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With regulatory costs skyrocketing for biotech companies as FDA clinical trials continually become more onerous and expensive, it is the biggest companies with the heaviest cash flow that have the easiest time adapting, and the smallest ones with the least ability to jump government hurdles that suffer the most. Given the rich-get-richer environment this has fostered in the pharmaceutical industry, how can little pharma ever break through? Let's begin with what is actually making the drug regulatory process so expensive in the last decade.

In an eye-opening piece published last April, Forbes breaks down the percentages of research and development costs for Big Pharma and how gargantuan these companies have become over the last 10 to 15 years. Most of these costs, writes the author Avik Roy, have to do with one specific aspect of the pipeline - phase III.

Overall, Phase III trials now represent about 40 percent of pharmaceutical companies' R&D expenditures. But this often-cited statistic actually understates the gravity of the burden. This is because overall R&D expenditures include all pharmaceutical candidates that a company tests-including hundreds that never reach the Phase III trial stage. When we confined our analysis to those drugs that actually get approved, we found that Phase III clinical trials typically represent 90 percent or more of the cost of developing an individual drug all the way from laboratory to pharmacy.

Phase III trials have become bigger, more complicated, more restrictive, and more time consuming as the years pass. Why should this be so? Is medical technology really getting all that more complicated that progressively more restrictive phase III trials are the only thing standing between global health and a renegade pharmaceutical industry intent on poisoning the human race with wildly experimental drugs?

No. There are, in my opinion, two primary reasons that are opposite sides of the same coin. The first is that regulating and restricting and thereby being able to control entire multi-billion dollar industries by force is, for the average government bureaucrat, a total thrill. This may sound tongue-in-cheek, but an infamous quote by one Marthe Kent, the Occupational Safety and Health Administration's (OSHA) New England regional head, put it this way, "If you put out a reg, it matters. I think that's really where the thrill comes from. And it is a thrill; it's a high…I love it; I absolutely love it. I was born to regulate. I don't know why, but that's very true. So as long as I'm regulating, I'm happy."

The second reason is that the biggest companies stand to gain most from more restrictions. While bureaucrats get a thrill regulating, Big Pharma encourages it. Think about it this way. A huge company can spend money competing with smaller companies, which requires competitive pricing, higher quality, and intensive marketing, and brings with it the risk of being pushed out of the market by smaller companies with better products and tighter operations. Or it can spend a fraction of the cost lobbying for more government hoops, pay for the hoops with some of its extra cash flow, and not worry about too much competition from newcomers. And if some scrappy start-up has a new idea, Big Pharma can always "lend a helping hand" through the hoops it helped create and in that way take most of the revenues for itself in a partnership.

But it goes deeper than that. While government via the FDA makes drugs more expensive on the supply side, government also subsidizes the demand side with prescription drug programs like Medicare Part D and soon-to-be Obamacare. The investment picture this creates is, and I hate to say it, buy the right companies and you'll get a slice of this boondoggle.

How much of the gravy train you'll get varies from company to company. Three of the most generous also happen to have the most pipeline drugs in phase III this year: Novartis (NVS), Roche (RHHBY.OB), and Sanofi-Aventis (SNY). I will not go out on a limb and say that in terms of capital growth, these are great picks. These stocks are all inches away from all-time highs and would not be a good trade. But if you want a place to park money for the long term and earn income, these are among the best to hold in the industry for stability and dividends.

Let's start with Novartis. Novartis' last dividend was a very generous $2.48 per share annually. That's 4.6% per share since last dividend, and totals over $6B in dividends, which was an impressive 62% of its 2012 income. It spent close to $7B (page 50) in research and development costs in 2012, with around 20 drugs (pages 32-35) currently in phase III trials. No small cap would be able to afford such largesse, but that number is only 12% of its annual revenue. With government keeping out competition and subsidizing consumption, Novartis is sailing the corporatist sweet spot. At least it is nominally returning the favor to its shareholders with a dividend large enough to offset the risk of holding a stock that is near its all-time highs.

Roche comes up right behind Novartis with 19 drugs in the pipeline at the all-expensive Phase III. It spent a similar amount of money on R&D as Novartis did at a hefty $8B, which was about 17% of its 2011 revenue. RHHBY is at a similar juncture as NVS. Nearing all-time highs and sailing in the same protected sweet spot. At a $1.84 dividend it is also quite generous with its shareholders, totaling 4.27% per share annually, a total amount of $6.355B forked over to shareholders, which totals just under 60% of its 2012 income, just shy of Novartis' 62%.

Finally we have Sanofi. Its latest dividend was $1.69 a share, or 4.7% annually as of last dividend. Total money spent on shareholders was $4.46B, totaling just over 60% of 2012 income. Novartis beats out both Sanofi and Roche in terms of percentage of income paid out, Roche beats both the others in absolute terms of money paid to shareholders, but Novartis still pays the most per share. So take your pick.

Sanofi spent $6.5B, or 14.3% of its annual revenue in research and development with 14 drugs (page 52) in the pipeline at Phase III. Sanofi's best-selling drug and biggest money maker is Lantus, an insulin supplement for diabetics, which is certainly benefiting considering that diabetes cases have doubled in the past decade. SNY is in much of the same boat as NVS and RHHBY. Right near all-time highs. These Big Pharma stocks tend to trade in unison (see 5 year Google chart below), and it is next to impossible to predict which will be the best in terms of capital growth (probably none) so my advice for a balanced income portfolio of Big Pharma is to hold in proportion to what the companies pay out. The stocks will go up and down, but you'll keep earning money as long as you hold.

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Given the enormous size of Big Pharma and the out of control prohibitive cost in time and money of clinical trials, how is it possible for any small company to break through in this kind of environment? The answer is it's almost impossible, because Big Pharma usually sponsors these clinical trials of smaller companies in exchange for its soul, meaning 90% or so of the revenues from the new drug. But there is a drug candidate I see as potentially enabling its creators to break free independently and broaden the too-big-to-fail pharmaceutical market just a bit.

That drug is NVC-422, or Aganocide, developed by microcap NovaBay (NBY). Before I get into specifics, let me say that the future of this company depends on the success of this product candidate and while evidence is encouraging, failure of NVC-422 to pass clinical trials will mean trouble for NovaBay and its investors.

That said, NVC-422 is currently in phase II/III development for methicillin resistant impetigo as well as viral conjunctivitis. Aganocide is a first of its kind antibiotic molecule based on the human immune system itself that, according to NovaBay, virtually does not allow pathogens, both viruses and bacteria, to develop resistance. What makes NVC-422 a special case is that it can theoretically be applied to many pathogens, and not just one disease. NovaBay is indeed taking Big Pharma money from Galderma, a private dermatological operation sponsoring NVC-422 for impetigo.

However, this is only for one potential application of the drug. If the impetigo trials succeed, NovaBay will have lots of breathing room to stake out territory on its own for other NVC-422 uses. And if these viral conjunctivitis phase III trials succeed as well and the investment community gets word on the success of NVC-422 for more than one disease, then investors themselves will "sponsor" the next clinical trials so to speak, allowing NovaBay the rare opportunity of breaking away from Big Pharma and making it on its own. Top line results on viral conjunctivitis will be available in the 2nd half of 2013. If the results are positive, there could be fireworks.

Conclusion

In today's regulatory environment, it is nearly impossible for small companies to make it in the pharmaceutical space without selling out to bigger companies. The safest thing to do with the market reaching new highs is to park money with the most generous companies and get a slice of the benefits of over-regulation. For a riskier move with much more potential reward, look for a paradigm shifting multi-use drug sponsored by Little Pharma such as NovaBay's Aganocide that has the potential of giving a small company a big independent sponsor-free push through the regulatory hurdles.

Source: How Big Pharma Gets Bigger, And What Little Pharma Can Do About It