I hate to do another post on this subject, after a good part of the week has been devoted to layoff news and the like, but this one is too much to ignore. A reader sent along this link, which quotes a Morgan Stanley appraisal of the pharma industry as an investment. Here’s what they’re telling their clients:
“. . .Still significant value in Pharma – we see material upside to ROIC [return on invested capital], earnings and multiples as Pharma withdraws from most internal small-molecule research and reallocates capital to in-licensing and other non-pharma assets. Worsening generic pressure and R&D management changes lead us to expect material cuts to internal small research spend (~40% total R&D) in 2010/11, after a decade of dismal internal R&D returns. We expect AstraZeneca and Sanofi-Aventis to be among the leaders in externalizing research, and this is a key driver of our upgrade of AstraZeneca today to Overweight.
Reinvestment of internal research savings into in-licensing will yield three times the likely return, we calculate. Under in-licensing deals, downside risk for pharma companies is currently materially lower than for internally developed drugs. Although upside is also capped by pay-aways and milestone obligations, the net present value of these payments is more than offset by the lower risk-adjusted invested capital. Over one-third of pharma R&D spend is in pre-phase II, where the probability of reaching the market is <10%. our proprietary analysis indicates that, unless the probability of an in-house molecule reaching the market is 30% or more, the risk-adjusted economic value added, or eva, is three times higher under the external research model, with a greater predictability."
It could be said in fewer words, but it’s all there. If you’re looking for the reason the big companies are doing what they’re doing, look no further. Agree with it or not, there’s a case to be made – and there’s Morgan Stanley, making it – that the cost of running new drug projects in big pharma is just too high relative to the risks of failure. Those returns, in fact, are calculated to be off by a factor of three.
You may not believe that factor, and I have to say, I found it hard to believe myself. But let’s say the Morgan Stanley folks have their numbers off. Perhaps it’s only twice as profitable to bring in outside drugs as it is to develop them internally. Don’t believe that one, either? Maybe it’s only 25% more profitable – can you imagine making a move that would increase your company’s return on investment by 25%? Industries get remade by such changes at the margin, and this one is remaking ours. Why do we have any internal R&D left at all, if those figures are anywhere near right?
Well, no one’s tried to run a large company entirely by in-licensing, and I think that there are a lot of reasons why that wouldn’t work. (For one thing, I don’t think that there are enough things to in-license, and if one or more large companies announced that they were doing that exclusively, the price of each deal would go right up). And there needs to be some internal expertise left, if only to evaluate those external drug candidates to make sure you’re not being taken. But still. All this means is that internal R&D will stay around, but it has to get cheaper and will very likely get smaller.
We can argue about the assumptions behind all this, but there’s no doubt that a compelling business case can be made for this world view. Anyone who wants to argue differently – and a lot of us do – will have to come up with solid numbers and reasoning for why it just ain’t so. I’m not sure such numbers exist.
There are many corollaries to this line of thought. One of them – and I hate to bring this up, considering all the horrible layoff news recently – is that one of the most psychologically comforting theories that we in R&D have for our present fix is likely wrong. I refer to the “Evil Clueless MBA CEO” theory, which has its satisfactions, but is a hazardous way to think. It is always dangerous to assume that people who do things you disagree with are doing them because they’re just idiots or because they’re innately malicious. In general, I’d say that the first explanation to jettison is malice, followed by stupidity (Hanlon’s Razor). What that leaves you with is that these actions, stupid and malicious though they may appear, are probably being done for reasons that appear valid to the people doing them. I know, I know – some of these reasons are things like “So I can keep my high-paying CEO job”, and we can’t ignore that one. But a good way to lose a high-paying CEO job is to try to tell your board of directors (and your shareholders) why you’re going to pass up an opportunity to get three times your ROIC.
Another thing to think about is, if these cost estimates are right, how did we get here? The best reason I can think of for such a disparity is that small companies (the source of these in-licensed drugs and projects) are often betting their entire existence on these ideas. They are very strongly motivated to do whatever they can do to get them to work (sometimes a bit too motivated, but that risk is already factored in), and if things don’t pan out, they usually disappear. Basically, the in-licensing world unloads the risk from the large pharma company (and its shareholders) onto the investors in the smaller ones. The cost disparity will exist for as long as people are willing to back smaller companies. Now, this isn’t to say that the big companies are always going to do a great job picking what to bring in. We’ve been talking a lot, for example, about the GSK-Sirtris deal, and that one may or may not work out. But the idea of doing big in-licensing deals in general – that’s a different story, no matter how any individual company manages to execute it.
What that also means is that more of us are going to end up working for those smaller companies (which is something that I, and several commenters around here, have been saying for a while). If the large pharma outfits are going to devote more money to in-licensing, there will then be more opportunities for people developing things for them to in-license. The rough part is that all these structural changes in the drug industry are taking place (largely by coincidence, I think) during economic conditions which make funding such companies difficult.
And then there’s the internal cost-cutting, for the R&D that’s actually staying at the big companies. That, of course, generally means sending a lot of it to China, or wherever else it can be done more cheaply. And that’s going to continue as long as it can indeed be done more cheaply, which means “not forever”. Costs are already rising in China and India, although they have a good ways to go before they catch up to the US and Europe. I know that we can argue about how well that whole idea is going to work – there are clearly inefficiencies to doing a lot of your work through outsourcing, but as long as those don’t eat up all the cost savings, it’s still going to keep happening.
This, as a side note, is why I think that one of the suggestions that gets floated here in the comments from time to time, the idea of forming a “medicinal chemist’s union”, is completely useless. Unions form when workers have the leverage to preserve a higher-cost business model. In the end, the big industrial concerns of the early 20th century had to have workers, and they had to have them in certain locations, so the unions always had the threat of going on strike. At attempt to lower the boom under these conditions would result in everything going to China, and damned quickly.
So. . .what’s happening to us, and to our industry, is not really mysterious. Our cost structure does not look to be supportable, and since there are cheaper alternatives that appear to be feasible, those will get tried. The disruption and destruction that all this is causing is real, of course. But the best I can offer is to try to understand what’s driving all this upheaval, because that might help people to figure out how to protect their own jobs or where to jump next. Everyone has to give this some serious thought, because I don’t see any reason why all this won’t keep going on for some time to come.