Hello, Rule Breakers, and welcome to another Monday. Today's column is about drug discovery -- a biotech industry that will see many slow and painful deaths. It's not all downbeat, however, because it might explain yet another reason why Human Genome Sciences (Nasdaq: HGSI) and Millennium Pharmaceuticals (Nasdaq: MLNM) -- very, very risky investments and Rule Breakers -- might just be profitable survivors.

Speaking of biotech: If you enjoyed our Rule Breaker columns on tissue engineering and biochips, you might like to buy and read The Motley Fool's Industry Focus 2001. Two articles look more broadly at biomaterials (tissue engineering, regenerative medicine, stem cells) and genomics tool makers (including biochips). Also, the Fool has put together a bang-up Biotech Investing Guide, chock-full of detailed analytical tools for evaluating biotechs, with an emphasis on drug companies. It's a different approach from Rule Breaking, another arrow in the investing quiver.

Too many drug discovery platform companies!
A subscription to Nature Biotechnology is worth the price just for these cautionary words from Stelios Papadopoulos, managing director of SG Cowen, who guest-penned a feature on biotech business models: 

"The trademark of Biotech 2000 is that, almost without any connection between perceived and real value, dozens of these companies have had successful initial public offerings during the first half of 2000.... What happens to the hundred or so early stage technology platform companies, both private and public?"

By platform companies, Papadopoulos means companies with "integrated technology platforms" or "solutions" (one of my least favorite corporate words du jour, but I have no solution) to make the drug development process work better. Their customers are big drug makers and other biotechs. There are way too many platform companies out there to survive long-term. Too many mice and not enough cheese. Too many kids and not enough Oreos. You get the idea: It's not pretty.

Some drug discovery platform companies, with information from their websites (emphasis added):

  • Genome Therapeutics' (Nasdaq: GENE) "commercial gene discovery strategy is to identify and characterize human genes associated with major diseases and elucidate bacterial genes responsible for many serious infectious diseases."
  • Rosetta Inpharmatics (Nasdaq: RSTA) "delivers informational genomics solutions. Our mission is to innovate and integrate technologies in computational and molecular biology to catalyze discovery for the life sciences industry."
  • Millennium Pharmaceuticals "employs large-scale genetics, genomics, high-throughput screening and informatics in an integrated science and technology platform."

Everyone, but especially Rule Breaking investors, must think about the size of a company's markets. A Foolish investor should only take a substantial risk of loss if there's a shot at a tremendous rewards. The RB Port accepted the risk of Amazon.com (Nasdaq: AMZN) because the prize was a potential lock on the worldwide Internet retail market. eBay (Nasdaq: EBAY)? Oh, only the worldwide market for second-hand goods. Starbucks (Nasdaq: SBUX) and Amgen (Nasdaq: AMGN) both have the potential to dominate major -- humongous -- markets.

Repeat: We want Rule Breakers with at least a chance of becoming Rule Makers, as Amgen and America Online (NYSE: AOL) might be or become. Rule Maker criteria require a minimum of $1 billion in sales.

How many drug discovery platforms will the market support?
Just how much do big drug makers spend to buy genomics-based drug discovery? Let's do it on the back of an envelope. There are about 12 big, traditional, non-genomics-based drug companies, with market caps ranging from the mid-$40 billions to $275 billion Pfizer (NYSE: PFE). They spend from $1 billion to more than $3 billion (Pfizer) per year on R&D, with a rough average of $2 billion. Let's call that $24 billion total for the 12 companies, and add another $4 billion annually for the biotech drug makers, including Amgen, Genentech (NYSE: DNA), Immunex (Nasdaq: IMNX), MedImmune (Nasdaq: MEDI), Human Genome Sciences, and Millennium Pharmaceuticals, to name a few.

Now we're at $28 billion for annual drug maker R&D spending. If drug companies outsource 10% of their R&D to biotechs -- this figure gets bandied about -- that makes a pie of $2.8 billion to divide among 100 platform companies. The average company would earn $28 million a year.

Are you excited to divide a $2.8 billion pie among 100 companies?
I'm not. It not only offers an insufficient chance for Rule Breaking investment returns, but it's also too small a pie for 100 companies to divide up and survive. That's why many will die a slow and painful death, when the IPO and follow-on stock offering cash dwindles, and the cash burn rate meets insufficient revenues.

You might say that biotechs can capture a larger share of Big Pharma R&D than 10%. But the response is that the $28 billion for R&D won't grow, because the biotech revolution promises cheaper drug R&D. And, even if you double the 10% to 20%, you still have a limited upside for drug discovery platform companies.

And the winners are...
The small pie must be one reason Papadopoulos believes that only a handful of platform companies will succeed as platform companies. The real winners will be those that "gradually turn the technology platform into a proprietary R&D discovery effort and ultimately transform the organization into an emerging pharmaceutical company." They can control more of the destiny -- and profits -- from the drugs they develop, instead of just collecting royalties after they hand the discoveries over to Big Pharma.

Two companies that have turned platforms into proprietary R&D and have become drug-producer hopefuls are Human Genome Sciences and Millennium Pharmaceuticals. (Another may be privately held, Seattle-based ZymoGenetics, quietly going about its business competing with HGS and Genentech in developing and selling protein-based drugs. Watch for an upcoming Fool interview with ZymoGenetics' CEO!) But, they are far from sure shots, given that even if they do eventually have FDA-approved, on-the-market drugs, they still must partner with Big Pharma to gain worldwide marketing clout.

Don't get me wrong. There are going to be good drug discovery platform company investments. But, for Rule Breaking investing, we might have already identified the best shots -- the fully integrated genomics drug companies. But I don't have Madame Fooliana's biotech crystal ball. Am I right? Chime in on the Rule Breaker Strategies discussion board!

Tomorrow: If you've noticed last year's rise for Celera Genomics (NYSE: CRA) from the RB Port's purchase price to the moon and back to within points, well, now you know why the Rule Breaker Team called it their riskiest purchase yet! We'll take a look at the bioinformatics universe a year after the Celera buy, asking what's happened to bioinformatics and whether other Rule Breakers lurk there.

Yours in Fooldom,
Tom Jacobs -- TMF Tom9 on the discussion boards!