Last week I brought up the possibility that institutional investors have been and will continue to flock to defensive plays – namely consumer staples, utilities, and pharmaceuticals – in the coming months because quality and consistency of earnings matters now more than it has in years. Rob, one of our readers, suggested going beyond big name pharmaceuticals and into the contract research organizations (CROs) that are capturing a growing share of R&D work formerly done in-house by the Pfizers, Mercks, et al.

Now with Mad Money on, the industry of Cramer’s focus is CROs. Cramer is touting Covance (CVD) as his favorite play in the sector, given its diversified customer base, split early/late testing abilities, and solid balance sheet. At the same time, Cramer admits the stock is not cheap – but says it should go higher, possibly by 35%.
CVD is not cheap, as the stock already trades at a PEG of 1.92x and 22.1x operating cash flow, even though the firm spends 65% of operating cash flow on capital expenditures.

Rob suggested ICON (ICLR), another full-service firm, albeit smaller than Covance. ICON is a fast grower that trades at a lower PEG (1.78x) than CVD and recently raised guidance that puts the stock on at 28.8x forward earnings.

Parexel (PRXL) is another stock in this sector, and in addition to being the smallest of the three companies it is the cheapest on a PEG and forward P/E basis. The performance of all three stocks in the last year is depicted on the chart below.
[You may need to scroll down to see the chart]

Even while these stocks are expensive by most traditional metrics, why would they go higher? If Cramer’s estimate that CROs can do the R&D work for 60% less than the major pharmas is correct, these companies have an enormous market. Consider the R&D spending of some of the major pharmas in the last four quarters:

-Johnson & Johnson (JNJ), $7.4 billion
-Pfizer (PFE), $8.2 billion
-Merck (MRK), $5.2 billion
-Abbott Labs (ABT), $2.4 billion

The combined revenues of Covance, ICON, and Parexel in the last year amounts to $3.1 billion – a pittance on the world of R&D spending for pharma. The R&D spending from the four large pharmas above totals $23.2 billion, and ignores the tens of billions in spending from others like Novartis (NVS), AstraZeneca (AZN), Sanofi-Aventis (SNY), and others – before we even get into biotechs like Amgen (AMGN) or Genentech (DNA), each of whom spend more on R&D than the combined revenues of those three CROs.

Bottom line: there is a huge market opportunity here, and that leaves the door wide open for CROs to become the next secular growth story in a slow/stalling/recessionary economy. Even with the great runs stocks like CVD, ICLR, and PRXL had last year, I think they’ll see more upside in the coming months.