Would you start a project if you knew that it only had a 13.8% chance of succeeding? For biotech companies, there isn't much of a choice in the matter, given that those are the odds of a medicine in development making it through all the phases of clinical trials to become commercialized.
The fact that developing new medicines is really risky isn't new to most biotech investors, though. But the fact that it's getting harder and more expensive to make new drugs might be. Let's take a look at two trends that demonstrate how the game is getting fiercer for biopharmas to understand how the industry is changing over time.
1. Returns on research have collapsed
Research and development (R&D) is the biotech industry's bread and butter activity from which the majority of revenue and earnings are made. That means it's a priority for investment -- even after companies have a product on the market.
According to the Congressional Budget Office, biopharma companies spend around 25% of their revenue on R&D, on average, a share which has doubled from 2000 to 2019 and is continuing to increase over time.
As an example, the famous Moderna (MRNA 1.06%) spent in excess of $1.9 billion on R&D in 2021, which accounted for 10.7% of its annual revenue of $18.4 billion, making it a relatively low spender proportionally.
There's just one big problem with rising research budgets. Each dollar spent on R&D isn't going as far as it used to.
Look at this chart:
Whereas every $10 spent on developing a new medicine might have credibly (eventually) led to around $1 in revenue from sales of that medicine in 2010, in 2019 it was closer to a return of $0.18.
And remember, most companies aren't Moderna developing a coronavirus vaccine in a crash program. The drug development process often takes upwards of a decade, so R&D investments made today might take quite some time to pay off.
There are quite a few reasons why the returns on R&D fell so sharply during the last decade, but the simplest reasons are actually the most frightening from the perspective of investors. Much of the low-hanging fruit has already been picked in terms of drug development, and what remains are the fruits higher on the tree.
In English, that means many of the conditions that are easy to treat with freshly developed drugs have been treated. So the remaining maladies require the development of more complex medicines (like biologics or antibody-drug conjugates) -- which are inherently more challenging to test, manufacture, and successfully implement.
Note that this paradigm does not imply biotechs are doomed to experience diminishing earnings or revenue over time as breakthroughs become harder and harder to come by. After all, companies can control the prices of their drugs, which allows them to target their preferred margins.
What this does mean is that the industry is becoming more capital-intensive. In turn, it'll be harder and harder for businesses with less cash to advance their pipeline projects with the funds they have. Expect biotechs to focus on fewer programs, and expect them to fight harder to wring regulatory approvals out of each program, even if the path might be fraught.
2. Bringing drugs to market is (almost) as expensive as ever
Despite the above, investors should also recognize that the price tag for moving one program from inception to commercialization isn't actually increasing by that much compared to early in the last decade.
Take a gander:
In practical terms, drugs that get approved tend to incur an average of $2 billion in costs to reach the market. Typically, most of those expenses are incurred in the clinical stage of development, as clinical trials tend to be extremely expensive endeavors.
To square this with the trend shown in the previous chart, it helps to keep in mind that the cost of successful programs doesn't appear to be increasing that quickly anymore. But, because failed programs are more common than ever, the rate of return on R&D is still falling.
Of course, it's possible that improvements in drug design and growing scientific mastery of biomedicine will reverse this trend.
But, for now, I wouldn't bet on it. That means if a company is running short on cash and clinical-stage programs at the same time, it often makes mathematical sense to avoid it, or at least to hedge the bet by diversifying across several different options.
And moving forward, investors will probably need to diversify their biotech investments more aggressively than ever.