Here’s something many investors probably don’t know about major drug makers like Pfizer (NYSE: PFE), Bristol-Meyers Squibb (NYSE: BMY), Eli Lilly (NYSE: LLY) and others (collectively known as Big Pharma): They’re a lot like the major car companies.

To save money back in the 1970s, the auto industry started farming out portions of the manufacturing process that could be completed much more cheaply elsewhere, typically overseas. They’re still doing it, as I’m sure you’re aware.

#-ad_banner-#Big Pharma has been doing the same kind of thing with a costly aspect of drug development — clinical trials (testing drugs with humans). In the United States, a drug trial typically runs about $150 million. The largest, most elaborate trials can be twice that. So drug makers naturally want cheaper help with this sort of research wherever they can find it.

Like the auto industry, they often look for that help overseas.

India, for example, is one hot spot for drug trials. According to PaidClinicalTrials.org, a public registry of clinical trials conducted around the world, the cost to do a drug trial in India is $90 million — $60 million cheaper than the typical U.S. drug trial.

The work is outsourced to companies called contract research organizations (CROs), which number in the hundreds worldwide. Each year, CROs begin about 8,000 drug trials, or around 40% of the yearly total.

I haven’t been able to track down exactly how much Big Pharma saves by using CROs, but it has to be in the billions. Say, just for the sake of argument, that only 400, or 5%, of the drug trials farmed out to CROs are actually completed (most end quickly because of poor preliminary findings). Then, that CRO only gets paid for a completed trial, and the drug company saves $60 million each time. In that scenario, there would be $24 billion in savings — a full third of the drug industry’s 2010 net profit of $72 billion.

That’s a very rough analysis, I know. But hopefully it gives you a sense of just how much the pharmaceutical industry relies on CROs for profitability, just as the auto industry counts heavily on foreign outsourcing for its bottom line.

If the idea of investing in CROs appeals to you, then consider Dublin-based ICON PLC (Nasdaq: ICLR). Analysts say the $20 billion CRO industry will grow 50% in the next five years. ICON is well-positioned to lead the expansion.

The company is already deeply entrenched, having achieved “preferred provider” status among the drug industry giants. It has won business from every one of the top 20 pharmaceutical companies and maintained a customer retention rate of more than 90%.

ICON earned its reputation through a unique, client-focused approach in which each trial is assigned a dedicated research team familiar with all the associated clinical and regulatory obstacles. This helps to ensure high-quality trials, differentiate the firm from rivals and maintain barriers to entry for new competitors.

Because it’s a preferred provider, ICON managed to eke out modest revenue and earnings growth of 2% and 5% per year, respectively, during the lean years of 2008-2010, even as many competitors faltered. Main rival Covance Inc. (NYSE: CVD), for example, saw earnings drop more than 41% annually from 2008 to 2010.

Since Big Pharma usually only awards business to trusted CROs like ICON, the company’s future is likely to be especially bright. Economic recovery, coupled with an aging population in the developed world could spurn the need for new, innovative treatments. Drug makers should respond to this by ramping up research and development (R&D) spending. In the next five years, analysts say ICON’s earnings will grow 16% annually, pushing its stock as high as $54 a share from about $24 now.

 

Action to Take –> ICON’s strong reputation, unique business model and growth potential make it, in my opinion, today’s best play on the burgeoning CRO industry. It held up far better than Covance during the recession and its stock is set to rise much faster. (According to analysts, Covance has perhaps 40% upside in the coming five years, compared with up to 100% or more for ICON.)

Of course, if the economy doesn’t cooperate and Big Pharma decides to skimp on research and development spending, then there might be a CRO industry price war that squashes profits, earnings and investor returns all around. But at this point in the recovery, I think it’s much more likely ICON will go on to reward investors handsomely.

P.S. — Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America’s electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here’s what’s going on…