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By Tony D’Altorio

Big pharmaceutical companies seem to be taking tips from an unlikely source these days.

A decade ago, big mining companies had a big problem on their hands in the form of declining prices. With less incoming funds to spend on finding new deposits, they started thinking creatively… They let small entrepreneurial companies handle early-stage exploration, a difficult task in remote parts of the world. Then, if those operations struck it rich, the big miners swooped in to buy them out.

Drug development might not seem like it has much in common with such ventures. But it involves the same high-risk, high reward discovery efforts.

So the pharmaceuticals are going for the gold as well with this new approach. Cutting back on in-house research and development (R&D), they’re hiring contract research organizations (CROs) like Covance (NYSE: CVD) instead.

Big Pharma’s Outsourcing Deals

Convance landed its first such deal in 2008 through a 10-year agreement with Eli Lilly (NYSE: LLY). That landmark, $1.6 billion contract set it in charge of much of LLY’s service facilities in Indianapolis.

Sanofi-Aventis ADR (NYSE: SNY) chose the same route last month, though for $2.2 billion. So Covance now has the next ten years to improve Sanofi’s Porcheville, France and Alnwick, UK R&D productivity sites.

Now, GlaxoSmithKline ADR (NYSE: GSK) has taken up the trend too. It is moving 14 researchers and several patent rights to Convergence Pharmaceuticals, in exchange for an 18% equity stake.

The larger company hopes to cut R&D costs that way, thus boosting productivity. And, if all goes well, it can simultaneously benefit from any drugs Convergence develops.

Earlier this year, GSK made a similar move by selling its research unit that focused on depression. It – and other big pharma companies – has very good reason to do so too…

Scientist salaries make up a very high proportion of the billions of dollars spent each year on R&D. More often than not, the actual businesses receive little back terms of new blockbuster drugs.

Most investors also know by now that many big pharmaceuticals face impending patent expiry on existing products. So those companies are now restructuring, including outsourcing of both clinical services and research in order to boost productivity.

And “as consolidation in the industry continues, there is going to be a lot more of these types of relationships,” according to Aptuit CEO Tim Tyson.

He believes that a company like GSK, for instance, normally handles 200 molecules a year. But he can offer better productivity for a range of clients, processing an annual 2,000 molecules.

Will Outsourcing Work?

Contracting out services seems an obvious area for big pharmaceuticals to save. It should also easily boost their earnings over the short term.

But what about over the long-term? Outsourcing research could actually backfire on them, lowering the number of new drugs available to replace those with expiring patents.

More than likely, they’ll come to rely increasingly on smaller, poorly funded external biotechnology companies to conduct early stage drug development.

Thompson Reuters produced a study earlier this year that cautioned against such projects. It showed them receiving lower rates of regulatory approval than “self-oriented” products from large companies.

Also against them are the very mining companies’ track records they’re trying to emulate. Many of the small, high-risk businesses in that sector found it very difficult to raise funding.

They went out of business, forcing large miners to increase their in-house exploration budgets again. But that’s a risk struggling pharmaceuticals are apparently willing to take.

Many businesses within it have lost money for investors in the past. But some industry insiders think that big pharma has what it takes to lead them out of that slump.

They believe that an increase in experimental drugs divested from those giants and a squeeze on funding will result in a focus on only the most promising drugs. Or as Bernstein Research analyst Jack Scannell says, “Small groups focused on big problems can deliver more.”

Pharma Outsourcing Investments

The new philosophy of the major pharmaceutical companies does look set to continue regardless. And it could work out very well for them in the end.

Then again, it might not. So avoiding them altogether remains the safest play. Instead, CROs like Covance look much more worthwhile.

Some of its noteworthy competitors include:

  • Charles River Laboratories International (NYSE: CRL)
  • Pharmaceutical Product Development (Nasdaq: PPDI)
  • ICON Plc ADR (Nasdaq: ICLR)
  • Chinese firm WuXi PharmaTech (NYSE: WX)

As business continues to flow their way, their bottom lines will rise… and so will their stock.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.

Disclaimer: The Oxford Club LLC/Investment U and Stansberry & Associates Investment Research are separate companies, and entirely distinct. Their only common thread is a shared parent company, Agora Inc. Agora Inc. was named in the suit by the SEC and was exonerated by the court, and thus dropped from the case. Stansberry & Associates was found civilly liable for a matter that dealt with one writer's report on a company. The action was not a criminal matter.

Source: Big Pharma Begins Outsourcing Research and Development