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.

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:

• These pharmas still have cash to license drugs.
• Increasing dividends are usually a good sign.
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