Over the past 20 years, both established pharmaceutical companies and emerging biotechnology firms have become increasingly reliant upon outsourcing their lab and clinical trial work to third parties. These entities, known as contract research organizations (CRO), are better able to maintain a costly lab infrastructure because their business model enables them to conduct such testing year round.

In contrast, the lumpy drug development cycle means that pharmaceutical companies end up eating the high fixed costs of maintaining underutilized testing facilities when they perform such work in-house. By outsourcing these efforts, drugmakers can spend more time focusing on core areas of expertise such as drug discovery and marketing.

Drugmakers can spend as long as 15 years and over $1 billion bringing a drug to market, so they place a high premium on CROs’ reputation for conducting trials in a trustworthy manner. There have been occasional scandals involving the mishandling of trials among smaller CROs, so once a CRO develops a reputation for its consistency and attention to detail, it enjoys stickier revenues from recurring contracts with large clients.

The CRO industry tends to be split among firms that specialize in preclinical and early-stage clinical testing, and those firms that specialize in higher-margin, late-stage clinical testing. The lower barriers to entry for early-stage testing make this arena more competitive, including the possibility of pricing wars. Firms that specialize in late-stage testing are less susceptible to upstarts encroaching upon their market share, but face greater risk from project cancellation.

At present, 25 percent of preclinical trials are outsourced, and some industry experts believe this number could ultimately reach 50 percent over the next decade. CROs have already experienced an amazing run, enjoying revenue growth in the high teens for much of the past decade.

Unfortunately, big pharma is approaching a patent cliff beginning in 2012 during which a number of blockbuster drugs will lose their patent protection. The decrease in revenues from these blockbuster drugs means the drug industry could experience restructuring and consolidation as companies scramble to cut costs and refill their pipelines. Although big pharma will likely be in cost-cutting mode for the next several years, this trend could actually cause them to become even more dependent upon the cheaper cost of outsourcing this portion of their research and development to CROs.

Among the more attractive names in the CRO space, Covance’s (NYSE: CVD) scale has enabled it to forge strategic partnerships with a number of the largest drugmakers. Covance’s expertise spans the full range of the clinical trial spectrum, which helps it secure deals that are beyond the scope of more specialized firms. However, the firm’s early-stage testing business, which accounts for roughly half its revenue, is suffering from the drug industry’s focus on those compounds that are further along in development. This could spark an increase in pricing competition in this lower-margin realm, which could erode Covance’s margins.

PAREXEL International Corp (NSDQ: PRXL) similarly enjoys a robust international presence, largely specializing in complex, later-stage clinical trial work. PAREXEL differentiates itself from its peers with a significant investment in information technology with its Perceptive Informatics unit, which enables it to conduct its trial work with greater efficiency. The firm is also working toward expanding its early-stage testing business, which could help it secure more contracts and increase utilization of its facilities.

In contrast to its peers, ICON (NSDQ: ICLR) uses a dedicated-team approach in its clinical testing, which enables it to provide a level of service that increases customer retention. However, this approach can also hurt the firm when late-stage trials are cancelled and it’s unable to quickly redeploy a team to its other projects. The firm has formed a number of strategic partnerships, including most recently with Pfizer (NYSE: PFE). It has no long-term debt and substantial cash on its balance sheet, which should allow it to further expand via opportunistic acquisitions.