Big Pharma's R&D Model Is Broken

In theory, bigger should be better, right? Large pharmaceutical companies should be unstoppable powerhouses with marketing and research and development departments that blow the little guys out of the water. They should have economies of scale and scope to help in reducing costs, which helps the bottom line. Investors should be making out like bandits in a recession-proof industry.

But it hasn't exactly worked out that way. The problem, as I see it, starts at the beginning of pharma's business cycle: R&D. New drug development has just barely been able to keep up with growing patent expirations.

Company

Annualized Revenue Growth (Last 3 Years)

Pfizer (NYSE: PFE  )

0.6%

Eli Lilly (NYSE: LLY  )

11.6%

GlaxoSmithKline (NYSE: GSK  )

4.0%

Merck (NYSE: MRK  )

2.7%

Wyeth (NYSE: WYE  )

6.8%

Source: Capital IQ, a division of Standard & Poor's.

Except for Eli Lilly, which benefited from an acquisition of ICOS in 2007, none of the companies came close to the double-digit growth seen in years past. With patents continuing to expire and pipelines not nearly as stocked as everyone would like, what's a company to do?

Get bigger, of course
That's one way to raise revenue -- especially if Pfizer and Merck don't sell off all the random side businesses they’ll acquire when they take hold of Wyeth and Schering-Plough (NYSE: SGP  ) , respectively.

If all the cost savings fall into place, Pfizer and Merck will benefit from the acquisitions in the short term, but there's still the long-term issue of expiring patents and less-than-stellar research and development.

The solution is to let smaller drug developers be the R&D departments for the pharmaceutical industry. Smaller companies are more nimble, and they're probably more effective, because researchers need to make discoveries to keep their company going -- slack off, and the funds to pay salaries dry up pretty quickly.

Some companies like Glaxo seem to get it, although many of its drug discovery deals, like those with Exelixis (Nasdaq: EXEL  ) , Dynavax Technologies, and Regulus Therapeutics, are still in the clinic. Others -- yeah, I'm looking at you, Pfizer and Merck -- don't.

It's ironic that one of Pfizer's fastest-growing drugs, cancer treatment Sutent, was acquired when the company bought Pharmacia, but was originally developed by a small drugmaker, Sugen, which Pharmacia had purchased. And Merck touted that buying Schering-Plough doubled the number of drugs it had in phase 3 trials, but many of the compounds Merck added came from Schering's previous purchase of Organon BioSciences.

When will they ever learn?
So where does this leave investors? Fortunately -- or unfortunately, if you've owned them all this time -- shares of pharmaceutical companies are fairly cheap right now, and it looks like pharma may be wising up to the fact that bigger might not be better.

Pfizer is reorganizing itself into smaller units so that it can be more nimble. In theory, the units, which put drug developers in with marketers, should help produce drugs that are more economically viable. We’ll see whether that's just reorganizing the deck chairs on the Titanic, or whether it'll help steer the company in the right direction.

And the bigger question is how well those smaller units will help Pfizer to incorporate Wyeth's staff. Martin Mackay, Pfizer's head of R&D, said the merger is going to be so successful it's "going to be used as a Harvard Business School case study." If that's the case, the long-term benefits could be huge, but whether Pfizer has learned from its previous mistakes remains to be seen.

Roche has also made it perfectly clear that smaller is better by insisting that it plans to leave Genentech alone and not taint the culture that's produced so many blockbusters. Maybe it'll be smart enough to spin Genentech back out in a few years -- again.

It's going to take years to see whether big pharma's talk can turn into productivity. Fortunately, most companies are paying a handsome dividend to reward investors for waiting for brighter days.

Our Foolishness isn't broken:

GlaxoSmithKline is a Motley Fool Income Investor recommendation. To see how dividend-paying stocks can offer both secure income and the opportunity for growth, take a free look at this newsletter with a 30-day free trial.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Pfizer is an Inside Value recommendation. Exelixis is a Rule Breakers selection. The Fool owns shares of Exelixis and has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (8)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 26, 2009, at 5:28 PM, lancebergstrom wrote:

    Can't any American companies just make money and grow just a little bit. Isn't the balance sheet enough for people to buy a stock. Are these pharmaceutical companies in the red or the black? That is my question.

    Why does every article for investors have to focus on double digit growth in a company? Isn't that the very reason investment bubbles are produced?

    I apologize in advance for the rhetorical questions, but I am just so tired of investors not concentrating on whether a company is profitable. BLAH!

    You can move the chairs around as much as you want but a ship is either floating or sinking.

  • Report this Comment On March 26, 2009, at 6:21 PM, FlyBoyRDJ wrote:

    lancebergstrom is so right-on. What's up with all this greed? Let's see: invest long-term in companies creating stable, long-term economic growth, increasing their productivity and helping the entire economy over the long run, or invest in companies trading CDOs so they can make a huge quarterly profit, parachute out their top execs with big bonuses, and hope I as a small investor can time my purchase/sale properly to cash in before it all hits the fan.

    We've recently seen how well the latter works and how helpful it is to overall economic prosperity in the long run.

    All that said, I think the article has it right, and the drug companies are doing the right thing. Smaller is almost always better when it comes to innovation, and there's nothing wrong with hefty dividends in lieu of rapid stock price appreciation for a profitable company.

  • Report this Comment On March 26, 2009, at 9:51 PM, bigkansasfool wrote:

    The author is right about big pharm's R&D being broken, but wrong on the details. The reason why is that as they get bigger they cut down on R&D spending as a percentage of expenses and a larger share of earnings go to the shareholders rather than plowing them back into the company. This is a byproduct of having CEO that are pushed to make short term decisions to make the next quarter's numbers rather than the long term health of the company. Many drugs that would be profitable for the company get cut from the R&D for many reasons (few are based on solid business judgment).

    The author offered a prime example in Pfizer. Pfizer purchased Pharmacia, who's former CEO Fred Hassan (no former CEO of schering plough) is a CEO who's only business strategy is to come into a company, cut R&D expenses to pretty up the balance sheet, and then sells off the company. In the process he collects a nice golden parachute and moves on to the next one. So now a little history. Pharmacia use to be Pharmacia-Upjohn, that was itself created by the merger of Pharmacia and Upjohn. Upjohn use to be a profitable company with a very impressive R&D record, as was Pharmacia. They merged and R&D expenditures were cut to pay for shiny new offices in New Jersey for Fred. Just a couple years later he sold off Pharmacia-Upjohn to Pfizer, who only bought the company for the drug portfolio. It then shut down all of the R&D projects and facilities of Pharmacia-Upjohn.

    This is the typical pattern in the industry and will lead to the large pharmas being poor investments over time as more and more of your equity is wasted in goodwill costs of new mergers and acquisitions. I have yet to see a merger or acquisition in the pharma industry that has made sound long-term business sense and resulted in increased long-term shareholder value.

  • Report this Comment On April 10, 2009, at 3:08 AM, GoNuke wrote:

    Current technology is driving scientific advances at a very rapid pace.

    The people who understand and use this technology are in a position to "engineer" successful drugs instead of employing the old hit and miss strategies. Small pharma CEO's tend to have Ph.D's in the relevant scientific disciplines so their focus is R&D. As we unravel more and more of the mysteries of the human machine it will become increasingly easy to find new drug targets and develop new and effective drugs. Remember that the first two complete human genomes cost over $1 million to sequence.

    Two firms are on the verge of delivering machinery that can sequence an entire genome for less than $100 (Pacific Biosciences and Oxford Nanopore Technologies), in just a few hours.

    http://www.nature.com/nmeth/journal/v6/n4/full/nmeth0409-244...

    This is just one example of the spectacular advances in technology that are making drug discovery much easier.

    The key to success here is to be on top of the technology. A large firm such as Pfizer ends up being dominated by "businessmen" with backgrounds in management and finance. The senior people don't really understand the technology so, like Warren Buffet, they don't understand the pipeline.

    I see a strong parallel here between GM choosing "finance guys" over "car guys" as CEO's for many many years. There was a big disconnect between senior management and understanding what constitutes a better automobile.

    Pfizer's CEO BA, JD (lawyer)

    JnJ's CEO BS (OK he studied science as an undergrad but started life as a drug salesman)

    Bayer's CEO (apprenticed as accountant at Bayer)

    GlaxoSmithKline's CEO BA economics

    Novartis' CEO MD!

    Sanofi-Aventis CEO engineer who began life teaching math

    Roche's CEO BA economics Doctorate in Law

    AstraZenica's CEO BA business

    Merck's CEO BA, MBA

    Lilly's CEO Ph.D. in biochemistry!

    Wyeth's CEO Ecole Supérieure de Commerce de Paris (business degree)

    quite a contrast to:

    Genetech's CEO Ph.D. biochemistry, Post Doctoral position with position with Michael Bishop and Harold Varmus: co-recipients of the 1989 Nobel Prize in Physiology or Medicine Microbiology UC San Francisco

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