient portions of their in-house research operations. Many companies realized sizable cost savings from outsourcing the clinical testing stages of product development. Instead of maintaining a diverse team of expensive specialists strictly for this purpose, companies turned to CROs specializing in approval processes dictated by the FDA, EMEA, or other regulatory bodies. With this “a la carte” approach, companies effectively freed up resources that could be appropriated for other purposes.

Employing an external research contractor is not a perfect solution, however, and comes with plenty of risks. A loss of control over the quality and timeliness of the contracted project can sometimes become an issue. Moreover, outsourcing to an external vendor often introduces intellectual property security concerns. During the early stages of development, products under development may not yet be protected by patents, and are particularly susceptible to corporate espionage. Few companies will want to risk losing a promising product to a competitor just because their contractor may have provided insufficient internal controls or lax security measures.

Therefore, core research activities related to the initial discovery of new products should remain in-house. Indeed, few CROs can match the deep pockets of their larger customers, which typically attract the best and the brightest scientists. With expiring patents a constant threat on the horizon, big pharma will want to keep these folks close, as they work on discovering the next big breakthrough. In the meantime, companies like Pfizer will likely continue to forge collaborative relationships with CROs like Parexel and Icon, and thus, reap the best of both worlds. The cost efficiencies gained from these outsourcing agreements provide customers of CROs with even more resources which can then be used to fund additional efforts to create or acquire original research. 

With the success of the CRO model, some research contractors have developed their internal capabilities to such an extent that they are able to provide comprehensive solutions to their smaller customers. These solutions can even include the subsequent commercial production of the product under development. Full-service CROs, also known as contract manufacturing organizations, potentially represent an area of significant growth in the future.

Smaller biomedical research houses and new upstarts are typically unable or unwilling to make substantial capital expenditures in projects that may not pan out. By having the necessary process efficiencies and expertise, CMOs are able to monetize a customer’s products in a shorter amount of time and at lower costs than would otherwise be possible. These research contractors specialize in specific areas of research. For example, Cambrex (CBM), focuses on small molecule active pharmaceutical ingredients. As a result, CMOs provide a hedge against uncertain market conditions due to the critical services that they provide.

The demand for research contractors figures to be strong over the long term, as the current outsourcing trend should continue to strengthen. Big pharmaceuticals will likely continue to seek out CROs for their clinical expertise, and scour the field of smaller companies for particularly promising product pipelines. This should translate into greater demand for new upstarts, which ought to, in turn, fuel the demand for full-service CMOs. Investors looking to capitalize on this research model of the future will certainly want to take a closer look at this exciting secondary layer of the biomedical research business.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.