Are Drug Companies Being Shortsighted With R&D?

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There's no easy way to sugarcoat this: Many pharmaceutical companies are in for a world of hurt. It'll be really hard for these companies to increase profits when top-selling drugs suddenly face generic competition, sending their revenue hurtling toward zero.

Sure, companies can cut back on staff and announce major restructuring plans. But they shouldn't reduce research and development spending; it's the life blood of drug developers, and a major determinant of a company's future growth prospects.

Yet R&D must look tantalizing for companies eyeing cutbacks. Given the years-long development cycle for drugs, any return on investment might not be seen for a long time. In the shortsighted world of Wall Street, where the latest quarter matters more than the years down the road, CEOs might be tempted to trim a little just to boost the current bottom line.

Let's take a look
It turns out that companies in the pharmaceutical industry span a whole range of shortsightedness:

Company	Change in revenue (YOY) (TTM)	Change in R&D spending (YOY) (TTM)
Pfizer (NYSE: PFE)	0.8%	(5.7)%
GlaxoSmithKline (NYSE: GSK)	0.6%*	(3.4)%
Bristol-Myers Squibb (NYSE: BMY)	28.7%	5.6%
Eli Lilly (NYSE: LLY)	16.3%	9.8%
Merck (NYSE: MRK)	3.7%	11.3%
AstraZeneca (NYSE: AZN)	10.9%	13.9%
Schering-Plough (NYSE: SGP)	41.6%	28.7%

Source: Capital IQ. TTM is trailing 12 months.
*In British pounds.

Interestingly, Pfizer and Glaxo, which have both seen their revenue growth tread water, have also cut their R&D spending. Coincidence? Maybe, but the cuts suggest efforts to prop up earnings in a tough environment.

AstraZeneca and Schering's increased spending certainly looks impressive, but both companies picked up a lot of drug candidates with their acquisitions of MedImmune and Organon BioSciences, respectively. Still, the companies seem to be capably supporting their newly stocked pipelines.

Bristol-Myers and Lilly's stellar revenue growth hasn't translated into an equal increase in R&D spending. Unless the companies have suddenly found the secret to researching more effectively with less money, it's unlikely that either will continue to see growth in revenue or earnings down the road without stepping on the R&D spending pedal.

Perhaps most impressive is Merck, which has increased its research and development spending even amid less than impressive revenue and earnings growth. The company came back from the loss of Vioxx, and it seems to be planning for another comeback after the loss of osteoporosis drug Fosamax and slowing sales of Vytorin and Zetia. Don't look for an overnight success story, but the increased spending bodes well for Merck's prospects.

More to the numbers
Of course, companies spend more money than shows up in their R&D numbers to expand their pipelines.

For instance, Pfizer acquired both Encysive Pharmaceuticals and Sernex in the second quarter of this year. It recorded $156 million in R&D expenses for the in-process research and development from these two companies, and $450 million in intangible assets related to the intellectual property of their product pipelines and goodwill. So not all of what is spent to expand a pipeline shows up in the table above, even though the acquired pipeline candidates should have an effect on revenue down the road.

Also, long-term investors realize that one year does not make a trend. A lot of issues can affect R&D spending in the short term. For instance, wrapping up large clinical trials, successful or not, will cause research and development spending to slip before the next compound moves in to replace it.

What counts
The important thing for investors to look for is that companies are restocking their pipelines and moving the compounds through the clinic, so that the Food and Drug Administration can make a ruling on them. Successfully doing so is the only way companies will have enough cash to grow and continue paying out their dividends.