Drug Company Cost Cuts: Careful What You Wish For

Drug companies, perhaps more than those in any other industry, have a hard time catering to both short-term and long-term investors at the same time. Because of the long development leeway, investments in research and development (R&D) don't bear fruit for many years down the line. But if drug companies cater to short-term investors now and cut R&D, they put the future of the company in jeopardy.

The patent cliff may be coming, but so far most major drug companies have kept research and development expenses fairly constant, with a few notable increases due to acquisitions.

Company

2007 R&D Expense Relative to 2006

2008 R&D Expense Relative to 2006

2009 R&D Expense Relative to 2006

Abbott Labs

112%

121%

123%

AstraZeneca

128%

125%

112%

Bristol-Myers Squibb (NYSE: BMY  )

108%

119%

124%

Eli Lilly (NYSE: LLY  )

111%

123%

138%

GlaxoSmithKline (NYSE: GSK  )

95%

74%

90%

Johnson & Johnson (NYSE: JNJ  )

108%

106%

98%

Merck (NYSE: MRK  )

115%

118%

142%

Novartis (NYSE: NVS  )

121%

131%

140%

Pfizer (NYSE: PFE  )

102%

101%

105%

sanofi-aventis

113%

109%

112%

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

That's about to change.

More with less?
During their end-of-the-year conference calls, Pfizer, Glaxo, and AstraZeneca said they plan to scale back R&D expenses.

After the acquisition of Wyeth, it makes sense for Pfizer to spend less than the combined companies would have individually. This year, it is budgeting between $9.1 billion and $9.6 billion on research and development, which is down sharply from the $11 billion that Pfizer and Wyeth spent when they were separate companies. Some savings might come from redundant support staff and auxiliary equipment, but most of the savings will probably come from killing duplicate programs. There's little reason to develop two drugs that go after the same target, after all, and picking the better of the two should only make Pfizer stronger.

The bigger worry is what Pfizer plans to do once Wyeth is fully integrated. In 2012, Pfizer expects that it will reduce research and development spending to between $8 billion and $8.5 billion. You can understand why Pfizer would want to decrease costs in its post-Lipitor era, but it's still worrisome for investors who plan to hold well beyond the transition period.

Glaxo plans to focus on fewer therapeutic areas and cut development of drugs for certain indications like depression and pain. The company plans to save $750 million per year by 2012 from cuts to R&D, sales, and administrative expense. Depending on how the cuts break down, R&D might not be hurt so badly; the company says it'll plow 30% of the cuts back into the company, with the other 70% trickling down into the profit line.

AstraZeneca's plan is to consolidate its research sites to save money. Not having to pay for extra heating and cafeterias might be a good idea, but it also plans to reduce the research staff by 1,800 positions. That's a lot fewer bodies looking for the next blockbuster.

In-licensing is the new centrifuge
OK, maybe that last play on words didn't work out so well. What I mean is that while drug companies may be decreasing their research workforce, they're likely to continue spending on the development side of things. One analyst estimates that in-licensing drugs from small drugmakers can yield returns three times higher than developing them in-house.

That estimated savings may be a bit high, but it's clear that pharmaceuticals can reduce their risk of failure by licensing the drugs after some risk has passed -- for instance, after the safety checks out in a phase 1 trial, or proof of concept in phase 2. They're also able to avoid some of the later development risk on the original developer by tying milestone payments to the clinical and commercial success of the drug.

Investors really shouldn't care whether the drugs are developed in-house or not. All they need to worry about is whether drug companies are spending money somewhere today in order to have revenue for tomorrow.

Chuck Saletta has five companies for you that are set to dominate the competition.

Pfizer is a Motley Fool Inside Value recommendation. Novartis is a Global Gains selection. Johnson & Johnson is an Income Investor selection, and Motley Fool Options has recommended buying calls on the stock. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Fool owns shares of GlaxoSmithKline and has a disclosure policy.


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