Big Pharma's Response to R&D Woes: More Early-Stage Compound Deals

The earnest tone of the discussions at this year's Pharmaceutical Strategic Alliances Conference reflected an increasingly common assumption among industry executives and insiders: the drug industry's growth problem isn't a merely cyclical issue. Declining productivity, a problem evident in biotech companies as well as Big Pharma, is to blame. Industry executives provided mixed opinions on how to best tackle this challenge, but both Pfizer and Bristol-Myers Squibb suggested a trend towards early-stage compound licensing.

The earnest tone of the discussions at this year's Pharmaceutical Strategic Alliances (PSA) Conference held in New York City reflected an increasingly common assumption among industry executives and insiders: the drug industry's growth problem isn't a merely cyclical issue. Forecasts for flat or single-digit earnings growth are widely accepted. Worse, confidence in the industry's projections – once one of the sector's greatest investment assets – has disappeared. "The whole aura of predictability has melted away for Big Pharma," remarked Arnie Snider, General Partner, Deerfield Management. "It will take a while to get this back."

The fundamental cause, noted speaker after speaker, is declining R&D productivity.

McKinsey & Co.'s Rodney Zemmel, PhD, quantified the decline by presenting the results of a study which tracked the number of products entering the clinic for the top 15 pharma companies from 1991-2000. Zemmel found that R&D productivity, which takes into account the number of products and R&D costs over time, fell by 25% between the first five years (1991-1995) and the next (1996-2000).

The productivity problem is only likely to be exacerbated when firms work on new targets, noted a number of speakers. (See "Testing Drugs Against New Targets: Like Playing Blind Man's Bluff?" IN VIVO, October 2002 (Also see "Testing Drugs Against New Targets: Like Playing Blind Man's Bluff?" - In Vivo, 1 Oct, 2002.).) For example, Scott Sacane of Durus Capital, pointed out that the dismal historical success rates of clinical trials (1 in 10 at Phase I, 1 in 4 at Phase II, and 1 in 2 at Phase III) mostly involved drugs against validated targets. He asked: "What are the probability and success rates going to be with novel targets going forward?"

Pouring additional monies into R&D spending seemed a solution to no one. For Kenneth Weg, former vice chairman of Bristol-Myers Squibb Co. , the problem is managerial and bureaucratic. He proposed a radical solution: deconstruct Big Pharma and create publicly-traded spin-offs by therapeutic area.

In his view, Big Pharma companies aren't driven by competitive pressures of the marketplace when making major R&D funding decisions. "These organizations develop momentum and they get funded every year," remarked Weg. "There is no competitive dynamic that determines the size of the funding and how many programs they should be working on." Weg feels that spin-offs create more potential for growth and will ultimately force the core company to "think long and hard about the kind of science, programs, and areas [in which] to invest R&D money."

But others disputed the potential for spin-offs to promote growth. Norm Fidel, SVP at Alliance Capital, argued the duplication of expenses would handicap such spin-offs. He cautioned that a full assessment is necessary. "Just to say that we are going to break Merck up into ten pieces doesn't make any sense to me," noted Fidel. "There may be one piece of that company that may make good business sense being alone, but I don't think that you can categorize it one way or another. It gets down to the specifics."

Indeed, smaller and more focused organizations aren't necessarily more productive. An additional analysis by Zemmel of 15 biotech companies shows no strong correlation between smaller organizations and higher productivity (see Exhibit 1). In fact, it suggested that the declining productivity at biotechs indicates that they are encountering the same problems as Big Pharma.

Still, the most frequently applied response to the R&D drought has been the heightened competition for late-stage in-licensing deals. But as the costs of such deals have skyrocketed, some of the most aggressive late-stage dealmakers indicated at the conference that they are changing their in-licensing targets.

Alan Proctor, PhD, VP of strategic alliances at Pfizer Inc. , suggested the industry will move in the direction of early-stage compound (i.e., pre-clinical to Phase I) deal-making. He cited another McKinsey analysis which supports this vision, and even though he stressed that Pfizer would "continue to pursue late-stage licensing with all of the vigor demonstrated in the past," he was clear that it is Pfizer's objective to execute more early-stage compound deals. (See "Why Pharma Needs to Do Early-Stage Deals," IN VIVO, September 2002 (Also see "Why Pharma Needs to Do Early-Stage Deals" - In Vivo, 1 Sep, 2002.).) Tamar Howson, SVP of corporate and business development for Bristol-Myers Squibb, made a similar point, noting her company's desire to get "more shots on goal."

So far, though, there has been little early-stage activity in part, suggested Proctor and Howson, because the deal-making economics aren't clear with these still very risky projects. Roche is the only Big Pharma firm to venture aggressively into this territory while others seem hesitant about how to appropriately structure deals. Howson closed her presentation by saying that "deals need to be risk-sharing with biotechs so that all of the burden is not on the balance sheet of Big Pharma." (See "Roche Bucks the Trend, with Early-Stage Deals" IN VIVO, October 2002 (Also see "Roche Bucks the Trend, with Early-Stage Deals" - In Vivo, 1 Oct, 2002.).) Proctor also emphasized this point: "We have a strong business driver that says we can't afford to invest in a portfolio of 25 to 30 early-stage compounds to make sure one or two gets to the market."

To some extent, such public remarks signal the opening of negotiations: drug companies indicating a desire for products in which they have hitherto shown little interest but for which they are unwilling to see prices rise as abruptly as they have for late-stage compounds. In pricing deals, they will certainly be able to exert significant leverage over cash-strapped biotechs that may not be able to fund their pre-clinical products' progress through later stage trials on their own.

But biotechs, in particular those with substantial cash, are also positioning themselves for negotiations. For example, in his presentation on corporate reinvention, Tony White, chairman & CEO of Applera Corp. , noted that the changing business model at Applera tracking stock Celera Genomics Group , has forced it to try to hold on to its products longer until it can prove their value. Celera Genomics – no longer a database provider but a product-focused biotech company – will partner with pharma, but White maintains the relationship must be on an equal footing in order to generate an acceptable return to shareholders. He cited the joint venture between Celera Diagnostics and Abbott Laboratories Inc. as an example of this commitment – both companies will share R&D, manufacturing, and marketing expenses, and split profits evenly as they collaborate to develop new in vitro molecular diagnostics [See Deal]. Big Pharma may want access to earlier stage drug programs, but the price will have to be preemptively high or the risks will have to be shared to allow companies like Celera a way to gain an equal share of proceeds.

In short, the fulcrum balancing the P&L risk in biotech and Big Pharma deals – now favoring the out-licenser in late-stage deals – is still sliding uncertainly under the see-saw as early-stage compound deals become more popular.