Reworking the Broken R&D Model

Normally, competition in innovative industries is good for everyone. Consumers win, because it usually results in better products, and investors can win big if they can identify the superior product.

But for drug development, it's becoming increasingly clear that competition isn't always the best thing for the industry. When several companies research the same drug target, duplicate costs are inevitable. Considering how many compounds get thrown in the trash before ever becoming marketed drugs, overlapping searches waste a lot of research and development dollars. With growing pressure to lower health-care costs, companies will need a way to decrease the cost of developing drugs, or their operating margins will surely suffer.

Combining forces
Collaborations have always been a mainstay of drugmakers, usually with small development-stage drugmakers doing the research and early work in the clinic, and then pharmaceutical companies taking over the heavy lifting for phase 3 trials and marketing. Those deals will surely continue, but I think we're going to see pharmaceutical companies sticking their hand in the cookie jar earlier in development.

We're likely to see more development-stage deals like the ones GlaxoSmithKline (NYSE:GSK) has done, or this week's partnership between Merck (NYSE:MRK) and Belgium's Galapagos to develop drugs for inflammatory diseases. The smaller companies may not need much help in determining the next step scientifically, but the bigger partner could offer advice on which compounds might be marketing successes, and which potential losers could lower costs if ditched earlier in development.

We may even see some rivals hook up to decrease risk and speed along development. Isis Pharmaceuticals (NASDAQ:ISIS) and Alnylam Pharmaceuticals have done this by forming Regulus Therapeutics. The joint venture is developing microRNA (miRNA) therapeutics, a relatively new class of drugs for which teamwork from the two companies is expected to lead to faster, cheaper discoveries than if the two companies had gone it alone.

Making good drugs better
In addition to hooking up at the discovery level, companies will likely continue to collaborate to make current drugs even better. For instance, Bristol-Myers Squibb (NYSE:BMY) and Gilead Sciences (NASDAQ:GILD) have combined their HIV drugs into one pill called Atripla. The research required to design the drug was minimal, and five years after setting up the partnership, the drug's a blockbuster. Glaxo and Pfizer (NYSE:PFE) look like they're following suit by starting a joint venture that can develop HIV combination pills.

The convenience factor for patients, something Gilead has worked hard on, should also play well for drugmakers that specialize in making extended-release drugs. Companies like Alkermes -- which has helped make extended-release formulas of Johnson & Johnson's (NYSE:JNJ) Risperdal and Amylin Pharmaceuticals' Byetta -- should be able to get lucrative deals from drugmakers looking to cheaply extend the lives of their products. As long as the extended-release formulations offer real improvement for the patients -- and I'd call it an upgrade to go from two needle pokes a day to one a week, as is the case for Byetta -- then patent expirations and generic competition for the original formula shouldn't be as much of a problem.

Patent pools
Some drugmakers have taken the collaboration efforts to even greater extremes, suggesting that companies pool their patents together to develop drugs. Johnson & Johnson and Glaxo have been most vocal about the idea, but it seems that most of the patent donations will come in areas where there's probably not much money to be made anyway, like tropical diseases.

I'm not convinced that this will be a major contribution to drugmakers' revenue, but it could help patients get drugs that wouldn't otherwise be developed, which could in turn help pharma's negative public relations rap. Plus, if big pharma sees this strategy working successfully, they could be motivated to extend the idea, moving toward a more "open source" model for R&D.

Foolish lesson for investors
As the government continues to pressure health-care companies to lower costs, investors will be left with two choices to deal with the lower margins: find an alternative industry to invest in, or find companies that can work with the new system.

Some drug companies will be able to keep margins up by developing drugs that knock the socks off the competition, but the rest will have to find a way to decrease R&D costs in order to compete. Keep your eye open for the ones that have what it takes.