More R&D: Not Boosting Big Pharma

Despite stepped-up levels of research spending, drug outfits are launching fewer new products, says S&P

By Herman Saftlas From Standard & Poor's Equity Research

Drug industry R&D spending, by U.S. members of PhRMA, an industry trade group, expanded 20% from 2004 through 2007. Yet the number of Food & Drug Administration-approved new molecular entities and novel biologics declined from 36 to 18 over the same period. This attrition occurred despite important advances in R&D technology platforms, such as rational drug design and genomics earlier in the decade.

The relative strength of new launches, as measured by initial 12-month sales, has also deteriorated in recent years. According to data provided by IMS, a health-care researcher, 12-month sales of the top-10 new chemical entities fell to between $120 million and $130 million in 2007, down from nearly $300 million in 2002-4.

S&P also believes that generic companies have become much more aggressive in challenging branded patents, as well in launching generic rivals "at risk," which means before patent litigation with branded companies is resolved.

No Help from a Strong Dollar

S&P forecasts sales growth in the low-to-mid single digits, and operating earnings-per-share growth in the mid-to-high single digits for the large-capitalization pharmaceuticals industry in 2008-09. This compares with average sales growth of about 10% and operating earnings growth of 12% in 2007. One caveat to our 2009 sales forecast is that foreign currency translation will probably not provide quite the boost it has in recent years, as the dollar has strengthened against most other world currencies for at least six months now.

Aggressive efforts to contain costs (by government and third-party payers, both in the U.S. and overseas), and a decline in the influence of large sales forces (as new marketing strategies emphasize niche specialty products) are also likely to hurt sales growth. In addition, Medicare Part D is completing its third year of operation. As enrollment stabilizes, the program's contribution to revenue growth should be lower than it was during its start-up phase in 2006 and 2007.

Furthermore, we believe the sector is operating under much tougher scrutiny from the FDA—both in terms of approving new medicines and monitoring pharmaceutical advertising—than it has in past years. Finally, we think the uncertain political horizon is not encouraging for the sector. Earnings, however, should benefit from aggressive cost-cutting initiatives and common share buybacks.

Although we believe the pharmaceutical industry's long-term prospects remain favorable, it is undergoing a multiyear transformation. Underperforming R&D and increasingly fierce price competition from generics have forced the industry to change. Big Pharma continues to struggle, even as small biotechnology companies have made stellar progress.

Merger Mania

In the past three years, large pharmaceutical companies have responded by merging, forming alliances, buying biotech companies, litigating against generic competitors, and cutting costs. Recent acquisition activity has been focused on smaller biotech firms with promising R&D profiles. S&P believes these responses could help mitigate some of the effects of generic competition and improve new product pipelines in the next three to five years.

After a relative lull in 2007, merger and acquisition activity increased substantially throughout the pharmaceutical and biotechnology sectors during 2008, partly spurred on by declining stock prices that rendered deals more attractive. The first big deal of the year was Takeda Pharmaceuticals of Japan's purchase of U.S. biotech Millennium Pharmaceuticals for $8.8 billion in May.

Takeda was looking to expand its sales base to help offset the upcoming expiration of its U.S. patents on its popular ulcer treatment Prevacid in 2009, and diabetes drug Actos, in 2011, and chose Millennium for its blood-cancer drug Velcade, which Takeda hopes will eventually achieve blockbuster status. Another big deal was AstraZeneca's (AZN) 2007 acquisition of MedImmune, one of the top 10 biotech companies in the U.S., for $15.6 billion.

The deals underscore the need for big drug companies to expand more aggressively in biotechnology, which is faster growing than pharmaceuticals and also not presently vulnerable to generic competition. Given their strong cash positions, drug giants are also well situated to complete cash acquisitions without having to rely on external debt financing in the present constrained financial marketplace.

Analyst Saftlas follows shares of pharmaceutical companies for Standard & Poor's Equity Research Services .