Last month, fellow Fool Ben McClure wrote the excellent article Rethinking Big Pharma, which presented several solid arguments as to why the pharmaceutical industry is a risky place to invest. I think Ben made some really good points, especially with regard to the increasingly high R&D costs to develop drugs and the risk of pricing pressures from politicians playing Santa Claus.
Of course, since I'm a biotech guy, I'm a big fan of the drug industry. For investors with a long-term focus, the drug industry can be a great place to invest. While Ben nailed all of the challenges facing the industry (I agree with nearly everything he said), there are also a lot of important factors that the drug companies have in their favor. With strong balance sheets and pre-existing marketing capabilities, the pharmaceutical companies play an essential role in getting many of the best-selling drugs to market. With all due respect to my good friend Ben, I don't see that fact changing anytime soon.
The rich uncle
Very few people would dispute that drugs are incredibly expensive to develop. It doesn't matter if you look at the study from the Tufts Center for the Study of Drug Development, which found that drugs cost $800 million to develop, or the article Rebuilding Big Pharma's Business Model from Bain & Company, stating that drugs cost $1.7 billion to develop, launch, and market. Either way, developing and launching a new drug costs a lot of money.
This raises the question as to whether or not small biotech companies can even afford to develop drugs independently or if there's a necessity to cozy up to a Big Pharma partner, such as Eli Lilly (NYSE:LLY), Merck (NYSE:MRK), or Pfizer (NYSE:PFE), with deep pockets?
I did a survey of 40 small biotech companies with market caps in the $100 million to $1 billion range to get a feel for the financial strength of the small guys. At the end of the second quarter, these companies had, on average, $150 million cash on hand. When compared to the cost of drug development, that's not a lot of money.
While small biotech companies can afford to develop drugs in areas such as cancer, it is much more difficult to finance drug development in indications, such as cardiovascular diseases or osteoporosis, where the FDA requires large and lengthy clinical trials. These trials that enroll thousands of patients and take years to run are solely within the financial capabilities and expertise of the large pharmaceutical companies.
Therefore, because of the fat balance sheets at the pharmas and the relative poverty of small biotechs, many compounds that are in development at a biotech company are going to end up in the portfolio of a pharma company. Essentially, this ensures that Big Pharma will always have a supply of drugs in its pipeline, despite what may be a lack of internal R&D productivity.
Marketing prowess
Successful promotion of a drug requires a multipronged approach that would be difficult for underfunded biotech companies to execute without taking on a lot of financial risks.
The most visible approach used is direct-to-consumer (DTC) advertising. If you haven't seen Bob Dole pitching Viagra, then you've been living in a cave. Running TV ads is expensive and only fits within the budget of a large pharmaceutical company. While DTC advertising is important, there are additional methods for promoting drugs where Big Pharma also has a distinct advantage.
An important component of a drug-promotion strategy is getting the product in front of the physicians that will prescribe it. Detailing physicians can require sales forces in the hundreds or even thousands of sales reps. Setting up a sizable sales force from scratch can cost tens of millions of dollars.
Small biotech companies just on the verge of launching their first product often can't take the financial risk of hiring a sales force. If the product hits a setback with the FDA, it would be quite a blow to have hundreds of employees sitting around with nothing to do except waiting to get laid off. Instead, the small companies mitigate this risk by partnering with companies such as the large pharmaceutical companies that already have established marketing infrastructure in place.
There is also the matter of launching a drug in international markets. Even large biotech companies that market drugs in the U.S. will frequently partner with the pharmas for international distribution. A few examples are Genentech (NYSE:DNA) and Millennium Pharmaceuticals (NASDAQ:MLNM), which have partnered with Roche and Johnson & Johnson (NYSE:JNJ), respectively. The bottom line is that the pharmas are essentially the only companies that can fulfill this role, because the costs of setting up international operations would be prohibitive for many smaller companies.
Aging populations
It's an unfortunate fact that the elderly are hit hardest with maladies such as cardiovascular disease, osteoporosis, and Alzheimer's, all of which require extensive use of drugs. And we know who is responsible for the marketing of drugs to treat these diseases. Yes, it's Big Pharma.
As the demographic time bomb continues to tick in Big Pharma's main markets, drugs targeting the elderly will continue to proliferate.
While Ben mentioned the very real threats to Big Pharma's profits by price controls and competition, I would argue that the increasing market size due to demographic trends in our population could very well offset those downward pressures on drug prices.
Foolish takeaways
There are definitely major threats to the profitability of the drug industry. Governmental meddling, skyrocketing R&D costs, stiff competition, and loss of patent protection on major products are very real concerns for those of us that invest in drug companies.
Perhaps because of this combination of influences, the pharmaceutical companies will no longer be a vehicle for superb investment returns. However, the other side of the coin is that there are quite a few aspects of the drug industry business model that work to the advantage of Big Pharma.
Primarily, there are key functions in the areas of drug development and marketing that can be incredibly expensive to execute. This serves as a moat protecting the businesses of the pharmaceutical companies, which makes it very difficult for small drug companies to go it alone.
While some industries come and go, the drug industry is not in as bad shape as the airlines or the auto industry, and it is not likely to disappear anytime soon. Since I much prefer to look at the merits of companies on an individual basis and not on the industry as a whole, I think that certain drug companies will continue to thrive for a long time and remain viable options for investors looking for long-term holdings that can beat the market.
To read more by Charly on the biotech industry, check out his recent articles:
- Surviving Biotech's Downturns
- What's a Drug Worth?
- Biotech's Full Monte
- Unraveling Biotech Potential
- Don't Be a Biotech Gambler
Fool contributor Charly Travers does not own shares of any company mentioned in this article. The Motley Fool is investors writing for investors.
